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A reporter uses a Blackberry device to photograph Blackberry CEO John Chen as he speaks to reporters following their annual general meeting for shareholders in Waterloo, Canada in this June 23, 2015, file photo.

MARK BLINCH/REUTERS

One of the biggest determinants of whether a company will be a profitable investment lies in the strength of its management team.

This team is made up of highly talented, driven individuals who steer the organization's strategies. Because these individuals can have a huge influence on a company's success, it is important to highlight that improperly compensated executives may have the potential to cost shareholders dearly.

As investors, how can we ensure that the actions of executives are aligned with the interests of shareholders? How can we determine if executive compensation will aid or hinder a company's success? This is where analyzing management compensation structure comes in and why it matters.

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According to Canadian Business, the top 100 highest-paid CEOs in Canada now make, on average, $9.2-million a year, more than 190 times the average Canadian's annual income of $47,358. The Canadian Centre for Policy Alternatives states that BlackBerry's CEO John Chen took the No. 1 spot in 2014 with a total pay package of $89.7-million.

It might surprise those unfamiliar with modern executive compensation to learn that Mr. Chen's actual base salary is only $351,452. The remaining lion's share of the $89,373,567 takes the form of "other compensation" which includes bonuses, shares, options, pensions, and other financial perks.

Can this level of compensation be at all justified? And why is there a disparity between salary and total compensation?

At Mawer, we examine a company's compensation plan by asking these two questions:

1. Is the overall level of compensation reasonable, given the value created by the company and the difficulty of attracting the level of talent needed to run that particular organization?

2. Are the incentives aligned properly?

To answer these questions, let's first dig into what executive pay packages for publicly traded companies typically include:

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- An annual fixed cash salary

- Short-term incentive plans (STIPs) – a variable cash bonus

- Long -term incentive plans (LTIPs) – deferred compensation for tax purposes, including Restricted Stock Unit (RSU) options (company stock received through a vesting plan and distribution schedule after achieving required milestones)

- Executive pensions

- "Golden Parachute" packages – lucrative benefits received if terminated (may include stock options, cash bonuses and generous severance pay)

- Executive perks

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Altogether, these multiple avenues of pay lead to the very generous total compensation numbers the top 100 CEOs in Canada earn. But what is reasonable?

At Mawer, we feel that most packages appear too high in relation to the value created for shareholders by any single individual when compared to the risk borne by the providers of capital (shareholders). Further, these compensation packages are often based on what we believe to be a flawed model of comparing compensation to others in similar roles, which creates a ratchet up effect over time.

This is not to say that we believe no executive deserves their pay. Rather, we hold executives to a very high standard for the compensation they earn. Specifically, we examine a company's track record of wealth creation by looking at performance metrics such as return on invested capital (ROIC), return on equity (ROE), and earnings per share (EPS) growth over an executive's tenure. If a management team is indeed creating shareholder value, we feel it is fair that a portion of that value is paid to that team in compensation. You pay for good performance.

So how about alignment?

As with BlackBerry's CEO, John Chen, an increasing number of executive's compensation is comprised of LTIPs. Compensation theory suggests that management teams are more incentivized to act on behalf of the owners (the shareholders) if you bring them into the tent, so to speak, and that's why we have seen share-based compensation become an increasing part of overall management compensation.

Rather than giving a CEO a million dollars of cash per year as compensation, give her half a million in cash and half a million of some combination of shares, stock options, share unit plans, restricted share units, performance share units, or deferred share units. We generally like to see the annual cash salary for CEOs be less than half the total compensation because we want poor performance to be punished and good performance to be adequately rewarded. This creates alignment.

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However, not all forms of share-based compensation are created equal. Specifically, there also needs to be an awareness of the potential misalignment of interest created by a preponderance of stock options and other forms of compensation that don't necessarily reward good long-term wealth creation.

Alignment is achieved when elements of the compensation package are linked to wealth creation, and ultimately, long-term share price performance. If wealth is created, shares eventually go up, and so does the executive's personal remuneration. However, measures need to be in place to prevent reckless actions by executives simply to affect share price spikes for shorter term gain.

Ideally, all actions should be focused on long-term benefits for the company, the shareholders and the management team, as a whole. Options increase in value faster than shares when a stock goes up, but stop decreasing in value if a stock goes below the initial option issue price. This creates high reward but lower risk over the term of the option. Executives with options, therefore, could be incentivized to take on undue risk for shorter-term gain which could be to the detriment of the company over the long-term. Therefore, options are our least-preferred form of share-based compensation.

"Say on pay" proxy votes coordinated through management information circulars serve as an accountability mechanism for Canadian shareholders, providing them with an opportunity to voice concerns with executive compensation practices. At Mawer we make a point to invest in companies with good management teams, but that doesn't mean we won't vote against them in a proxy. Having a good board of directors and management team does not mean we will necessarily agree with every aspect of what they do, and one area that we often find ourselves not in alignment with the board of directors governing the companies we invest in is management compensation.

Our view is any board that has moved down the path of compensating their management teams with some level of equity/linked security is probably a good thing. Our stance on executive compensation has generally been that options are not the greatest incentive and that stock ownership is better for achieving that desired alignment.

We believe in compensation packages that are competitive enough to attract talent, promote alignment with shareholders, and are tied to various performance metrics that create wealth for shareholders over the long term. We find many compensation plans used today don't exhibit these characteristics. Most plans appear too high for the value created for shareholders by any single individual and are based on what we believe to be a flawed model of comparing compensation to others in similar roles. Constellation Software is a good example of a company we like because it has chosen to align its managers. The CEO draws a $1 salary and they don't use securities to link the alignment. Instead, all their key managers are shareholders with a genuine stake in the company's success, earned through years of share-based compensation.

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Ultimately, we do believe we should fairly pay those most responsible for growing revenue, reducing cost and risk, and allocating capital for the shareholders. And the closer a management team's compensation is connected to the long-term growth of a company's share price, the greater the likelihood of success for all concerned.

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Jeff Mo is a Portfolio Manager at Mawer Investment Management Ltd., which he joined in 2008. He is the lead manager of the Mawer New Canada Fund and Mawer's Canadian small cap mandates.

Jason Brink is the Content Specialist at Mawer Investment Management Ltd. with over 20 years of editorial and writing experience.

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