The Hard Part About Investing

When I contemplate a potential investment, one of the hard decisions to make is defining the point at which a management team’s executive compensation becomes so excessive that it ought to deter investment.

So far in my life, the only stock I ever disqualified from consideration solely on the grounds of excessive compensation was Occidental Petroleum, where Ray Irani was doing things like collecting $76 million pay packages here and there. He’s gone now, but you can read about some of his collected spoils by clicking here.

lIn addition to executives given lavish pay packages, there is the fact that some stock options come with low performance hurdles. For instance, I was reading this article on the St. Louis Post-Dispatch website about the new President and Chief Operating Officer at Peabody Energy. Per the Post-Dispatch article, this is what Glenn Kellow has to do at Peabody to get his stock award:

To collect on the $2 million in restricted stock, though, he needs a little help from the stock market. Half of the shares vest only if Peabody’s stock price, plus dividends, rises by at least 20 percent within the next four years, and stays at that level for at least 20 trading days. The other half of the shares vest only if the stock delivers a 40 percent return within five years.

Let’s break that down into the annualized terms that our brains are wired to think in—the first bonus occurs if he can get a 20% rise within 4 years, which amounts to a compounded annual growth rate of 4.6635%. To collect on the rest of his bonus, he needs a 40% return within five years, which amounts to a compound annual growth rate of 6.9610%. My problem is that there is nothing exceptional about those figures—the S&P 500 grew by 10% for most of the 20th century. Why are giving someone substantial benefits if he delivers shareholder returns that are substantially worse than what a large collection of 500 American businesses did on average during the past century (as an FYI, the 10% figures refer to the 1926-2006 stretch). The press releases dress the figures up by using phrases like 20% or 40% to create the illusion of impressive performance, but that is just a trick that uses basic compounding over medium periods of time to cloak the low hurdle of the stock award.

And it’s not that I have a problem with high executive compensation—if Charlie Munger demanded $100 million next year at Berkshire on the grounds that his insights will generate substantially more profits than he received in compensation, I wouldn’t blink an eye if I were a Berkshire shareholder. The best deserve to be compensated for the services they provide—the problem is when shareholders have to cough up substantial amounts of cash for managerial talent that lacks the whole “talent” part of the equation.

Like almost everything else with investing, this is more art than science—do you sell Coca-Cola stock if the management team makes $200 million? $500 million? $1 billion? I don’t have answers to that question that will leave you satisfied, but I can share with you what I do: I keep an eye on the total shares outstanding because that determines how many others you will have to share the profit pie with. If the share count is rising by about more than 5% or so per year and the company is not making any corresponding acquisitions, then I would seriously consider moving my money elsewhere. If you can see your share of the profits getting watered down, get out. It’s not a perfect method—for instance, Cisco has historically dedicated substantial blocks of its buyback program to covering up executive dilution, but the “5% rule” is a good initial filter to weed out the companies that are casually scratching their middle-finger in the direction of shareholders.

And if the company chooses to pay its management team in cash rather than stock grants, then your best defense is to keep your eye on the company’s total debt and earnings per share. It’s hard to grow earnings per share by a substantial amount when your executive team is taking in 20% of the profits.

I don’t like it when management teams treat shareholder cash like Monopoly money. But as a small shareholder in the grand scheme of things, my job is mostly reactionary—that is, I don’t have the power to stop executive X from making $Y, but I can get out of companies that have track records of disrespecting shareholders. For some reason (*cough*), it is difficult to find out exactly how many shares of a company’s stock are unvested rewards for managers (even when you do your homework, there’s still a chance you might be missing something).

Because I make investments based on the net results I expect to receive, I keep my eye on the changes in earnings per share, share count, and total outstanding debt to monitor whether I want to continue being a shareholder of the company I’m analyzing. Those three elements are the canaries in the coal mine that can tip you off.