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.

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2 thoughts on “The Hard Part About Investing

  1. obie ephyhm says:

    There are, I think, at least two general problems with some of the underlying thesis, here. I agree the average shareholder, under the current system, has next to no real say in executive compensation. Our 'vote' as shareholders, in this regard, is little more than a vague shareholder sentiment sensor that the BoD should pay attention to. And I do agree that *extraordinary* management should reap reasonable benefits in proportion to their contribution to *extraordinary returns* for the corporation and its shareholders.

    The problems that arise are complex, interwoven and without a single 'thread' of solution that will work to resolve them all. One problem is the difficulty in defining whether a corporate success is based on management or despite mismanagement or from some other factor altogether (just as 'luck' is some part of investing, so it is with management and sales).

    Another problem is assessing whether there really is anything fundamentally more valuable within the senior management that is SOLELY responsible for the growth. Last I check, no one in executive management or on the BoD are out there on the loading docks, working overtime on an assembly line or working 18 hours a day to wrestle through several million lines of computer code to get product out on schedule. There is at least some reasonable argument that *all* employees of a successful company should receive the same relative benefit. But that's not what's happening when management's pay rises at 2.5x the rate of the lowest 1/3 of the pay scale year after year; something seems a wee-bit out of whack.

    There is arguably another problem asking whether excessive pay isn't anything more than the equivalent of corporate robber-barons who are, essentially, stealing wealth that rightfully belongs to the shareholders. This is especially true in the age of the 'me-too' executive pay packages based upon the hope of future performance and, too frequently, followed by gi-normous severance packages to get rid of those who failed to live up to those promises. Or even worse, entrenched management that shareholders cannot get rid of but who put the corporation into a slow death-spiral of incompetent leadership.

    Failure to address the not-infrequent disparity arising during 'hard times' when senior management demands sacrifices from the rank and file including unpaid furloughs, lay-offs, force reductions, wage freezes, profit-sharing suspensions, etc — which applies and disproportionately hurts the lower 50% of the corporate pay scale. Yet, the overpaid executives are very quick to make sure they don't take any form of a hit or any accountability for what ends up being blamed as the fault of the 'economy and other acts of God'. These are actions of questionable ethics and represent an absurd form of corporate welfare that should be addressed. If no one is to blame for the mess, then everyone should take an equal 'hit' to help get things back on track.

    While this is not a complete list, by any means, I will close with this last potential problem: just how much money can one person spend? Does anyone really need to be paid more than a million dollars a year to do anything? People from the investing world are frequently offended by such a question but I don't believe it is unreasonable for one to really examine the question and determine at what point is one taking more than a reasonable share of something — especially if they cannot really make use of it. It's like one person going into a grand and free food-buffet with a grocery cart and stuffing as much food into the cart then leaving. They cannot possibly eat all that food before it will spoil. They probably don't need to even try. All they've done is wasted food and denied someone else and opportunity to feed.

    This is probably too long of a comment and I'm sure most will disagree with it. Nonetheless, I think it is worth considering some of these potential problems.

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