Is Your CEO a Partner or a Plunderer?
Compensation is a good litmus test for management's character.
One of the most frequent questions I get from Morningstar subscribers and other investors concerns corporate management: How to get a feel for whether a management team is looking out for shareholders or just for themselves.
This is a great question. Excellent management can make the difference between a mediocre business and an outstanding one, and poor management can run even a great business into the ground. Moreover, long-term investing means finding corporate managers who act like business partners rather than hired hands. True business partners will seek to maximize the long-term value of an enterprise, while managers who think of themselves as hired guns will usually make short-term decisions that line their own pockets first and foremost.
It's All in the Proxy
The bulk of the information you'll need to get a feel for a management team is contained in a single document, called the "proxy statement." This is the form that companies mail shareholders around the time of the annual meeting, usually in March or April of every year. You're probably most familiar with it because it contains proposals from management and other shareholders on which you're asked to vote. There's also a lot of other juicy stuff here, though, like how much executives are paid and what perks they get. (You can find this form online at the SEC's EDGAR service. Look for form DEF14A.)
Here's what to look for in a company's compensation plan. First and foremost, how much does management pay itself? Generally, I prefer big bonuses to big base salaries, and restricted stock grants to generous option packages, but that's just the tip of the iceberg. First, I look at the raw level of cash compensation to see if it's reasonable. There's not necessarily a strict limit here, though I personally think an $8 million cash bonus is just silly no matter how well the company has done. (For reference, the average CEO of a large U.S. firm earns about 500 times as much as the average employee. Twenty years ago, this multiple was closer to 40.) In any case, use your own judgement--if the amount that executives earn makes you cringe, it's probably too much.
Here's one of my favorite cringe-worthy examples: Verizon Communication's (VZ) former chairman and co-CEO, Charles Lee, became a "consultant" for the firm when he retired in 2002. In addition to the standard goodies, like office space, a staff, and use of an aircraft, he's currently receiving a consulting fee of $250,000 per month. (That's not a typo.) You'd think after getting paid $4 to $5 million annually in salary plus bonus between 2000 and 2002, and $27 million in options in 2002 alone, he'd have enough to retire on. Guess not.
Pay for Performance?
Although the raw level of salary is worth looking at, what's even more important is whether executives' pay is truly tied to the company's performance. At many companies, so-called "performance targets" are set by a subcommittee of the Board of Directors, which can often rewrite the rules of the game if the CEO appears to be losing. A while back, for example, Coca-Cola's (KO) board reduced CEO Douglas Daft's goal of 15% earnings growth over five years to 11%.
Be careful of what a soft-hearted compensation committee might construe as "performance," however. For example, many firms pay big bonuses to executives who succeed in consummating large acquisitions. But since more than two thirds of corporate acquisitions fail to deliver positive economic value for shareholders, I think it's putting the cart before the horse to reward execs when they sign a deal. It would be far better to wait a couple of years to pay a bonus--once the acquisition has provided an adequate (and predetermined) return on the investment. (Can you imagine negotiating with your boss for approval to, say, develop a new product, and then immediately asking him or her for a huge bonus once he or she gives you the go-ahead? Uh, no. More likely, you'd ask for a raise or bonus if and when the product successfully launches.)
For example, AT&T (T) paid former CEO Michael Armstrong a $2.5 million "transaction bonus" in 2002 when the deal to sell the firm's cable networks to Comcast (CMCSA) closed. This occured after Armstrong spent billions trying--and failing--to make AT&T a cable powerhouse. Essentially, the board paid him a big fat bonus for exiting a money-losing strategy. And a few years back, Walt Disney (DIS) paid some senior executives a "special bonus" for completing the acquisition of Fox Family Worldwide, which has turned out very poorly for Disney. In general, paying managers for doing deals just encourages them to do more deals, when shareholders would generally be better off if the same managers just spent some time running their own business better.
In any case, the bottom line is this: Executives' pay should rise and fall based on the performance of the company. So, after reviewing a company's historical financials, go back and read the past few years' proxies to see whether this has truly been the case, or whether a bunch of lackeys on the board of directors have cooked up justifications for big bonuses even in bad times.
Other Red Flags
Aside from the big-picture question of whether executives' pay truly is linked to company performance, there's a lot of other stuff to watch out for:
Have executives been given "loans" that were subsequently forgiven? This was a common--and disgusting--practice before the Sarbanes-Oxley Act banned it in 2002. In my book, a loan that's not repaid is a bonus, and companies that tried to fudge executive pay in this fashion weren't treating shareholders with respect. Even though it's not legal any longer, companies that engaged in this kind of behavior in the past should be viewed with skepticism--after all, would they have stopped unless they were forced to?
Do executives get perks paid for by the company that they should really be paying for themselves? To me, it's a sure sign of corporate excess when execs get country club memberships and other frippery paid for by shareholders. After all, when you're paying someone several hundred thousand dollars per year, making shareholders foot the bill for "financial planning services" seems rather silly. (Conversely, thrifty CEOs are a plus. One of the managers I respect the most, for example, pays for his own parking in the company garage.)
Does management hog most of the stock options granted in a given year, or do rank-and-file employees share in the wealth? Generally, firms with more-equitable distribution schemes perform better.
Does management use stock options excessively? Even if they're distributed beyond the executive suite, giving out too many options dilutes existing shareholders' equity. If a company gives out more than 1% or 2% of the outstanding shares each year, they're getting out of my comfort zone. Big bonus points here if the firm issues restricted stock--which has to be expensed--instead of options.
If a founder or large owner is still involved in the company, does he or she also get a big stock option grant each year? This makes me queasy. After all, it's hard to argue that, say, Larry Ellison of Oracle (ORCL) or Michael Dell of Dell need additional options to motivate them when they already own giant chunks of their firms.
Do executives have some "skin in the game?" That is, do they have substantial holdings of company stock, or do they tend to sell shares right after they exercise options? As a shareholder, I want management to have meaningful equity in the company. After all, selling shares in the name of "diversification" means not being exposed if the company goes downhill. Generally, I'm a lot happier owning companies where executives own stock right alongside me. Large unexercised option positions are cold comfort.
Finally, has management repriced options? This is up there with the outlawed loans as a red flag, since canceling one set of options and issuing another set at a lower price is essentially ripping off shareholders by rewriting the compensation rules. In early 2002, for example, Ciena's (CIEN) board of directors gave executives 2 million stock options exercisable at $10 per share because their old options were worthless. But Ciena's share price kept falling, so the board decided that "executive officers still lacked meaningful long-term incentives" and gave management another 2 million options exercisable at a low strike price of $4.53 per share. Even worse, the board did this at a "special meeting" just before the release of strong earnings. Two weeks after the grant, Ciena's stock was up 60%. Yuck.
Morningstar's first full-length book on stock investing is out--look for it in your favorite bookstore, on BN.com, and on Amazon.com. (You can also order it directly from Morningstar.) It's titled The Five Rules for Successful Stock Investing, and it was written by yours truly in conjunction with Morningstar's stock analyst staff. The first half of the book covers the basics of fundamental analysis: Developing an investment philosophy, a mercifully short introduction to reading financial statements, a primer on valuation, and a guide to evaluating company management and assessing economic moats. The second half is a series of chapters on each sector of the market--from hardware to health care to banking--that explains industry jargon and helps you analyze complicated companies.
A version of this article appeared Nov. 13, 2002.
Pat Dorsey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.