Kerry, I recently ran across these articles which I thought would be helpful to me in my stock purchases. You might have ran across them already, but I do like to read the SEC filings because of some previous bad experiences.
Is Your CEO Paid Too Much? Morningstar
by Pat Dorsey | 11-13-2002
In response to last week's column about ways to lose money in the market, Morningstar reader John Walsh sent in the following pertinent query: "How do you gauge management? What do you look for, and how do you find this information?"
These are great questions, and not just because all the latest corporate scandals make them timely. 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. I think it's useful to divide the process into three (related) parts: Compensation, character, and operations. I'll go over the compensation part this week, and I'll write about how to assess character and operational issues in future columns.
Compensation: It's All in the Proxy
This is the easiest of the three areas to assess, since the bulk of the information is contained in a single document, usually called the "proxy statement." This is the form that companies mail shareholders around the time of the annual meeting. 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 currently earns about 500 times as much as the average employee. Twenty years ago, this multiple was just 40.) In any case, use your own judgement--if the amount that executives earn makes you cringe, it's probably too much.
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. Last year, for example, Coca-Cola's KO board reduced CEO Douglas Daft's goal of 20% earnings growth over five years to 16%. But, hey, at least Coke shareholders knew what the target was.
Walt Disney's DIS compensation gurus have decided that bonuses "may be based on one or more of the following business criteria, or on any combination thereof, on a consolidated basis: net income (or adjusted net income), return on equity (or adjusted return on equity), return on assets (or adjusted return on assets), earnings per share (diluted) (or adjusted earnings per share (diluted))." In other words, anything they want. To add insult to injury, the gang at Disney "believes that the specific target constitutes confidential business information the disclosure of which could adversely affect the Company." Yeah, right. More likely, it would adversely affect Disney management, since the board wouldn't be able to move the goalposts closer in the middle of the game.
Disney is often held up as a poster child for poor corporate governance, so let me use it for a further example. Whereas CEO Michael Eisner received only his $1 million salary in 2001 (don't cry for him, though--Disney has paid him about $1 billion since 1984), some of his buddies in the executive suite were luckier. From Disney's proxy: "As permitted by the plan, special bonuses were paid outside the plan to three executives...Peter Murphy, Thomas Staggs and Louis Meisinger--for extraordinary services to the Company unrelated to the plan's performance targets, including, in the case of Messrs. Murphy and Staggs, services related to the Company's acquisition of Fox Family Worldwide, Inc."
Since more than two thirds of corporate acquisitions fail to deliver positive economic value for shareholders, doesn't it seem to be putting the cart before the horse to reward execs when they sign a deal? Why not 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.)
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:
Are executives given "loans" that are subsequently forgiven? This is a common--and disgusting--practice. As I said in last week's column, a loan that's not repaid is a bonus, and companies that try to fudge executive pay in this fashion aren't treating shareholders with respect.
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 their mortgage seems rather silly. (Conversely, thrifty CEOs are a plus in my book. Expeditors International EXPD CEO Peter Rose, 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. (Last Sunday's New York Times had an excellent article on this issue.)
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 so 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, CEO Larry Ellison of Oracle ORCL needs additional options to motivate him when he already owns 25% of the firm.
Finally, 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.
That's it for the "compensation" part of assessing management. Next week: Getting a handle on management's character.
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Is Your CEO Worth Trusting?
by Pat Dorsey | 11-20-02 | 06:00 AM |E-mail Article to a Friend
Last week I discussed ways you can judge whether a firm's management is paying itself reasonably. Of course, compensation by itself is often a good litmus test for character--anecdotally, I think there's a pretty strong relationship between management teams that are in it for the money and management teams that treat shareholders poorly. However, there are some other questions you can ask to get a handle on whether a firm's management deserves your trust.
Does management use its position to enrich friends and relatives?
In a company's annual 10-K filing, look for what are known as "related-party transactions." In a nutshell, if a friend or relative of a company officer has substantial business dealings with the firm, you’ll read about it here. Often, this stuff is pretty innocuous--an ex-officer or director is paid some nominal amount each year for consulting services. As long as the firm isn't paying out hundreds of thousands of dollars, this kind of thing doesn't get my hackles up.
But what about when the firm pays large sums of money to, say, an interior-design firm run by the CEO's wife, or to a law firm in which the CFO's son-in-law is a partner? Now that's when I sit up and take notice. The key here is to make sure that a) the firm isn’t sending a ton of business in the direction of related parties, and b) there's not an egregious pattern of abuse. One or two small related-party transactions aren't a big deal, but if it looks like virtually all family members of the company officers have their hands in the till, then you've got a character issue.
Is the board of directors stacked with management's family members?
Take a look at the biographies of the board, which are in that handy proxy statement I mentioned last week. If a lot of them are closely related to top management, it's a good bet the board isn't going to be as hard-nosed when questioning management's actions as it could be. And since the board is shareholders' last line of defense against a CEO running amok, that's hardly a good thing.
Is management candid about its mistakes?
No one--not even Jack Welch--gets everything right, and it's important that a management team be able to honestly discuss poor decisions and why they were made. ,CEOs who bury mistakes might be burying other things as well. Look for this type of candor in annual reports and in quarterly conference calls. I especially like to look at the letter to shareholders in the annual report. Is it a candid assessment of the past year's successes and failures or a fluff piece? Be especially wary when a formerly open manager clams up during tough times.
How promotional is management?
Although a certain amount of rallying-the-troops is the job of a CEO, watch out for company officers who cross the line and begin blindly pumping up the stock or themselves. The former is a red flag because management's job is to worry about running the company--if it gets that right, the stock price will take care of itself over time. Executives who complain about how undervalued their firm's shares are, or who opine as to its true worth, are probably more concerned with the value of their options than on making solid, long-term business decisions. Self-promotional managers, meanwhile, are not likely to make decisions that are in the best interests of long-term shareholders. If you read a number of glowing media articles in which a CEO paints himself or herself as a latter-day savior, watch out.
Can the CEO retain high-quality talent?
Some firms judge the quality of managers by the turnover rate of their subordinates, because turnover is seen as the ultimate acid test of the working environment and employees' views of a company's potential. Extend this view to the executive team: How often do officers turn over? What is the tenure of key officers? Is executive hiring done from the outside? Long tenure is a great signal of intrinsic motivation and confidence in the business. A CEO who keeps forcing out immediate subordinates is likely spending too much time on internal power struggles and not enough on running the business.
Finally, does accounting motivate behavior?
Using accounting to cloud the true state of affairs shows a willingness to deceive, and using aggressive (though legal) techniques shows that management is more interested in the letter of the law than the spirit of it. Pay special attention to the timing of disposals and acquisitions, the consolidation method for subsidiaries, currency-hedging decisions, the timing of write-offs, the use of reserves or reversals to improve reported margins, strange changes in pension assumptions, revised (or liberal) depreciation assumptions, and liberal revenue recognition and deferred tax asset/bad receivable allowance policies (among others).
Of course, if decisions are made that actually hurt reported results, you’re in luck. Management teams that use stock grants instead of options--since the former has to be expensed, while the latter doesn't--or who expense rather than capitalize items such as research and development or software costs, are the kind of folks who are more interested in running the business than playing numbers games. And those are precisely the kind of people you want running companies of which you own a piece.
Next week: Assessing how well management is running the business.
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