Monday, November 16, 2009

A Closer Look at Executive Compensation

By Eric Jackson
11/13/2009 1:59 PM EST
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We read a lot about corporate governance and executive compensation these days, in the wake of last year's economic collapse. Many politicians are now jumping into the fray, saying we need to legislate certain governance requirements, such as splitting the roles of CEO and chairman or lowering CEO pay. Although philosophically I support many of these arguments, it turns out that many of these prescriptions have no long-term relationship with an increase in a company's stock price. Which of these governance and executive pay factors should you pay attention to as an investor?

As any good investor knows, there's no silver-bullet metric (such as P/E ratio or price-to-book or leverage ratio) that, on its own, predicts a stock future increase or decrease. Even if you take a number of internal factors into account, your perfect analysis can be thrown out the window by an industry downturn or some random comment by Tim Geithner on his trip to Asia.

With this in mind, I believe you can improve your investment batting average by paying attention to two factors relating to corporate governance and executive compensation that most people overlook.

Two Kinds of Insider Stock

First, how much stock do the company's directors own? In a big long study I took part in several years ago, we scoured company's proxy statements and examined how a bunch of so-called "good" corporate governance factors were actually linked to longer-term stock returns. Almost all of them (such as whether there was a split CEO and chairman, or if the board had a number of "independent" directors or not) had no correlation with stock price increases. However, we found one variable that had a whopping link: whether a company had a lot of directors who had dug into their own pockets and actually bought stock in the company. This is different from a case in which stock ownership in the company was only due to stock grants or stock options.

When we talked to directors about this finding, they said it didn't surprise them. It's the difference between having "found money" on the line (i.e., their stock was paid for from other people's money, not theirs) instead of their own. One director said, "I sit on a lot of boards right now, but there's one where I've got about $250,000 of my own money on the line. It sounds bad to admit it, but I care a heck of a lot more about how that company does. I lose sleep over it."

If you were a shareholder in that company, his sleepless nights are probably comfort to you. I bet there are many Bank of America (BAC - commentary - Trade Now) and Citigroup (C - commentary - Trade Now) shareholders wish they'd had more directors losing sleep (and their own money) a couple of years ago.

Payments to the Chief

The second characteristic I like to look at is the total compensation the CEO and his/her management team take home. Is it significantly above other companies in that industry, even though the stock returns between the companies over time is not different? If so, that's a big red flag. Why does this management team (and the board members who approve their pay packages) think they're worth so much more than their peers, with no commensurate better historical track record?

As part of total comp, you should also look out for extreme executive perks that have been thrown in to supplement an executive's already high salary. I mentioned recently a Las Vegas Sands (LVS - commentary - Trade Now) senior vice president, Rob Goldstein, who got the company to pay $364,000 to remodel his home and never had to pay it back. Mark Hurd and his senior management team at Hewlett-Packard (HPQ - commentary - Trade Now) saw their total compensation double last year, after they imposed 10% to 15% pay cuts across the organization. The H-P execs also get to spend hundreds of thousands of shareholders' dollars jaunting around the country on the H-P corporate jets for personal use, with hotels and meals also covered for personal use.

I've heard some people say, "Who cares about the perks? Shocking that there's gambling going on in the casino. Come on." I disagree. Not every CEO or management team does this. It says something about how they approach executive decisions. To me, it tells me that they will look for every chance to make decisions that benefit them first and foremost before the shareholders. I don't want to invest in a company like that. (Maybe not surprisingly, I currently have short positions in LVS and HPQ because of many factors, but the perks factor certainly played a role in my decision.)

So how do you find this information? It's easy: go to the SEC's Web site. Search "company filings" and look for the company's most recent proxy statement. Its technical filing name is "DEF-14A," which stands for the company's definitive proxy statement. In there, you will find info on who is on the board of directors, how much they're paid, their bios, and how much stock they own in the company. It's not always immediately obvious how much of their current stock ownership is from past stock grants and stock options given to them (for free) vs. how much they've bought themselves, but it can be figured out if you look over a number of these past filings.

In the same filing, you'll find everything you've ever wanted to know about how much in total comp the management team is making (and more), down to the often most illuminating footnotes. The SEC is often tinkering with its requirements on companies in how they present this data. However, the current version makes it clear what each exec's total comp is.

These two characteristics of outside directors' stock ownership in their companies and the size of CEO total comp and executive perks aren't silver bullets. They should supplement all the normal financial analysis you do. However, they can often be very helpful in deciding whether to proceed with an investment or not.

At the time of publication, Jackson's fund held a net short position in LVS and a short position in HPQ. Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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