In fact, Frazier was promoted to CEO because he helped Merck defend itself from lawsuits, not because he was successful in helping Merck develop new drugs. Frazier’s background was in the corporate suite, and even though he was head of the global human health division (which is Merck’s largest unit) from 2007 to 2010, Frazier’s experience running the operations of the business was more limited. Therefore, this increases the risk that Frazier will fail to execute as CEO.
What Was the Culture Like at Businesses Where This Manager Worked in the Past?
You need to understand the culture of the businesses where the manager has worked in the past. For example, software and hardware business Oracle is known for a take-no-prisoners culture that is results oriented, whereas British Airways is known for an excessively bureaucratic culture.15 This will give you tremendous insight into how he or she is likely to manage the current business, especially if the manager worked at the prior business for a long period of time.
Start by reading articles about the culture of the former business where the manager worked, as well as articles about the CEO this manager worked for. Were the CEO and the culture aggressive and hard-charging, or transparent and authentic? For example, if a manager worked at General Electric (GE), take a look at any of several books and articles written about “the GE Way.” The GE Way is taught at GE’s management school: It involves rotating managers through many jobs, teaches them how to grow a business through acquisitions, and teaches productivity and quality-control tools such as Six Sigma.
When Jim McNerney was passed over as CEO of GE, he was immediately recruited by 3M to be CEO (in 2001). Once he was CEO of 3M, he immediately began to look for acquisitions to make, and he instituted money-saving Six Sigma process-management systems companywide.16 By reading about the GE Way, you would have had a great insight into how McNerney would likely manage 3M.
37. How are senior managers compensated, and how did they gain their ownership interest?
It is important to spend time reviewing the compensation and ownership interest of management by viewing the proxy statement. You can gain great insight into the character and motivation of managers by understanding how they are compensated. You want to understand if the compensation package rewards for long-term or short-term performance. For example, if a CEO owns $100 million of stock, and he is paid $100,000 per year, then he is more likely to make long-term decisions. In contrast, if a CEO gets paid $5 million a year and owns $1 million of stock, then he will likely value his job more than the value of the company’s stock.
Let’s take a closer look at different compensation scenarios and what aspects you should pay attention to.
Look for CEOs Who Have Low Salaries and High Stock Ownership
Some of the best long-term performing stocks have been run by CEOs with low cash compensation and high stock ownership. These managers generally have a long-term view. Here are a few examples:
Robert Kierlin, founder of Fastenal (a distributor of industrial products), and his successor as CEO, Willard Oberton. Fastenal consistently ranks at the bottom of CEO compensation: For example, Kierlin made $63,000 in total cash compensation in 2001 and owned 5.87 percent of the business.17 But take a look at how well the stock has performed: The stock price has appreciated from $0.32 per share on September 1, 1987 to $60 per share on December 31, 2010—that’s a huge increase!18
Dave Gold, co-founder of 99 Cent Only Stores, was paid $62,000 to $180,000 in total cash compensation (and did not receive any stock options or bonuses) when he was CEO, yet he owned approximately 40 percent of the business.19 Under his tenure, the stock price increased from $3.81 per share at its initial public offering (IPO) on May 23, 1996, to $15.32 per share when he stepped down as CEO in January 2005—again, a huge increase: more than 400 percent.
Joe Mansueto, founder of Morningstar, is paid $100,000 in total cash compensation and owns 52 percent of Morningstar.20 The stock price has increased from $21 per share at its IPO in May 2005 to $53 per share in December 2010—in other words, more than double in a little more than five years.
Russel Gerdin, CEO of trucking firm Heartland Express, earned $300,000 per year in total cash compensation, a salary that hasn’t changed since 1986. He also owns 34 percent of shares and does not receive stock options. The stock price has increased from $0.43 per share in 1986 to $16 per share in 201021—another enormous increase.
Be Wary of Managers Who Hold Stock Options
One of the most common ways that management is compensated is through stock options, which give the owner the right to buy shares at a specific stock price. They represent a potential payoff to the manager with no risk: The downside is zero (if the stock price doesn’t increase, there’s no payout to the managers, and if the stock price does increase, then they benefit). Investors believe that giving stock option grants to managers will motivate them to create shareholder value, because it gives them an ownership interest in the business.
The problem is that stock options often reward managers for things that they are not responsible for, such as broad economic gains or industry growth. As one investor said: “The argument that someone is worth tens of millions of dollars in compensation per year because his or her company’s market value went up many times is so ludicrous that I’ve always been amazed anyone can espouse it as fair with a straight face.”
In reality, most stock-option programs reward managers for short-term gains. This is because managers with a lot of options rather than actual shares are prone to adopt Wall Street’s short-term focus in order to increase the stock price and therefore the value of their options. They can take several harmful actions to drive the price of a stock up in the near-term to the detriment of the long-term health of the business. Examples would be making acquisitions to boost short-term earnings or cutting too many costs. These short-term decisions can eventually cause the value of the business to deteriorate as one bad decision piles up on top of another.
Be Wary of Companies that Offer Mega-Equity Grants to CEOs or Other Managers
The highest pay packages are typically given to managers who are brought in from another company or industry. You need to be cautious of management compensation schemes that give out mega-equity grants that are out of proportion to the CEO’s contribution, such as when Robert Nardelli was given $30 million in restricted stock awards plus $7 million in cash when he joined Home Depot as CEO. Furthermore, after pulling in $38 million in 2006, Nardelli was also given an astronomical $210 million in severance when he exited the business. This was money that would otherwise have benefited shareholders. The stock price under Nardelli’s tenure was $45 per share when he joined (in December 2000) and $39 per share when he left (on January 2, 2007).22
When Nardelli landed at Chrysler later that year, he also landed another lucrative compensation package. Under Nardelli, 35,000 workers at Chrysler were laid off and Chrysler headed for bankruptcy. Nardelli left after only 21 months. In both of these instances, Nardelli was paid not on the performance of the business, but instead was paid to join the business.
However, large compensation packages do not always necessarily indicate that a stock will underperform. For example, Larry Ellison, founder and chief executive of software maker Oracle, has been one of the highest-paid CEOs of any publicly traded business, earning in excess of $78 million in option awards alone in 2009, yet investors in Oracle would have made 3.5 times their money in the last 10 years ended 2010. (However, it is still difficult to argue that Ellison needs additional stock options to motivate him to do his job, as he owns 23.4 percent of Oracle, as of August 9, 2010.23)
Look for Managers Who Don’t Monopolize Stock Options but Offer Options to All Employees
You need to determine if the stock option plan of a company is geared to only a few of the top executive officers or if options are widely distributed among employees. This will give you an insight into the character of senior managers, because if they share the wealth with all of their employees through a wide
ly distributed plan, this means they care about their employees. If, instead, they only award themselves a large option package, this means they care more about themselves.
For example, in a letter to shareholders, Richard Reese, former CEO of document-management company Iron Mountain, explained why he would not accept any stock options, saying that he preferred to use them to retain good people rather than compensate himself.
To find information on a company’s stock option-program, look for a table in the proxy statement that lists the total number of options awarded to the top five executive officers. Add up the total number of options awarded to the top five executive officers. Then, in the 10-K or proxy, find the total number of options awarded to all employees. Calculate the percentage of options given to the top five executive officers compared to all employees. Determine if stock options are widely distributed or if they are concentrated within the top group.
For example, at Whole Foods Market, approximately 92 percent of the stock options granted under the plan since its inception in 1992 have been granted to employees who are not executive officers.24 On the other hand, the management team at bond-rating firm Moody’s awarded itself a large percentage of stock options when it was spun off from Dun & Bradstreet. Moody’s 2000 proxy statement shows that CEO John Rutherfurd received 4.1 percent of all options granted to employees in the fiscal year, followed by Donald Noe, SVP of Global Ratings and Research, who received 3.0 percent. These two executive officers received about the same percentage of stock options as all of the top executive officers at Whole Foods Market combined. This should serve as a warning signal because it indicates that senior managers at Moody’s view the business as one where they can personally benefit without sharing those benefits with their employees.
Look for Compensation Plans that Reward Long-Term Performance
In order for a compensation program to reward long-term performance, it must tie compensation to long-term results. For example, at ExxonMobil, half of an executive officer’s restricted shares vest over five years, and the other half must be held for 10 years or until retirement, whichever is greater. This rewards management for long-term results.
The ideal compensation structures are those that award for long-term value-creation factors, such as operating income or book value per share, instead of the stock price. Determine if the compensation is tied to variables that make the business better, rather than just bigger. For example:
Expeditors International (a global logistics company) bases its bonuses on operating income, and these bonuses make up the majority of executive officer compensation.
Reckitt Benckiser Group (a global manufacturer of household and healthcare products) links performance-based compensation for all executive officers to economic value added.
Markel Insurance (a specialty insurer) uses growth in book value per share over a five-year measurement period to base its total compensation package.
Let’s look at each of these companies’ compensation structures in more detail.
Expeditors International’s Compensation System
Expeditors International ties its compensation system to operating profit instead of stock price by paying its top executive officers from a pool of 10 percent of pre-bonus operating income. This system has been in place since Expeditors International went public in 1984. If operating income drops (as it did in 2009, when operating income dropped 19 percent compared to 2008), then incentive compensation also drops by the same amount. Furthermore, the compensation system is also based on cumulative operating income, so if any operating losses are incurred, then these losses must be recovered before the executive team can earn a percentage of operating profits. This gives senior managers a longer-term incentive because if they engage in activities that increase short-term profits at the expense of long-term profits, then they will receive a lower bonus down the line. This creates a direct alignment between corporate performance and shareholder interests because the compensation is directly proportional to the profit responsibility of each manager.
Reckitt Benckiser Group’s Compensation System
Reckitt Benckiser Group links performance-based compensation for all executive officers to economic value added, measuring net sales growth, profit after taxes, and net working capital. The long-term incentive program requires that EPS has to grow by 30 percent over three years for the options and the shares to fully vest. When Chairman Peter Harf was asked why the compensation plan did not reward for stock price increases, he said, “We have stayed away from that [performance tied to total shareholder return], because it can lead to outcomes that are completely uncoupled from the company’s performance.”25
Markel Insurance’s Compensation System
Markel Insurance chose growth in book value per share over a five-year measurement period to set its compensation program for its executive officers. The executive officers at Markel believe that the primary creator of value for an insurance business is its book value per share, not the stock price. Markel uses a five-year period in order to discourage managers from taking unnecessary risks.
There are various other forms of compensation that are positive indicators that the compensation package is based on long-term results, such as restricted stock awards. Stock-ownership requirements also align management interests with the long term.
Look for Restricted Stock Awards because They Reward Long-Term Value Creation
Restricted stock awards reward long-term value creation more than stock options because they often are conditioned on such factors as longevity or performance. In other words, a manager must be employed by the company for a certain length of time or must meet specific performance goals. This is meant to encourage long-term ownership in the firm.
For example, at Goldman Sachs, 40 percent of the restricted stock an employee receives typically vests immediately, but it isn’t delivered for three years. Therefore, if an employee leaves, then that employee risks losing his or her restricted shares.
Similarly, at insurance underwriter Markel Insurance Company, restricted stock is given to senior managers after they meet pre-established performance goals, which are granted based on growth in book value per share, over a five-year period. Markel believes that by paying a substantial portion of incentive compensation in restricted stock units (RSUs), it has both the advantage of increasing management’s equity ownership and creating a retention incentive, because the manager must remain employed by the company to receive the stock.
Look for Companies that Require Stock Ownership
Some businesses have stock-ownership and retention guidelines that require management to own a certain amount of stock. For example, the 2009 proxy statement for Markel Insurance Corporation states:
The Company places a strong emphasis on equity ownership by executive officers and other members of senior management. The Board of Directors has adopted stock ownership guidelines that require executive officers to acquire and maintain ownership of Common Stock with a value at least equal to five times base salary and other members of senior management to acquire and maintain ownership of Common Stock with a value at least equal to two or three times base salary, depending on position. Newly hired or newly promoted executive officers are expected to reach these minimum levels of ownership within five years.
If you find this type of compensation program in the proxy, then it is likely that the management has an incentive to perform over the long term.
Other Valuable Insights You Can Glean from Reading the Proxy Statement on How the Compensation System Is Set Up
The way a compensation system is structured can gave you valuable insights into the character and motivation of management. Rather than focusing on how much executive officers are paid, it is more useful to understand how an executive compensation plan is structured. Start by viewing the proxy statement section titled Compensation Discussion and Analysis, where the compensation committee of the board of directors communicates how it sets the compensation package for the t
op executive officers and employees. For example, an executive officer might be compensated even if he or she did not meet the performance targets. The former CEO of Shell, Jeroen van de Veer, received a $1.9 million bonus from an incentive program where he failed to meet the performance targets set for three years. Running across a compensation arrangement such as this would certainly provide insight into the type of management team you are thinking of partnering with.26
In contrast, the 2009 proxy statement for Morningstar states:
In consideration of his status as our principal shareholder, Joe Mansueto believes his compensation as our chief executive officer should be realized primarily through appreciation in the long-term value of our common stock. Accordingly, at his request, he doesn’t participate in our equity or cash-based incentive programs. In addition, since resuming his role as our chief executive officer in 2000, his annual salary has been fixed at $100,000.
You can evaluate Mansueto’s character and that he manages the business in the interest of his shareholders, because he refuses to accept stock options. This gives you great insight into his character, and this is the type of CEO you should look for as a long-term partner.
Beware of Companies that Use Compensation Consultants
If a compensation package is determined by consultants hired by the board of directors, this should serve as a red flag. This kind of compensation benchmarking is usually not about the performance of the business, but rather a comparison to what others in the industry make. However, the peer groups used are often in completely unrelated business lines. You will find that the majority of compensation plans are determined in this way.
For example, in FY 2010, jewelry retailer Zale hired a compensation consultant who put together a list of 21 companies as a peer group. The consultant included such companies as Abercrombie & Fitch, American Eagle Outfitters, and Children’s Place, which are specialty apparel companies, not jewelry retailers. The consulting firm then targeted compensation within a certain percentile range of the peer group. For example, the 2009 Zale proxy states: “Accordingly, base salaries generally were targeted between the 25th and 50th percentile of market, and annual performance-based bonuses generally were targeted between the 25th and 50th percentile of market.”
The Investment Checklist Page 24