The Investment Checklist

by Michael Shearn

  Two red flags are raised here: That compensation was determined by comparison to loosely related peers, and the fact that base compensation does not have anything to do with the performance of the business.

  Beware of Companies that Use Employment Contracts

  Another red flag is when you find employment contracts in the proxy statement that guarantee that a manager will be paid a certain amount in total cash compensation. This guarantee of compensation does not directly align the executive officers with the long-term interests of the business.

  For example, K-Mart handed out roughly $30 million in retention loans (retention loans are given when the company is failing, but often they are awarded after a bankruptcy filing) to its 25 top managers, including $5 million to then-CEO Chuck Conaway. The loans were given to entice the managers to stay at the business. At the same time, however, management was firing thousands of employees and cutting the salaries of other managers. This likely decreased morale among the employees at K-Mart, and these managers were ultimately unsuccessful in turning around the business. Eventually, these executive officers were fired by the board of directors, but they had already been given millions of dollars in compensation because it was guaranteed.27

  You should always watch for managers who demand extremely high compensation packages before joining a business or who demand them to remain at the business. There is a saying that people who demand the most up front are usually the ones who deliver the least at the back end. This is generally true because those who receive guaranteed salaries and bonuses, regardless of the performance of the business, do not have any incentive to create long-term value.

  For example, the CEO and founder of an energy company was awarded a $75 million-option package to renew his employment contract with the company for five years and not pursue other entrepreneurial ventures. This is a warning signal. Why would a CEO demand to be paid $75 million to remain at a business he founded? If he were truly passionate about the business, it is likely the board of directors would not need to entice him to stay at the business with financial incentives. This is just plain common sense. Clearly, the interests of the shareholders and management were not aligned.

  Look for Managers Who Continually Increase Their Ownership Interest in the Business

  The best managers to partner with are those who continually increase or retain their ownership in the business. For example, the following CEOs have sold very limited quantities of their companies’ stock during their tenures:

  Warren Buffett, CEO of Berkshire Hathaway;

  Bruce Flatt, CEO of Brookfield Asset Management;

  Dave and Sherry Gold, founders of 99 Cent Only Stores; and

  Henry Singleton, former CEO of Teledyne.

  Singleton, for example, did not receive any option awards and only sold stock in 1987 and 1988 after continuing to buy it for more than 20 years.28 Bruce Flatt was once asked what his hobby was, and he responded that it was collecting shares of his stock. All of these businesses have created tremendous value for shareholders over the long term.

  Use the proxy statement to construct a manager’s ownership of the stock by viewing the stock ownership section over a 5- to 10-year period. Note how the shares were acquired, either through direct purchases or through option issuances. Determine if the manager is increasing his or her ownership interest in the business rather than decreasing it. If the manager’s ownership interest is declining over time, this is not a positive sign. Many times, managers will claim they are selling for diversification purposes: This is reasonable and certainly believable, but remember that at the end of the day, a sale is a sale.

  38. Have the managers been buying or selling the stock?

  It is important to keep up with the purchases and sales of stock made by management by continually monitoring Form 3, 4, and 5 filings (which are SEC filings related to insider trading) and schedule 13-D filings (which are required for anyone who acquires beneficial ownership of 5 percent or more of a public company). Insider transactions signal where senior managers really believe their companies are going, without the corporate spin. They can also be a useful indicator of whether a stock will out-perform or under-perform. In his 1998 book Investment Intelligence from Insider Trading, Nejat Seyhun examined insider activity from 1975 to 1995 and discovered that stocks bought but not sold by insiders outperformed the market by 7.5 percent, on average, during the 12 months that followed the insider purchases. In contrast, companies with insider selling underperformed the market by 6.1 percent.

  You must be careful not to jump to conclusions from an executive officer who is buying or selling stock without first examining the motivation behind the purchases or sales and whether the buying and selling is material to the total net worth of that executive officer. For example, insider purchases have become less useful indicators than they were in the past. Many executive officers have learned that by buying stock, they can increase the price of the stock, because the media reports these purchases. You have to be aware that the top executive officers may be attempting to manipulate the stock.

  In order to be a useful signal, the insider buying or selling must be significant compared to the total net worth of the insider—for example, representing 15 percent or more of their total ownership. Unless you see these high-conviction purchases, then purchases and sales are just noise, and you need to be careful not to regard them as useful indicators.

  For example, one CEO bought $100 million worth of stock in 2008, which sounds like a big sum. However, when compared to his total net worth, which was estimated by Forbes magazine to be $17.3 billion in 2008, it represented a small amount.

  Here are a couple examples where insider purchases were useful indicators:

  A good example of a strong buy signal is the insider purchases of Carl Kirkland, founder of specialty retailer of home décor Kirkland’s. On March 23, 2006, Kirkland owned 1.3 million shares. A few months later, on September 10, 2008, in a 13-D filing, Kirkland disclosed that he purchased 3,464,032 shares of stock for $6,754,862 (i.e., at an average price of $1.95 per share) by taking out a loan using an airplane he owned and his vacation home as collateral. The 13-D filing listed a business loan agreement between Bank of America and Kirkland Aviation, which owned a Hawker Beechcraft B200GT for a loan in the amount of $4 million. He also took out a loan in the amount of $3.5 million, using his Avon, Colorado, vacation home as collateral. Whenever you see a former founder buying so much stock using loans to fund his purchases, this is a strong buy signal. The stock price of Kirkland’s shortly increased in price to more than $14 per share at the end of 2010.

  Three days before Jamie Dimon joined Bank One as CEO, he acquired two million shares for nearly $60 million, using his own capital. When asked why he bought so much stock, he said he felt a CEO should eat his own cooking. This is a clear signal that you and the CEO are aligned. The stock price increased from $30 per share when Dimon joined in March 2000 to $51 per share when Bank One was acquired by J.P. Morgan on January 15, 2004.29

  Examples of Good Sale Indicators

  If you see senior managers or board members selling a lot of shares, this is not a signal that you should sell your stock, but it is a signal that you should question their long-term faith in the business. You are looking for extremes rather than an insider selling a portion of his or her holdings: After all, that manager could be remodeling a house or have other reasons that have nothing to do with his or her confidence in the business. The following are a few examples of useful warning signals:

  If you see a stock whose price is continually dropping, yet insiders are selling, this is a warning sign.

  In two quarters alone, nine executives and directors of Novatel Wireless sold more than half of their holdings in 2007, at prices ranging from $17 to more than $20 per share. One year later, the stock price dropped below $10 per share and traded as low as $3 per share on December 1, 2008.30

  Five board members at Jones Soda Company disposed of nearly all of their shares of c
ompany stock over a three-month period in 2007 as the stock price reached $27 per share. That year, Jones Soda was developing into a mainstream brand with a national distribution contract, and the company had just announced strong fourth quarter earnings. The CEO also announced that the company would be in 25 percent of the retail market by selling at stores such as Wal-Mart, Kroger, and Safeway. Shortly thereafter, Jones Soda released 2007 first and second-quarter earnings that disappointed investors, causing the stock price to drop to $7 by the end of 2007. Most of the directors were able to sell their shares at prices ranging from $10 per share to $25 per share, while those stockholders who kept the stock suffered a decline in their net worth.31

  CEO John Hammergren of McKesson (a healthcare information technology company) owned 4.5 million shares as of June 1, 2010, including options and restricted stock holdings. He sold more than 2.9 million of these shares in 2010 (64 percent of his holdings), realizing more than $98 million in profits, according to SEC filings. This significant reduction in Hammergren’s ownership should serve as a warning signal to investors that he does not have long-term confidence in the business.

  Determine the Motivation When Management Purchases or Sells Company Stock

  You should also examine further the motivation of stock purchases or sales. To gain full perspective on insider purchases and sales, read the notes to Forms 3, 4, and 5, which often disclose the reason for the purchase or sale. If you are unable to determine the motivation behind the purchases or sales, then you do not have enough information to draw a conclusion, and you need to be careful to not make assumptions. Some of the most common reasons are listed here and described in more detail in the following paragraphs:

  10b5–1 programs

  Tax purposes

  Margin calls

  Personal reasons, such as commitments to charities that need to be funded

  Executive Officers Who Sell Shares under the Terms of a 10b5–1 Program

  A 10b5–1 program is set up under SEC regulation designed to allow insiders to buy or sell company shares in an orderly pattern without having to worry about allegations of improper use of insider information. The plans vary in complexity, but they generally specify the amount, price, and date of the purchase or sale of a stock. Many investors make the mistake of ignoring purchases and sales of stock in a 10b5–1 program because they believe there is an orderly pattern to trading the stock, but the executive officers have the ability to change the terms of the program at any point. Whenever you note significant deviations from the trading plan, this should serve as a warning signal.

  For example, the co-founder of subprime mortgage lender New Century Financial Corporation, Edward Gotschall, sold more than $15.4 million in stock from August 2006 to the first quarter of 2007, just before the company disclosed accounting problems related to reserves, and the business eventually filed for bankruptcy. This sale was conducted under a 10b5–1 plan and was ignored by most investors32—but it shouldn’t have been. If investors had paid attention to the historical sales pattern in the 10b5–1 program, they would have noticed that Gotschall changed the terms of the plan to dramatically accelerate his stock sales.

  Managers also sell stock for reasons that are unrelated to their confidence in the business. The following two examples represent two of the most common reasons.

  Managers Who Sell Stock for Tax Purposes

  When a manager exercises a stock option, it generates a tax liability for the difference between the price the option was originally granted and the price the stock is sold for. Therefore, the manager has two ways to handle this. One way is for the manager to sell all or a portion of the exercised stock and use the proceeds to pay the tax. The other way is for the manager to take out a loan, using the stock as collateral, to pay the tax, which has the effect of deferring the tax. The main risk to this is that if the stock price drops below a certain price, the manager will face a margin call.

  Managers Who Sell Stock to Meet Margin Calls

  During 2008, when the S&P 500 dropped by more than 37 percent, many managers had to sell stock to meet margin calls. One of the more noteworthy sales during this time was from Aubrey McClendon, co-founder and CEO of Chesapeake Energy Corporation, who was forced to sell 94 percent of his holdings for $569 million to meet margin calls when Chesapeake’s stock price dropped 65 percent.33

  Key Points to Keep in Mind

  Learn about the Background of Senior Managers

  The most logical predictor of the future success of a business is its management.

  If you are investing in a manager who has a long track record (i.e., more than 10 years) of successfully managing a business, the odds that he or she will continue to manage the business successfully are in your favor. It’s easier to predict what managers will do in the future if you have already seen what they do in both difficult and favorable environments.

  Outside managers who join the business and make major changes immediately, without fully understanding the customers and soliciting input from the employees, are more likely to fail.

  You can quickly judge several qualities in managers by using the lion/hyena metaphor.

  Managers who have risen from inside the corporate suite (e.g., CFOs and General Counsels) often do not make good operators because they have less experience with the day-to-day operations of the business; they have a constricted way of thinking; and their past interaction with the employees of the business is limited.

  How Managers Are Compensated Is Important

  Some of the best long-term performing stocks are run by CEOs with low cash compensation and high stock ownership.

  If a business has a widely distributed stock-option plan, this indicates that managers care about employees rather than just themselves.

  The ideal compensation structures are those that reward for long-term value creation factors, such as operating income or book value, instead of just the stock price (e.g. stock options).

  If a compensation package is determined by consultants hired by the board of directors, this should serve as a warning signal. 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.

  People who demand the most up front are usually the ones who deliver the least at the back end. Watch for those managers who demand high compensation packages before working at the business.

  Insider transactions signal where managers really believe their companies are going, without the corporate spin.

  1. Dell, Michael, speaking to analysts in Round Rock, Texas, April 2, 2008.

  2. Lublin, Joann, and Spencer Stuart, “CEO Tenure, Stock Gains Often Go Hand-in-Hand.” Wall Street Journal, July 6, 2010.

  3. Byrnes, Nanette, and David Kiley. “Hello, You Must Be Going.” BusinessWeek, February 12, 2007, pp. 30–32; “Executives Need More Than 90 Days to Integrate.” BusinessWire, March 13, 2006.

  4. Interview by Thomas Stewart, “Growth as a Process.” Harvard Business Review, June 2006.

  5. Byrne, John. “Chainsaw Al Cuts His Last Deal.” BusinessWeek Online, September 6, 2002.

  6. Interview with Seng Hock Tan in May 2010 and October 2010.

  7. Standard & Poor’s Capital IQ as of end of 2000 to 2009.

  8. Hawthorne, Fran. The Merck Druggernaut: The Inside Story of a Pharmaceutical Giant. Hoboken, N. J. : Wiley, 2003.

  9. Foust, Dean. “Where Headhunters Fear to Tread” BusinessWeek, September 14, 2009, pp. 42–44.

  10. CarMax 2009 Proxy Statement.

  11. Schwartz, Nelson D., Doris Burke, and Matthew Schuerman, “Greed-mart.” Fortune, October 14, 2002.

  12. Ibid.

  13. Dixon, Jennifer. “How Kmart Fell.” Charleston Gazette, July 14, 2002.

  14. Rockoff, Jonathan D. “Merck Names Frazier as CEO.” Wall Street Journal, December 1, 2010.

  15. Foust, Dean. “Where Headhunters Fear to Tread.” BusinessWeek, September 14, 2009, pp. 42–44.

  16. “3M
a Lab for Growth?” BusinessWeek, January 21, 2002, pp. 50–51.

  17. Fastenal Proxy Statements, 2001 to 2009.

  18. Standard & Poor’s Capital IQ.

  19. 99 Cent Only Proxy Statements, 1997 to 2005.

  20. 2009 Morningstar Proxy Statement.

  21. 2006 Heartland Express Proxy Statement and Standard & Poor’s Capital IQ.

  22. Standard & Poor’s Capital IQ.

  23. 2010 Oracle Corporation Proxy Statement.

  24. 2010 Whole Foods Market Proxy Statement.

  25. Dillon, Karen. “The Coming Battle over Executive Pay.” Harvard Business Review, September 2009.

  26. Ibid.

  27. Schwartz, Nelson D., Doris Burke, and Matthew Schuerman. “Greed-mart.” Fortune, October 14, 2002.

  28. “The Brain Behind Teledyne: A Great American Capitalist.” New York Observer, April 7, 2003.

  29. Byrne, Harlan S. “Dimon in the Rough: A Turnaround at Bank One Won’t Be Quick Under Its New CEO.” Barron’s, April 3, 2000.

  30. Standard & Poor’s Capital IQ.

  31. Harris, Craig. “Sweet Deal for Soda Honchos?” Seattle Post-Intelligencer, August 14, 2007.

  32. Searcey, Dionne, and Kara Scannell. “SEC Now Takes a Hard Look at Insiders’ ‘Regular’ Sales.” Wall Street Journal, April 4, 2007.

  33. Casselman, Ben. “Chesapeake CEO Sells Holdings.” Wall Street Journal, October 11, 2008.

  CHAPTER 8

  Assessing the Quality of Management—Competence: How Management Operates the Business