After my last article appeared, a reader asked me about how I look at executive compensation in each of the Nintai Charitable Trust’s investments. I am pleased to say none of them are on the top 200 list of best compensated executives. In general my view on compensation in publicly traded US companies is quite poor. To me this isn’t just a matter of conscience but a fiduciary issue that all shareholders should care about. Management – and their respective Boards of Directors – who conceive of some of these enormous pay packages (more about this later) are providing little value to shareholders. Whether as cash, stock options, or deferred compensation, executive compensation is no different than any other labor cost. I want to be clear up front that I’m not bringing up the issue of executive compensation as a partisan or public policy issue. Rather I look at it as all investors should – a cost that ultimately can reduce your return in cases of poor performance or egregious payments,
There are several reasons why I think investment managers and shareholders should be concerned by some of these pay packages– the growth of compensation, how compensation is designed, and the measures used to compensate.
Growth of Compensation: A Great Anomaly of the Age
In 2015, CEO’s made more money than any year before. Average compensation for top 200 CEOs was $17.6M up about 2% from 2015. The median compensation for the top 100 CEOs was roughly $15.1M. This compares to roughly 47% of all Americans who earned less $25K per year or 75% who make less than $50K per year. The average (not the median) American worker makes roughly $46,300 per year or roughly 1/326th of the median CEO.
I have absolutely no problem paying a CEO for great performance. Sadly, most don’t come up to scratch. Jack Bogle, in his wonderful book “The Clash of Cultures”, shows that most senior executives performed quite badly during this steady run of annual increases. For instance CEO pay has risen roughly 6.5% annually since 1980. During this same time frame, management predicted 11.5% annual earnings growth but produced barely 6% growth. This is less than the average 6.2% nominal GDP growth for the same period. As Bogle says, “how that somewhat dispiriting lag can drive average CEO compensation to a cool $9.8M in 2004 and then to $11.4M in 2010 is one of the great anomalies of the age”. I couldn't agree more.
When you are looking to invest in a company peruse the annual reports for CEO pay, projected growth rates over the past 10 years, and the actual growth rate over that period. Any management that sees itself as either far more important than their average worker or worthy of steady pay increases for mediocre performance doesn't belong in your portfolio.
Compensation Methods: Not How Much, But How
When investors hear about CEOs taking a $1 salary and being “all in” with his/her shareholders, hold your nose and get out the latest SEC compensation numbers. Total compensation can be more than a salary. Much more. It might include bonuses, stock awards, options awards, non-equity incentive plan compensation, changes in pension value/deferred compensation earnings, and a more general “other” compensation (such body guards or personal use of the corporate jet).
You would think all these options and stock awards would make CEOs large shareholders in their companies. There you would be wrong. Per the Harvard Business Review, CEO stock ownership for large public companies (measured as a percentage of total shares outstanding) was ten times greater in the 1930s than in the 1980s. That number has dropped even further in the past 30 years (it’s now roughly 12 times greater).
A recent Conference Board/Arthur J. Gallagher & Co report showed that CEO David Zaslav was paid by Discovery Communications (DISCA) $156 million in compensation last year of which $145 million was in stock and stock options. CEO Satya Nadella was paid by Microsoft (MSFT) $84 million of which $80 million was in stock awards. And finally CEO Larry Ellison was paid by Oracle (ORCL) $67 million, $65 million of which was in stock options.
This focus on stock grants (while boosting ownership – which is good) unfortunately is not hinged to any long-term value performance measures. All too often we see the mix of compensation driving the CEO to fudge earnings reports, misrepresent financials, and sometimes to resort to outright fraud.
When you look to invest in a company the question that should be asked is how is management compensated not how much. Does the compensation reward for building long term corporate value? Does the CEO truly have skin in the game (not just warrants and options)? In the Nintai Charitable Trust we look for compounding machines to grow our investment. To get this type of performance, it all starts with how the CEO is compensated.
Compensation Measures: Where’s the Beef?
If CEO’s are being rewarded for underperforming their estimated growth by 50% as seen in the last section, what incentive is there to grow the long-term intrinsic value of their company? When CEOs are awarded $220M for nearly running their company into the ground (Bob Nardelli received $223M for being fired from Home Depot) it really isn’t an incentive to worry too much about underperformance.
Investors should look for companies that drive compensation through long-term value creation. For instance, Nintai Charitable Trust holding Fastenal (FAST) uses measures of return on capital to drive some of CEO compensation. Another holding – Expeditors International (EXPD) – faced a shareholder revolt in 2014 when investors felt the bonus package for outgoing CEO Peter Rose was not long-term focused (I should note we were a shareholder that voted against the package). The company got the message and changed its compensation calculations.
Golden parachutes for failed management and non-performance based compensation are two clear red flags for any potential investment. You don’t reward organizations that perform poorly in your personal life, so why should you in your investments?
Management compensation can tell you a lot about corporate culture and how the Board and executives see their shareholders. As value investors we should be seeking management that provide – and are compensated for – steady long-term value creation. There are many companies in the investment world that seriously address this and act accordingly. Unfortunately there are all too many who do not. Management that compensate themselves like the divine kings of old are a disgrace to their industry and do not belong in your portfolio. If investors are going to outperform the markets, then they need to invest in companies and management that look to do the same.
As always I look forward to your thoughts and comments.
 CEO compensation data was obtained from proxy statements filed with the U.S. Securities and Exchange Commission (SEC) for the CY2015 and CY2016
 “The Clash of Cultures”, Jack Bogle, Wiley & Sons, 2012