Your CEO Is a Lousy Investor

The most critical role of a CEO is to allocate capital. But is the average chief executive really better at it than the average investor?

Setting the bar low …
Left to their own devices, typical small investors have inevitably picked the worst time to invest. In the first quarter of 2000, investors poured a record $130 billion into equity funds at the top of the market. They then took out $70 billion of cash in the third quarter of 2002, close to the tech-bust bottom.

What do you suppose happened in 2008? You guessed it: Driven by fear, investors pulled more than $230 billion out of equities, according to the Investment Company Institute. Not surprisingly, fear and greed drives investors to enter and exit the stock market at precisely the wrong times.

… yet still falling short
You'd think that highly paid corporate executives would inevitably fare better. Yet their experience looks sadly similar to that of average investors'. According to S&P, since the fourth quarter of 2004, S&P 500 companies have bought back $1.78 trillion of their own stock, while they've reported $2.22 trillion in earnings. In other words, they've reinvested 80% of your earnings to buy back company stock.

Moreover, their timing hasn't been great. Buybacks peaked in 2007, to the tune of $589 billion, with stocks at record highs. As the stocks fell in 2008 and early 2009, so did corporate buybacks: Standard & Poor's reports that in the fourth quarter of 2008, stock buybacks fell 66% -- despite record levels of cash sitting on corporate balance sheets and much lower share prices.

Here are the top seven spenders on buybacks in 2007 and what they spent on stock from 2006 to 2008:

Data from Standard & Poor's.

Why that was a bad idea
Warren Buffett, the CEO of Berkshire Hathaway (NYSE:BRK-A), who knows a thing or two about capital allocation, has stated it's a good idea to buy back shares if two conditions exist:

1. You have surplus capital, AND
2. You can buy shares below their intrinsic value.

Alas, it seems that most executives don't follow that philosophy.

There's another thing about corporate behavior that troubles me right now. As I read through recent annual reports, it's amazing how many boards are requesting shareholder approval for new stock options plans. I've also read about companies like Google (NASDAQ:GOOG) requesting the right to re-price their options, while others, such as eBay (NASDAQ:EBAY), want to exchange their underwater stock options for restricted stock. Hmmm. It seems executives want all the upside without any of the downsides of options.

As I see it, either management is just not very good at allocating your capital, or insiders are putting their own interests ahead of yours. 

What to look for
Tom Russo, a well-known international value investor who seeks companies that generate copious amounts of free cash flow, has said, "As an investor in businesses, which generate enormous cash flows, my single most important issue to get right is what management will do with cash flow through reinvestment."

Even a second-grader can see how the managers of their companies make those decisions. For instance, look to see if board members and managers actually purchase shares of stock alongside shareholders, or just receive stock and options grants for free? As former Home Depot CEO Robert Nardelli's $200 million-plus retirement package reminds us, you often don't get what you pay for.

The Foolish bottom line
Famed management guru Peter Drucker warned of the death of big companies long ago, in part due to senior leadership taking all the credit and an oversized part of the compensation pie. As long as we continue to reward executives with insane pay with no risk, we can expect to keep seeing the same capital allocation errors of the past.

What do you think? Are executives doing a good job allocating our capital? Are they intelligently compensated? We want to hear your thoughts in the comments box below.