Why Compensation Should Matter to You

Executive compensation has been in the news a lot over the past few years, but why should it matter to individual investors? I sat down with analysts Matt Argersinger (TMFMattyA) and Andrew Sullivan (TMF Redwood) to find out.

Executive compensation has been in the news a lot in the last year as both Congress and the public have challenged how public companies compensate their higher-ups. Where do you stand and why?

Argersinger: People should be paid well if they deliver the goods. In fact, Warren Buffett himself is known for paying the CEOs of Berkshire Hathaway's (NYSE: BRK-B  ) subsidiary companies extremely well if they meet or exceed his performance expectations.

The problem is that a lot of executives are getting egregious sums of money for bad performance. But it's not government's job to determine how corporate executives are paid. It's the job of the Board of Directors and the shareholders who elect them.

Nell Minow of the Corporate Library believes the ideal executive compensation package includes low up-front payout, meaningful clawbacks, long-term incentives, and restricted stock grants and options. What do you think makes the ideal package? Do you see any examples that come close?

Argersinger: I think Minow has it right. However, the ideal compensation package isn't just about the types of compensation, but the performance measures behind that compensation.

Many companies tie their incentive compensation to year-over-year changes in earnings per share, for example. But we all know the discretion corporate accountants can have in determining that figure. A good compensation package links incentives to performance that is directly within the control of the executives.

One compensation scheme that I'm particularly fond of is the one employed by Markel (NYSE: MKL  ) , a specialty insurance company. Markel's executives are measured on the three-year rolling change in Markel's book value per share. Not only does that measure performance over a significant period of time, but it's tied to a financial metric that incentivizes Markel's executives to invest prudently and take a conservative approach to their insurance underwriting.

Sullivan: Nell's on the mark. Executives should share downside risk yet be rewarded for specific performance -- but usually the exact opposite happens. A perfect example is CapitalSource (NYSE: CSE  ) . In 2006 it generously awarded the CEO 7 million options, and then in 2008, after the stock collapsed and the options became essentially worthless, gave him 2 million vested stock units.

Sardar Biglari was once a market darling in the Warren Buffett mold, but his recent announcement of a hedge-fund-like compensation package has soured many former believers. What's your take on the drama?

Argersinger: My problem with Biglari's new scheme isn't so much the nature of the package. After all, it's almost identical to the scheme Warren Buffett used when he was managing money in the Buffett Partnership back in the '50s and '60s, and it's set up so that Biglari will spend roughly 50% of his after-tax compensation buying Biglari Holdings' (NYSE: BH  ) stock.

My problem is with the bait-and-switch. Biglari took over Steak 'n Shake, turned it around, engendered a loyal shareholder base, then rips the carpet out from under us by saying he's taking a cut of all gains in book value over 5%.

As a hedge fund investor, you know what you're agreeing to when you invest your money. With BH, Biglari is virtually pilfering shareholder capital and severely dampening future shareholder returns for his own personal gains. If BH wasn't such a compelling investment even in spite of Biglari's new scheme, I'd sell my shares today.

Sullivan: I haven't followed the story closely, but the new compensation plan is a joke -- the hurdle rate (5% increase in book value) is abysmally low and to take 25% of any increases over is extremely generous. It's not just the large amount that's at issue, it's that over time this will dramatically reduce the value accruing to an ordinary shareholder. A better-stacked deck can be found elsewhere.

If you're an investor looking into a possible stock buy, what should you take note of regarding compensation?

Argersinger: First and foremost, check to see what kind of ownership stake management has. If the CEO owns 5% or more of the shares outstanding, you can bet he or she is firmly aligned with shareholders and don't have to be nearly as introspective about the compensation package.

Sullivan: Look for 1) how the CEO is paid, 2) how much he is paid, and 3) is the board honorable? How refers to what is the CEO judged on -- cash flow is usually preferable to earnings or revenue growth. How much refers to how much is his total compensation in relation to the company's net income. Two to four percent is a typical ratio but it should be lower for larger companies. Third is the quality of the board -- if you can find an upstanding and conservative board, you've gone a long way to finding a good compensation system.

OK, final question -- which companies are getting compensation right and which are getting it all wrong -- and why?

Argersinger: Investors can save themselves a lot of trouble by concentrating in companies with founder-owners at the helm. You probably don't have to bother even looking at Jeff Bezos' compensation package at Amazon (Nasdaq: AMZN  ) . The company is his baby and he owns more than 20% of shares. Or take Barclay Simpson, of Simpson Manufacturing (NYSE: SSD  ) . I don't think he's given himself a raise since the IPO. That was nearly 20 years ago. With owner-founders, you can stop guessing whether or not their compensation scheme is aligned with you.

As for companies getting it wrong. I'm going to beat an old drum here, but when it comes to egregious pay packages, golden parachutes, and a sickening sense of entitlement, nothing beats Wall Street. I mean nothing.

Sullivan: Here's the thing: Seventy-five percent of CEOs don't add value relative to their peers and shouldn't be paid more than $2 million. Twenty percent destroy value and should be fired. The final five percent of CEOs are exceptional and deserve to be paid exceptionally well. The spirit of the policy is more important because the numbers can be gamed.

McKesson (NYSE: MCK  ) is getting it all wrong. This is a company with only a $19 billion market cap and yet the CEO made over $30 million in each of the past three years based on earnings per share, a measure that can be gamed. The compensation committee at McKesson should be ashamed of themselves.

Julie Clarenbach owns shares of Berkshire Hathaway. Matt Argersinger owns shares of Markel and Biglari Holdings. He's also written puts on Berkshire Hathaway. Andrew Sullivan owns shares of none of the companies mentioned here. Berkshire Hathaway and Markel are Motley Fool Inside Value picks. Amazon.com, Berkshire Hathaway, McKesson, and Simpson Manufacturing are Motley Fool Stock Advisor choices. The Fool owns shares of Berkshire Hathaway, Biglari Holdings, CapitalSource, and Markel. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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