Why Investors Shouldn't Always Shy Away From High-Paid CEOs

Why some CEOs deserve to earn the big bucks -- and how you can weed out the good from the bad in executive compensation.

Mar 26, 2014 at 3:23PM

Let's remember for a minute the story of former Tyco International (NYSE:TYC) CEO Dennis Kozlowski. Anyone with an MBA, or who had read a newspaper in the early 2000s, knows this story -- but I get a kick out of it every time it comes up. The ultrawealthy corporate leader squandered $6,000 on a shower curtain, $2,900 on coat hangers, and $15,000 on a dog-shaped umbrella stand (well, who doesn't need one of those?).

Kozlowski's outrageous spending, more than $110 million in white-collar theft, and subsequent imprisonment are quite well known. What is less well known is that, despite his nine-figure theft, he earned over $300 million in the four-year period 1998-2001. Why in the world would a company intentionally pay a CEO that much money? Let's look at executive compensation and what it means to investors.

What is executive compensation?
Executive compensation is simply the value of everything that an executive (we'll focus on CEOs) gets for being the CEO. In general, CEOs receive multiple forms of compensation, including a base salary, an incentive cash-based bonus, short-term stock grants and options, long-term stock grants and options, and a slew of others (pension, company car, etc.).

How is executive compensation set?
Every company sets a unique executive compensation plan for its leader. Generally, a few members of the company's board of directors will form a compensation committee and they will set all of the baselines and benchmarks related to the CEO's total compensation package.

To answer the question that just popped into your head: Yes, CEOs can have significant influence on the decisions made by their compensation committees (especially when the CEO is also the chairman of the board, as Kozlowski was), and CEO pay packages are not always unbiased. But we'll leave discussing CEO influence on the board for another time.

The common forms of CEO pay
Base salary: a check in the mail every month, just like the ones the janitors and parking attendants get.

Cash bonus: an additional cash payment that CEOs get, assuming they meet some short-term goal. Unfortunately for some investors, there is evidence to suggest that CEOs often get this cash bonus whether they meet their short-term goals or not.

Stock grants: a bunch of stocks that the CEO gets for meeting certain short- and long-term goals. These (along with options) often make up the majority of CEO total compensation, especially for larger companies. Investors take heart: Unlike cash bonuses, companies are much better about not paying these stock grants if the firm doesn't perform well under the CEO.

Stock options: the right to buy shares of the company's stock, given to the CEO, if certain goals are met. Typically there will be a vesting period of a few years where the CEO can't touch them.

What do these forms of payment mean to investors?
Simply put, the more money a company pays its CEO, the less money is left over for its investors. Below we can look at each type of payment and decide what it means for us investors.

Basically, base salaries and cash bonuses are going to be paid to CEOs regardless of how they do (assuming they don't pull a Kozlowski and get fired). As investors, we don't like to see too high of a cash payment, so that the company can hang on to that wealth if the CEO doesn't earn it.

Stock grants are the best form of payment, in my opinion. If the CEO holds a large portion of their personal wealth in the company's stock, they are very likely to do everything they can to maximize the value of that stock. This works out well for you, the investor, who surely wants the same. Even better is when the stock grants are blocked for a period of a few years: The CEO must do a good job for a long time before they can cash out. These are called restricted stock grants, and they benefit you, the long-term investor.

Stock options are good in the same way that stock grants are good. But because of the way people make money on stock options -- capitalizing on the difference between the set exercise price of the option and the market price of the stock -- option holders may be incentivized to alter their behavior to maximize the value of their options, in a way that could hurt the value of common stock; for example, reducing dividends would help an option holder and potentially hurt a common stockholder.

How to research executive compensation
Now that you know the different kinds of executive compensation out there, and what they may mean for you, it's time to incorporate it into your regular research. If you're researching big companies, it's likely that the information is already nicely compiled on a credible investing website. But if you have to dig around for it yourself, thankfully it's pretty easy!

Pull up most any annual report and what's included is a compensation report, remuneration report, or something with a similar title. If it isn't in the annual report, the annual report will point you to a separate proxy statement to read. It's usually a few pages long and can be a little dry. But by the time you get through it, you'll have a good feeling of how a CEO is compensated, and you can decide if their interests are forced to align with yours.

Kozlowski's compensation package
So, what was it about Kozlowski's compensation package that allowed him to decide it was in his own best interest to steal from the company? After all, the goal of an incentive package is to force the interests of the CEO to align with those of the shareholders. Below is a breakdown of Kozlowski's 1999 compensation.

Dennis Kozlowski Compensation (as reported in Tyco proxy statements)
Year Salary Bonus Restricted Stock Grants Total (excluding options) Options Total (including options)
1999 $1,350,000 $3,200,000 $25,707,178 $30,257,178 $68,420,000 $98,677,178

OK, what do we see here? We see $4.5 million in salary and bonus. That's a huge number, but it isn't too big compared to the total compensation, so no red flag there. I love to see that high number in restricted stock grants. As an investor, if I know that Dennis Kozlowski has $25 million of stock in Tyco and is going to hold it for at least a few years, I'm going to be pretty confident that he's going to maximize the value of that stock -- which is exactly what I want. As for the options, $68 million is a lot, and options can sometimes be problematic, but generally the goals of option holders are very close to the goals of stockholders.  

I would have liked Kozlowski's options to have been restricted for a much longer period, so that he could earn this money only if the company did well for a very long time. But overall, this isn't a terrible compensation package. The fact is that while compensation packages often do a very good job of aligning executive goals with those of shareholders, they're not a complete safeguard against greed and corruption. Kozlowski was set to earn a staggering amount of money legally and still decided to steal over $100 million of shareholder wealth.

Incorporating compensation analysis into your regular research will help see that management incentives are aligned with your own, but you also should make a qualitative assessment of the character of the individuals running the company. While you may not be able to identify future white-collar criminals just from reading a few press releases, thinking about the alignment of goals, compensation breakdowns, and character just may keep you from investing in a company headed by the next Kozlowski.

Warren Buffett didn't make billions by betting on half-baked stocks
He isolated his best few ideas, bet big, and rode them to riches, hardly ever selling. You deserve the same. That's why our CEO, legendary investor Tom Gardner, has permitted us to reveal "The Motley Fool's 3 Stocks to Own Forever." These picks are free today! Just click here now to uncover the three companies we love. 

Brian Anderson has no position in any stocks mentioned. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers