The Vilification of Bob Nardelli, Part 2

This seems to be at the heart of what led Home Depot (NYSE: HD  ) to part ways with CEO Bob Nardelli: Investors saw the company's top man taking home boatloads of money while they watched the value of their shares slip. Including his signing bonus and severance package, Nardelli added more than $400 million to his bank account during his six years with the company, while the stock is trading lower than when he started. Had Home Depot's stock price headed up and to the right during Nardelli's term, investors might very well be patting themselves on the back for money well spent on a great executive.

At health-care services company UnitedHealth (NYSE: UNH  ) , former CEO William McGuire was paid well more than $200 million over the same period (that amount doesn't include a starting bonus or severance package, as Nardelli's sum does, and also far understates the value of his options). Though McGuire recently stepped down because of stock-option backdating, I believe that had the problem not been found, investors would still be applauding him despite his massive compensation package. Why? Because even with the backdating scandal, UnitedHealth's stock is up 250% over the past six years.

Playing the blame game
Nardelli brought a whole new management style and culture to Home Depot, and many objected. But the same time, the board didn't hire the ex-GE executive to come in and play patty-cake -- it wanted efficiency and best practices, and it saw the Jack Welch protege as the man for that. And though one could blame the board for not only bringing Nardelli in, but also for OKing his pay package, that group of directors -- elected by shareholders -- most likely thought it was doing the best thing for the company. Heck, the Yankees didn't bring in Randy Johnson and his $16 million annual salary because they thought he'd go 34-19 with a 4.37 ERA.

In retrospect, could Nardelli have benefited from using $10 from his millions to buy (and read!) a copy of How to Win Friends and Influence People? Maybe he could have taken to heart Machiavelli's Discourse and remembered that "no prince has ever benefited by making himself hated." But should he have been a cheerleader for the stock to try to keep it buoyed for investors?

At the end of 2000, when Nardelli took over, Home Depot's stock was trading at near 40 times trailing EPS and the company was coming off a year when net income had grown just a bit more than 10%. Though the company had been growing at a higher rate, the onetime up-and-comer had turned into a $100 billion behemoth by the time Nardelli became CEO. During his tenure, the P/E multiple declined rapidly from 40 to just lower than 14, where it sits today. Though multiple contraction can happen because of a company's fundamentals deteriorating, sometimes it happens because the stock was simply overvalued.

There's a lesson here somewhere
High P/E stocks generally get that way because of high historical growth -- and investors expecting it to continue. Though Home Depot had managed to grow EPS by 40% in fiscal 1999 before dropping off to 10% growth in fiscal 2000, it is extremely difficult to maintain that kind of growth rate, particularly for a company already doing $40 billion in revenue.

A 1997 paper by professors Eugene Fama and Kenneth French says that from 1975 to 1995, there was a distinct return premium on value stocks, defined as the stocks in the bottom 30% of all stocks in terms of price-to-book value and price-to-earnings multiples. The duo showed that while the value stocks outperformed a global market portfolio by 3% to 5%, these stocks outperformed growth stocks -- the stocks in the highest 30% in terms of P/E and book value multiples -- by as much as 7.7%.

In my own research, using data from Capital IQ, I took a look at returns over the past 10 years for all stocks that had positive earnings and a market cap of more than $250 million. For that time frame, the top 25 performers had an average P/E of 28 times trailing EPS, and only four of them had a P/E ratio of more than 40. The bottom 25 performers, on the other hand, had an average P/E of 50 times trailing EPS, and 11 of them had a P/E ratio of more than 40. Going one step further and looking at the entire data set of 1,311 stocks, I found the P/E ratio to be negatively correlated with returns over that period. Regressing returns based on P/E came up with a similar result, showing that a higher P/E had a statistically significant negative impact on returns. I saw similar results when I looked at the size of the company: Larger companies were more likely to be in the group of biggest losers than they were to be with the biggest winners. UnitedHealth, which 10 years ago had a last-12-months (or LTM) P/E multiple of 22, was just one away from making it into the top 25 performers.

There were certainly some outliers in the group, such as Network Appliance, which had an LTM P/E of more than 100 and still returned more than 1,000%, or Delta, which lost more than 95% of its value despite its 5.5 LTM P/E at the time. Most of the stocks, though, fit the mold:

Company

1997 LTM P/E

1997 Market Cap

10-year Return

Best Buy (NYSE: BBY  )

10.7

$454.4

4,185.7%

SEI Investments

19.4

$404.0

1,514.5%

Legg Mason (NYSE: LM  )

14.4

$701.6

903.2%

Revlon (NYSE: REV  )

102.8

$1,521.0

(95.3%)

Danka Business Systems (Nasdaq: DANKY  )

37.6

$2,200

(96.2%)

Iomega (NYSE: IOM  )

47.7

$2,093.7

(91.3%)

Source: Capital IQ. Data current as of Jan. 6.

Those who don't learn from history ...
So why bring up all this? To recommend Home Depot stock now that Bob Nardelli is gone? In short, no. Home Depot is a fine company, and I imagine that the company's new CEO, Frank Blake, will find it easier to please investors because the stock is trading at a much lower multiple and expectations for the company, the stock, and the new CEO are nowhere near what they were in late 2000. But whether or not the lower-priced stock is worthy of investment is not the point.

The bottom line is that it's rare when the price of a stock accurately reflects the intrinsic value of the business. It's only in those few cases that change in the stock price can be used as a proxy for the company's success. The way Home Depot's stock has performed over the past six years serves as a good reminder that investors don't succeed just by investing in great companies -- they succeed by investing in great companies when the price is right. The strength of the fundamentals at Home Depot suggests that Bob Nardelli may not have been a failure as CEO, but overexuberance in the market when he took over may have doomed him to failure in investors' eyes.

For more value-oriented Foolishness:

Home Depot, UnitedHealth, and Legg Mason are all Inside Value recommendations. Best Buy and UnitedHealth are Stock Advisor recommendations. Need new ideas for your money? Talk stocks with other investors and our analysts when you give our newsletters a try.

Fool contributor Matt Koppenheffer encourages feedback and loves to hear about readers' favorite value stocks. He owns shares of UnitedHealth, but does not have an interest in any of the other companies mentioned. The Fool's disclosure policy is always well-constructed and never overpaid.


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  • Report this Comment On March 14, 2009, at 3:18 PM, jpath51 wrote:

    there are two reasons people buy stock one is the dividends and the other is stock price rise. to make stock price rise somebody has to buy it. nardelli cut out the employees from buying the stock by making mandatory wage cuts. without a engine to drive sales the stock stagnated. once sales slowed none employes looked at why they should buy stock. there was no reason to ..no large dividends no rising stock prices..profit from cutting employes wages is short term and bad for morale..nardellia likes to surrond himself with yes people.why a sinking company like chrysler hired him is strange.

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