Time to examine how our Rule Breaker Portfolio stocks hold up under the lens of employee stock option (ESO) grants. Enjoy last week's column, How Companies Dilute Your Share, which explains how to find the annual percentage of ESO grants yourself.

Why do you, as an individual investor, care? Maybe this is you:

You've started investing, learned something about what the numbers mean. Luckily, you own shares of a sweet little company with rising revenues, better gross and net profit margins, and rising earnings and free cash flow. You've held it for years and intend to keep holding, but there's one little thing: All these good results don't seem to be turning into stock gains. What gives?

There are three common reasons for this:

  • When you bought the stock, it was so highly valued in relation to its cash-generating potential (using a valuation measure such as price-to-earnings or price-to-free cash flow, for example) that growth will have to be impossibly huge to move the price higher;

  • A bear market has brought down all stock valuations;

  • Or, the company issued so many ESOs that the increase in value is being diluted among more ownership shares.

Our portfolio and stock options
As a rough guide, we want established companies to grant no more than 3% a year of their basic shares outstanding in the form of ESOs, and developing companies at 5% or less. Here's how our Rule Breaker Portfolio holdings stack up for the last three years:

       Stock Price   ESO Grants as % of 
         12/31/99-   Basic Shares Outstanding
Company  10/04/02    2001   2000   1999
Amgen        -27%    1.25%  1.80%  1.62%
Amazon       -78%   12.38%  5.86%  9.56%*
AOL TW       -84%    3.95%  3.80%   N/A
eBay         -16%    7.08%  4.51%  2.80%
Millennium   -70%    4.57%  7.15%  2.59%
Starbucks     75%    2.65%  1.22%  2.04%
LendingTree  567%*   4.13% 17.94% (!) N/A
S&P 500      -46%
Nasdaq       -72%
*I corrected these numbers after talking with
the company in Amazon Talks Back.

Among the established profitable companies, only Amgen (Nasdaq: AMGN) and Starbucks (Nasdaq: SBUX) come away with clean noses, and with Starbucks' business and stock performance, one might even look the other way if the company had its hands in the ESO coffee beans more often.

AOL Time Warner (NYSE: AOL), at almost 4% annually the last two years, exceeds our ESO standard for established companies by a bit, and during a period when its business performance deems it odd to offer ESOs as a reward. We've considered selling for some time now. Jeff Fischer (TMF Jeff) asked if it was time in July. I wrote later that I had lost confidence in management -- though we have yet to see how newer, untested America Online Chief Jonathan Miller will perform. We asked you what you thought, and the results were decidedly undecided. Lately, Motley Fool co-founder David Gardner made a very persuasive case for the company in Motley Fool Stock Advisor. No decision yet.

Can we call eBay (Nasdaq: EBAY) established? I could be wrong, but it's hard for me to imagine a world without this business. But the company's 7% ESO giveaway last year exceeds benchmarks for any type of company. Not good.

In the group of developing unprofitable companies, Amazon (Nasdaq: AMZN) fails every year for the past three, and compounding makes it scarier: Year 2000's 5.86% is on top of the previous year's gain, and 2001's 12.38% is on top of that. [Please note: Amazon responded to these comments with information that clearly makes the situation look better. A week later, I corrected and explained in Amazon Talks Back.]  

Millennium Pharmaceuticals (Nasdaq: MLNM) and LendingTree (Nasdaq: TREE) dropped under our 5% developing company marker in 2001, but each had lousy numbers in 2000, and LendingTree's 18% was horrible. However, LendingTree's 567% gain since the end of 2000 has more than substantially rewarded shareholders. That's no excuse, but as long as the company's ESO grants are in a positive downward trend, we may see that year as an aberration for a company whose very survival was in doubt.    

On the short side
We'd like ESO grants to be high at companies we've sold short. And indeed they are:

           Stock Price   ESO Grants as % of 
            12/31/99-    Basic Shares Outstanding
Company     10/04/02     2001   2000   1999
Sirius Satellite -98%    8.08%  5.14% 18.73%      
Guitar Center   51%*     4.50%  4.12%  N/A
S&P 500        -46%
Nasdaq         -72%

Sirius Satellite Radio (Nasdaq: SIRI) investors have had more to worry about than ESO grants. Their investment has always been a bet that subscriber numbers will ramp up in time to service debt and secure more credit. Many investors, like me, have taken that chance with stocks that needed the same magic, from Globalstar to Metricom to Excite@Home, with sad endings. Our portfolio shorted Sirius at $6.90 a share, and we're up about 87%. There are excellent arguments for covering, but right now, we think this puppy may just go to zero. We'll see.

Guitar Center (Nasdaq: GTRC), an established company with financial problems, has been handing out ESOs at a clip way beyond the 3% guidelines for a company of its ilk. We expect its share price to follow its financials. Down.

The big picture?
ESO grants will rarely be the single reason for selling a stock, but knowing a company's record helps you make informed investing decisions. Are there times where you should overlook the 3% or 5% guidelines? For example, I received several emails suggesting that shareholders really receive a benefit if a company secure excellent employees for lower salaries and ESO grants, even with share dilution as the price.

I'll tackle this, but with the unsurprising disclosure that my credentials for never having run a company are impeccable. I'm sure managers of public companies know far more than I do about what it takes to hire the best employees. When Human Genome Sciences (Nasdaq: HGSI) CEO William Haseltine told me frankly that expensing ESOs would make it impossible for him to hire the people he needs, I had no reason to doubt him.

That doesn't stop me from having an opinion, though. Most investors have never run a company and must make judgments about this all the time. After all, that's the social contract: We as shareholders turn over management of a company to execs, expecting them to act in our interests. We must apply criteria to determine which management is acting in our interests and which isn't. 

And I believe that excessive ESO grants are one indicator management isn't acting in shareholders' interests.

Employment incentives
The options-for-salary tradeoff has a certain pleasant ring to it, but it turns dissonant upon closer examination. For example, take NewTechGizmo (Ticker: WHATZIT), a developing company that can't compete on salary with dominant monster CiscIntSoft (Ticker: BIGFOLKS) for senior-level software developers. Yet NewTechGizmo must hire the very best to have a prayer of biting off and keeping a piece of any market in which CiscIntSoft plays. Its venture capital and IPO money must go to building the business. So while it can't pay the big bucks, it can attract entrepreneurial types with the promise of a piece of any future success in the form of stock options.

How about it: If it pays salaries, say, 33% under industry average, do the options grants simply balance the reduced "S" of SG&A (salaries, general, and administrative expenses)?

They very well may, at least in the short run. But for how long? Sooner or later, salaries will creep up to industry averages. Sooner or later, your younger staff that chose risks and ESOs over salary grows up, has a family, and thinks about mortgages, education, car repairs. They will want salaries. When that happens, do you think ESO programs will end? Doubt it. It's human nature to want more and more.

When downtimes come and employees are easier to get, do you think management will issue fewer options? I doubt it. I'll bet the company just reprices options downward and keeps offering new ones. Once you're hooked on absinthe, it's hard to give up. Live by the sword; die by the sword. (Insert your maxim here.) 

Solomon's compromise
But in the end, I just can't dismiss the use of ESO grants for newer, developing companies, even if Warren Buffett and others make strong arguments for eliminating them altogether. Let's account for the possibility that newer, developing companies may have to issue ESOs and at a higher rate than established companies. But all else being equal, a developing company shouldn't be giving away your ownership at a rate of more than 5% a year of shares outstanding (I've been using basic, but there are arguments for using diluted, too) in ESOs, and established companies should be at 3% or lower. Five percent is, after all, 67% more than 3%.

If you have an opinion on ESOs, please tell us on our Rule Breaker-Strategies discussion board.

You can always find our updated portfolio returns below. So far this month and week, the Rule Breaker Port beat out both the S&P 500 and Nasdaq. For the year, it's only a wee bit behind the S&P 500 and far in front of the Nasdaq.

Have a most Foolish week!

Tom Jacobs (TMF Tom9) is astonished by how cool -- and handy -- our new Foolish Calculators are. Check them out! He owns shares of LendingTree and Millennium Pharmaceuticals, and is short Guitar Center. To see his stock holdings, view his profile. The Motley Fool has a disclosure policy.

Rule Breaker Portfolio Returns as of 10/07/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      -0.17%**   -3.68%   --      -4.48%
Month     -0.17%**   -3.68%   --      -4.48%
Year     -32.04%**  -31.60%   --     -42.61%
using IRR*** since 8/4/94 +19.12% +6.80% +10.18% +5.54%

*Dividends added. Or, danger ahead. Whatever.

**Please keep in mind that these figures will be distorted for the RB Port for the short period around which we add any cash (see next note!). Since July 2001, we consider depositing $12,500 in new cash each quarter unless we have enough available for new investments without it. 

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure is more meaningful than total return because we began adding cash occasionally in July 2001. In a total return calculation, or ((Current Value - All Cash Deposited)/All Cash Deposited), cash added would show up as returns. And that wouldn't be cricket!