5 Real-World Winners

Shooting holes in each other's theories is a favorite pastime of financial academicians. One professor ventures forth with a revolutionary theory, and then another professor ventures forth with an opposing theory to explain why the first just ain't so.

For instance, we thought we'd hit upon the perfect compensation model when employer-granted stock options become the compensation scheme of choice in the late 1990s. After all, granting stock options meant that managers now had skin in the game. Being on the same side as the outside shareholders provided additional incentive to maximize shareholder value. Everyone was pulling on the same side of the rope.

Not so fast
It was a tidy, plausible theory -- until, that is, a university professor shot numerous holes in it. That professor was Roger Martin, dean of the Rotman School of Management at the University of Toronto, who published his theory-blasting article "Undermining Staying Power: The Role of Unhelpful Management Theories" for the Spring 2009 edition of Rotman Magazine. (Martin penned similarly themed articles for the Dec. 22, 2003 edition of Barron's and the May 11, 2009 edition of the Financial Times.)

According to Martin, stock compensation prompts managers to switch their focus from the "real market" to the "expectations market." Invoking an NFL analogy, Martin notes that both the corporate and pro-football worlds operate in the real market and the expectations market. Football players play real games, just as corporations produce real goods and services. But the NFL's expectations market is represented by the gambling market, in which bookies set spreads based on expectations of a future event -- the Sunday game.  

In the corporate world, the expectations markets is the stock market, where Martin argues that prices are set not by real-world sales, margins, or profits, but by the collective expectations of future sales, margins, and profits. Stock prices go up only when investors' expectations rise, not necessarily when sales, margins, or profits rise.

In football, players are prohibited from betting, and for good reason: Expectation markets provide incentives to increase expectations, but not performance. Hence, player performance would be compromised by counterproductive activities, like point-shaving. In the corporate world, there is no such prohibition, so we get counterproductive activities, like having management chat up the company's prospects or aggressively work the financial statements to inflate real-market performance -- actions that, in turn, raise expectations.

Is that really such a bad thing? Well, yes. To quote Martin: "The instant expectations rise, the base for new shareholders is a price consistent with the new level. This is why Cisco, trading at around $18.60 a share as it dominates its market, struggles to imagine how it can satisfy the expectations of those who bought at $80." In other words, investors can get burned by inflated expectations.

Real-world investing
I concur that the focus should be the real world. That's one reason I focus on two very real-world measures: the relatively-difficult-to-manipulate return on assets and the impossible-to-manipulate dividends. I favor companies that have averaged at least a 15% return on assets over the past five years and have increased their dividend at an average clip of 10% (or thereabouts) over the same time frame. I also favor little to no long-term debt, because low or no debt suggests a higher quality of earnings. And although stock options are difficult to avoid completely in the current zeitgeist, I minimize their impact by focusing on companies that don't issue too many of them. I consider only stocks for which the options' dilutive impact is less than 5% of shares outstanding. (You can usually find that information in the financial statements.)

Here are a few noteworthy stocks that meet my criteria:

Source: Reuters.

I'd be remiss not to mention two wild cards -- and they are "wild cards" only because neither pays a dividend: Berkshire Hathaway (NYSE:BRK-A) and Leucadia National (NYSE:LUK). Both are exceptionally real-world-centric and shareholder-friendly. Simply read either company's annual report and vet their historical returns for evidence. In fact, I encourage you to do so.