Remember high school geometry? It wasn't memorizing the formulas that made geometry difficult. It was relatively simple to memorize that for a right triangle, A squared plus B squared equals C squared, or that the sum of the angles of any triangle is 180 degrees. Instead, the tricky part was knowing which formulas to apply and when, because the teachers would use word problems with the clues to the right formula embedded somewhere in the text.
As analysts and investors, we all have access to the same information. Thanks to Regulation FD (Fair Disclosure), we all start on a relatively level playing field when it comes to accessing public SEC filings, conference and earnings calls, and newspaper articles. So just like geometry, the difference between success and failure isn't determined by how much information you have, but how you process the information that's available.
I recently read arguments that GAMCO (NYSE:GBL) shareholders should sell their stock because founder and CEO Mario Gabelli pays himself too much -- $55 million. I believe that reasoning is false, and here are my arguments.
Get to know GAMCO
As a primer for those who aren't familiar with this company, GAMCO is an asset management company run by founder and well-known value investor Mario Gabelli. Because he owns the majority of GAMCO's stock, Gabelli controls the company, and outside shareholders are mainly passive investors along for the ride. Some see this as a negative in light of Gabelli's enormous salary. However, Gabelli's GAMCO stake, worth hundreds of millions of dollars, ensures that he has an interest in seeing GAMCO's stock appreciate.
GAMCO manages roughly $26 billion in assets, half in mutual funds and half in separately managed accounts. The company has roughly $250 million in sales (equal to about 1% of assets), $100 million in operating income (and a 35% operating margin), and $60 million in net income. The company has a $1.08 billion market cap (as of this writing) and more than $400 million in net cash, giving it an enterprise value/EBIT multiple of roughly 6 and a price/earnings ratio of 17 (this becomes 10 if you subtract net cash). This is far cheaper than asset management peers such as T. Rowe Price (NASDAQ:TROW), Franklin Resources (NYSE:BEN), or Waddell & Reed (NYSE:WDR).
Mario Gabelli was embroiled in legal disputes with some of his founding partners that were recently settled. Gabelli was also involved with litigation because of wireless spectrum fraud cases unrelated to GAMCO, which were also settled. Furthermore, GAMCO's mutual funds have underperformed over the past five years. This is mostly due to Gabelli specializing in the TMT (tech, media, and telecom) sector. Wall Street believes old media (cable, newspaper, and landline telecom) is dead, but many value investors believe "old media" is due for a revival.
After reading a spate of articles demonizing Gabelli for his salary, I've decided that the market, the Street, and whoever else value investors like to criticize for doing non-value-investor-like things have got it all wrong.
Gabelli's options
- Pay himself more (a bad thing): This is almost certainly impossible. After the public and press all but burned former NYSE CEO Dick Grasso in effigy for his $139 million pay package, no self-loving human being would dare spit into the compensation-concerned public's face.
- Pay himself the same (neutral): This is the most likely scenario. Gabelli has made public statements outlining his justifications for his high pay, such as the fact that some hedge fund peers earn more, and the fact that his fame amounts to free advertising for GAMCO. Under this scenario, nothing changes.
- Pay himself less (very positive): If Gabelli worked for free, operating income would increase roughly 50%, which would send the stock skyrocketing. Any reduction in Gabelli's pay between 1% and 100% would be positive for GAMCO shareholders.
Even under the most likely scenario -- that Gabelli's compensation doesn't change at all -- I believe there are other positive catalysts.
- Bad press has helped to create a discount in the stock. However, the masses are fickle. If the public can forgive Latrell Sprewell for choking his former coach because he helped lead the Knicks to the NBA Finals in 1999, then the masses will certainly forgive Gabelli if his funds start performing better.
- Bad press may cause Gabelli to hunker down and focus on performance. At 63 years old, Gabelli is motivated more by legacy than by salary. Given his recent problems, it isn't hard to fault the guy for losing focus (while writing this article, I've checked 10 stock quotes and Googled my own name twice). Although better performance depends more on a turnaround in tech, media, and telecom, it doesn't hurt that Gabelli might have a chip on his shoulder.
- Most importantly, Gabelli's large salary essentially creates a margin of safety. His salary is roughly 30% of GAMCO's total expenses. Throw in distribution expenses, and variable compensation from those two items alone is nearly 50% of total expenses. This helps insulate investors from negative operating leverage. Of course, this also limits the upside, but given the company's low valuation, downside risk is more of an issue. Furthermore -- and I apologize for this rather gruesome point -- Gabelli's salary negates the "hit by a truck" risk. If Gabelli were to meet an unfortunate and untimely demise, many investors might choose to withdraw their funds. However, the company would also forgo paying his $55 million salary. By quick and dirty calculations, GAMCO would have to lose more than $10 billion in assets under management for operating income to take a hit. The last time GAMCO's assets were this low was 1998, and I was in high school.
Related Foolishness:
- A Value Opportunity at a Value Manager
- Morgan Stanley's Great Leap Forward
- Better Know a Stock Picker
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He owns shares of GAMCO, and the Motley Fool has a disclosure policy. Lee also likes to take long walks on the beach, as long as he can walk at a 40% or more discount to its intrinsic value. He appreciates any comments, concerns, and complaints.
