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Management Pay

July 03, 2012 | About:
A lot has been written about management pay over the years. While I certainly have nothing brilliant to add to the subject, nevertheless a thought did spark a while back when reading Yacktman’s view on the subject.

Mr. Yacktman criticized the awarding of stock options as an incentive for management. Specifically, having all upside and no downside does not align the manager with the stockholder. As an alternative, he offered the discounting of outright share purchases, but, more importantly, he advocated the supremacy of cash bonuses, not stock awards, for the senior agents of the corporation.

Here, his reasoning was simple – the stock price will not necessarily (in fact, rarely does) reflect accurately the performance of the individual divisions of a company. A division may do great while the company flounders and the stock tanks. A division may be a drag on a flourishing enterprise whose stock marches higher in spite of it. And, perhaps worst and most common of all, a division may do great or poor, and the company may do great or poor, while the stock will do whatever the manic vicissitudes of the stock market dictate over the short run. Mr. Yacktman’s insights prompted these two four-squares:

Business Unit Performance Is Good



Stock Award


Cash Award


Stock does poorly


Not fair to manager


Fair


Stock does well


“Lucky” for manager but fair


Fair




Business Unit Performance Is Poor



Stock Award


Cash Award


Stock does poorly


“Lucky” for shareholders but fair


Fair


Stock does well


Not fair to shareholders


Fair




Stock awards create an inherent gamble between management and shareholders. If a stock does poorly – for whatever “reason” – the good manager will not have received his just rewards, while the shareholders will have at least avoided having to come up with any real dough to compensate his efforts – shareholders win, in other words.

On the flip side, if a stock does well, the shareholders will have over-compensated the incompetent manager with windfall stock award profits – management gets away with a “fast one” win. In those events, when the stars align and the stock performs in line with the performance of the business unit (either good or bad), justice is served, but I qualify this as a “lucky” event for, as most value investors would agree, stocks – in anything but the long-run (much more than one year) – are not marked rationally while incentive systems generally reflect annual results (the better ones do have some element of “rolling years” to them).

The four-squares above do, however, show that an intelligently constructed (an assumption) cash-based incentive system will be fair regardless of what the stock price does, and this is Mr. Yacktman’s wise contention. My only addition to the matter would be the advocacy of the shareholder vote for top management pay. And this is to head off the major issue with the cash-based system – the assumption that the system is in fact intelligently constructed and not easily manipulated for the gain of management. I figure that if the top management pay is visible, scrutinized, and controlled by watchful, skeptical shareholders (well, at least, value investors tend to be), top management will, in turn, be quite interested in just how (or how much) their senior lieutenants are being compensated. In essence, shareholders, in controlling top management pay, can harness the power of envy to ensure a more rational and more shareholder-friendly distribution of profits throughout the organization.

Eric Houssels is the co-founder and managing member of Houssels Capital Management, LLC, a money management firm based in Las Vegas, NV. The firm focuses on investments in the stocks of publicly-traded companies of all capitalizations that possess, preferably, significant earnings power or, alternatively, assets that can be (re)deployed to achieve significant earnings power and are trading at reasonable valuations. Houssels Capital Management was founded in 2000.

About the author:

Eric Houssels
Eric Houssels is the co-founder and managing member of Houssels Capital Management, LLC, a money management firm based in Las Vegas, NV. The firm focuses on investments in the stocks of publicly-traded companies of all capitalizations that possess, preferably, significant earnings power or, alternatively, assets that can be (re)deployed to achieve significant earnings power and are trading at reasonable valuations. Houssels Capital Management was founded in 2000.

Visit Eric Houssels's Website


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Comments

Gaffey
Gaffey premium member - 2 years ago
Michael Burry, the doctor who short sold stock of financial institutions prior to the 08 crash had this to say on the subject. It should be of interest to value investors. Link here: http://www.scioncapital.com/PDFs/Scion%202001%202Q_web.pdf

"That is, to the extent the company is issuing stock at prices in excess of intrinsic value and in numbers and dollar volume in excess of any buyback, the company is creating incremental intrinsic value per share. To illustrate, when an employee exercises an option to buy stock at $15, the company issues stock at that $15 price and hence receives $15 cash. At the same time, assume intrinsic value is $10 per share. Intrinsic value is thus created at a rate of $5 per share issued.

Note that it does not matter if the market is currently valuing the stock at $20 per share. Intrinsic value is created whenever shares are issued at a price per share in excess of intrinsic value per share. Indeed, one could argue that for companies that issued and had exercised many options with high strike prices, value was created on a per share basis even though the shares were being issued to employees at seemingly low prices at the time and even though the even greater value creation that could be realized by issuing stock at much higher prevailing market prices is ignored. Here, "high" and "low" are defined relative to intrinsic value per share, not relative to prevailing share price.

Of course, if the company simultaneously buys back stock at those high prices, then it is to an extent offsetting any benefit. In many cases, one finds that the issuance of stock far outpaces the repurchase of stock, resulting in the seemingly paradoxical circumstance of shares outstanding rising in the face of an ostensibly strong share buyback. The gut reaction is that this is very wrong – that is, that the share buybacks are helpful while the share issuances are deleterious. The gut reaction is imprecise and possibly in error, however.

When evaluating an options compensation program, one must weigh the net value creation from (a) the issuance of excess options-related stock at prices higher than intrinsic value and (b) the tax benefit associated with the program against the net value destruction from (a) buying stock back at market prices higher than intrinsic value and (b) issuing options-related stock at prices lower than intrinsic value. Such an evaluation is most illustrative when it encompasses several bull and bear cycles in the company’s history. Also, note that this methodology does leave open the potential for tremendous value destruction if option-related stock is consistently issued at a discount to intrinsic value while an ongoing buyback consumes stock at a significant premium to intrinsic value.

To be clear, there is no easy rule of thumb, and digging through ten or more years of SEC filings to find the relevant numbers and trends is not generally a task most investors like to pursue. Certainly it is easier to listen to someone else’s opinion regarding the company’s growth rate or some other easily understood metric. It is likely, however, that the investors in the habit of overturning the most stones will find the most success.

Following are two general conclusions that I found while investigating options compensation over the last decade. One, it takes tremendous growth in the underlying business as well as a significantly inflated share price to justify options compensation. Such characteristics may result in share price issuances at prices above intrinsic value at the same time the value creation of early share buybacks is magnified and the value destruction of recent buybacks is minimized. So, to the extent that companies used options compensation to attract the key workers that helped drive earnings and share prices upward at dizzying rates, the options program may be less dilutive to shareholder value than a skeptic might initially believe. On the other hand, low stock prices relative to intrinsic value may increase shareholders’ susceptibility to options re-pricing or re-issuance, both of which tend to destroy value.

That is, to the extent the company is issuing stock at prices in excess of intrinsic value and in numbers and dollar volume in excess of any buyback, the company is creating incremental intrinsic value per share. To illustrate, when an employee exercises an option to buy stock at $15, the company issues stock at that $15 price and hence receives $15 cash. At the same time, assume intrinsic value is $10 per share. Intrinsic value is thus created at a rate of $5 per share issued.

Note that it does not matter if the market is currently valuing the stock at $20 per share. Intrinsic value is created whenever shares are issued at a price per share in excess of intrinsic value per share. Indeed, one could argue that for companies that issued and had exercised many options with high strike prices, value was created on a per share basis even though the shares were being issued to employees at seemingly low prices at the time and even though the even greater value creation that could be realized by issuing stock at much higher prevailing market prices is ignored. Here, "high" and "low" are defined relative to intrinsic value per share, not relative to prevailing share price.

Of course, if the company simultaneously buys back stock at those high prices, then it is to an extent offsetting any benefit. In many cases, one finds that the issuance of stock far outpaces the repurchase of stock, resulting in the seemingly paradoxical circumstance of shares outstanding rising in the face of an ostensibly strong share buyback. The gut reaction is that this is very wrong – that is, that the share buybacks are helpful while the share issuances are deleterious. The gut reaction is imprecise and possibly in error, however.

When evaluating an options compensation program, one must weigh the net value creation from (a) the issuance of excess options-related stock at prices higher than intrinsic value and (b) the tax benefit associated with the program against the net value destruction from (a) buying stock back at market prices higher than intrinsic value and (b) issuing options-related stock at prices lower than intrinsic value. Such an evaluation is most illustrative when it encompasses several bull and bear cycles in the company’s history. Also, note that this methodology does leave open the potential for tremendous value destruction if option-related stock is consistently issued at a discount to intrinsic value while an ongoing buyback consumes stock at a significant premium to intrinsic value.

To be clear, there is no easy rule of thumb, and digging through ten or more years of SEC filings to find the relevant numbers and trends is not generally a task most investors like to pursue. Certainly it is easier to listen to someone else’s opinion regarding the company’s growth rate or some other easily understood metric. It is likely, however, that the investors in the habit of overturning the most stones will find the most success.

Following are two general conclusions that I found while investigating options compensation over the last decade. One, it takes tremendous growth in the underlying business as well as a significantly inflated share price to justify options compensation. Such characteristics may result in share price issuances at prices above intrinsic value at the same time the value creation of early share buybacks is magnified and the value destruction of recent buybacks is minimized. So, to the extent that companies used options compensation to attract the key workers that helped drive earnings and share prices upward at dizzying rates, the options program may be less dilutive to shareholder value than a skeptic might initially believe. On the other hand, low stock prices relative to intrinsic value may increase shareholders’ susceptibility to options re-pricing or re-issuance, both of which tend to destroy value."

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