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Ben Reynolds
Ben Reynolds
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6 Signs of a Shareholder-Friendly Stock

Traits to look for when evaluating a company

(Published March 13 by Nicholas McCullum)

Shareholders are the ultimate owners of any publicly traded business.

By putting capital on the line to gain fractional ownership of a company, shareholders will participate in the successes (and failures) of the underlying business.

Company management teams have some very obvious goals that are dictated by shareholders, including:

  • Maximize profits
  • Minimize expenses
  • Reduce reputational risk
  • Make ethical and socially responsible decisions

There are also certain behaviors that are considered to be shareholder-friendly, which typically include dividend payments and share repurchases.

This article will discuss six signs of a shareholder-friendly stock in detail.

Reasonable levels of executive compensation

Executive compensation is a hot topic on both Main Street and Wall Street.

The CEOs of large corporations are almost always the highest-paid employees, and total compensation can reach the $20 million-plus range.

Further, CEO compensation has been growing more quickly than the rest of the 0.1% and the stock market (as measured by the S&P 500).

CEO Compensation Has Grown Faster than the Wages of the Top 0.1 Percent and the Stock Market

Source: Economic Policy Institute

There are two measures by which the shareholder-friendliness of a company’s executive compensation program can be checked.

First, the total compensation package of a business’ upper-level management should be in the same range as its peers.

Information about executive compensation is disclosed in a filing called the Definitive 14A proxy statement with the U.S. Securities and Exchange Commission.

You can find company filings with the SEC by searching this database. For information on executive compensation, search for "DEF 14A" filings, which will return the company’s "Other definitive proxy statements."

For an example, you can see Johnson & Johnson’s (NYSE:JNJ) CEO compensation package below.

JNJ CEO Compensation

Source: Johnson & Johnson Proxy Circular

Another important consideration is whether executive compensation is dependent on the performance of the business they lead.

In most cases, this is certainly the case. CEO compensation is usually dependent on the company meeting certain financial performance targets.

These targets are outlined in the same DEF 14A filings with the SEC. Johnson & Johnson’s criteria for its executive compensation package can be seen below.

JNJ Key Features

Source: Johnson & Johnson Proxy Circular

For investors looking to own shareholder-friendly companies, finding businesses whose executive compensation practices are reasonable and dependent on company performance is a great place to start.

High levels of insider ownership

Insider ownership is when company insiders (executives, board members, etc.) own company stock.

When insider ownership levels are high, it means the company's management has a lot of faith in the business’ investment prospects.

Since management knows more about the business than any investor, shareholders can rest assured the most informed individuals are confident in the company’s future.

The requirement of insider ownership is also seen as shareholder-friendly corporate governance.

Details about executive stock ownership requirements can also be found in the company’s 14A proxy statements.

For instance, Johnson & Johnson’s executive stock ownership requirements can be seen below.

JNJ Stock Ownership

Source: Johnson & Johnson Proxy Statement, page 44

Notice the stock ownership guidelines are expressed as a multiple of base salary. This is typical among companies that require executives to be shareholders.

A textbook example of high insider ownership is Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B).

Berkshire is a large conglomerate with holdings in many industries (including insurance, manufacturing and railways) that also has a large portfolio of common stock investments.

You can see an analysis of Berkshire Hathaway’s top 20 high-yield dividend stocks here.

In Berkshire Hathaway’s 2016 definitive proxy statement, the company reported Buffett owned 38.2% of Berkshire Hathaway’s Class A stock. This high level of insider ownership is almost unheard of in a company as large as Berkshire.

Insider ownership (and the requirement of insider ownership) is a sign of a shareholder-friendly stock.

Clear communication with shareholders

Through shareholder presentations and press releases, a company's management team has plenty of opportunities to communicate with shareholders.

Companies who make the most of these communication opportunities should be appreciated by their investors. There are two benefits to investing in companies that readily communicate with shareholders:

  • Gain a greater understanding of the underlying business.
  • Gain a greater understanding of the business’ prospects.

For the first point, there is no better example than Buffett (again).

His shareholder letters often elaborate on Berkshire’s businesses in much more detail than is required by regulators.

This helps investors understand the intricacies of the $433 billion conglomerate.

A great example of a company whose management is clear about the business’ prospects is 3M (NYSE:MMM). The company is very clear about its long-term goals for business growth:

MMM Long-Term Financial Objectives

Source: 3M Investor Presentation, slide 14

The Coca-Cola Co. (KO) is another business that is similarly candid about business prospects.

In the company’s presentation at the Consumer Analyst Group of New York (CAGNY) conference, it provided the following slide on its 2016 outlook.

KO 2016 Outlook

Source: Coca-Cola 2016 CAGNY Presentation, slide 47

As with most things, financial forecasting is best digested in moderation. Even the wisest management teams cannot fully predict the future.

Business forecasts that go beyond the realm of reasonable prediction should be considered a red flag by investors.

Buffett has warned against excessive forecasting in the past, writing the following in a letter to shareholders:

Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).

Source: Berkshire Hathaway 2002 Annual Report, page 2

With that in mind, management teams that work to help investors understand their business and its growth prospects (within reason) are a sign of a shareholder-friendly company.

Acceptable use of adjusted financial metrics

When companies report earnings, they have the option to report adjusted earnings per share, which generally backs out one-time expenses such as:

  • Restructuring charges
  • Severance packages
  • One-time tax liabilities

And other metrics that are perceived to impede comparability to previous fiscal years.

Including adjusted earnings in shareholder reports is completely optional. The proportion of companies that include adjusted financial metrics has been rising over time however.

Percentage of Companies Reporting Adjusted Earnings Has Risen Sharply

Source: Business Insider

Buffett commented on this trend in Berkshire Hathaway’s 2016 Annual Report:

Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, 'adjusted earnings' that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of 'restructuring costs' and 'stock-based compensation' as expenses.

Source: Berkshire Hathaway 2016 Annual Report, page 16

Buffett later elaborates on each of these, saying about restructuring costs:

Berkshire, I would say, has been restructuring from the first day we took over in 1965. […] We have never, however, singled out restructuring charges and told you to ignore them in estimating our normal earning power. If there were to be some truly major expenses in a single year, I would, of course, mention it in my commentary.”

Source: Berkshire Hathaway 2016 Annual Report, page 16

And later, on the exclusion of stock-based compensation in the calculation of adjusted earnings:

If CEOs want to leave out stock-based compensation in reporting earnings, they should be required to affirm to their owners one of two propositions: why items of value used to pay employees are not a cost or why a payroll cost should be excluded when calculating earnings.

Source: Berkshire Hathaway 2016 Annual Report, page 16

It is perfectly acceptable for a company to report adjusted earnings under one condition – shareholders read and understand the reconciliation between adjusted earnings and GAAP earnings.

These reconciliations can be found in quarterly earnings presentations. For example, the Walt Disney Co. (NYSE:DIS) included the following reconciliation in its first-quarter earnings release:

DIS Adjusted Earnings Reconciliation

Source: The Walt Disney Company Investor Document

Disney’s reconciliation is simple and easy to understand – which makes its use of adjusted earnings helpful and acceptable.

Another alternative method of presenting a company’s perceived earnings power is through EBITDA, which stands for earnings before interest, tax, depreciation and amortization.

Buffett, among others, has been vocally critical of this metric in the past since the implication is that the four excluded costs (interest, tax, depreciation and amortization) are not true expenses.

Every dime of depreciation expense we report is a real cost. That’s true, moreover, at most other companies. When CEOs tout EBITDA as a valuation guide, wire them up for a polygraph test.

Source: Berkshire Hathaway 2014 Annual Report, page 15

Buffett’s criticism of EBITDA has been long-standing. He also commented on the use of EBITDA in his 2002 shareholder letter, and probably earlier.

Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a 'non-cash' charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business.

Source: Berkshire Hathaway 2002 Annual Report, page 21

Overall, investors should only accept the use of adjusted financial metrics if they can understand the reconciliation between the GAAP and non-GAAP metrics.

Share repurchases

Share repurchases involve a company buying its own stock on the open market with the intent of reducing the number of shares outstanding.

This is beneficial because the company’s financial results are divided among less shares.

Share repurchases can have a pretty remarkable effect on bottom line growth and shareholder returns. The table below shows the amazing compounding power of a business that:

  • Grows earnings at 8% a year
  • Trades at a constant price-earnings ratio of 15
  • Uses 75% of earnings on share repurchases

Share Repurchase Example

Note this is a very simplified example because earnings growth, valuation multiples and share repurchases will all tend to fluctuate over time.

More importantly, note most of the total return was due to the share repurchases. The company’s stock price grew by more than a factor of 10, while earnings grew by a factor of approximately 4.6.

Without the buybacks, the company’s return over the 20-year period would be less than half as large.

The Effect of a 75% Share Repurchase Program on Per-Share Earnings Growth

Share repurchases create value only when the stock is trading at less than its perceived intrinsic value.

If company management repurchases shares at a high valuation, they are effectively "buying three quarters for the price of a dollar."

This has the same value-destroying capabilities as when investors buy overpriced stocks on the open market.

Buffett commented on this in his 2016 Annual Report:

For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value.

Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50.

The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.”

Source: Berkshire Hathaway 2016 Annual Report, page 7

A good example of a company repurchasing undervalued shares recently is Apple (NASDAQ:AAPL).

Because of its incredibly popular products like the iPhone, Mac and iPad, Apple has a massive cash hoard that has been effectively deployed to repurchase shares.

In the company’s first-quarter earnings release, Apple reported $10.9 billion spent on repurchases of common stock, which is more than three times the $3.1 billion spent on dividend payments.

AAPL Financing Activities

Source: Apple First Quarter 8-K, page 6

These buybacks have followed Buffett’s rule of only repurchasing undervalued shares.

Apple has traded at a notably lower price-earnings ratio than its peers (large-cap technology companies) over the past few years, and this trend continues today:

The valuation multiples listed above are based on trailing 12-month GAAP EPS.

When assessing a company’s investment prospects, the two main buyback-related considerations are whether it is engaged in a buyback program currently and whether the management states a particular price or valuation at which they would be happy to repurchase stock.

Dividend payments

Dividend payments are an important part of shareholder returns.

Dividends are the only way for an investor to profit from investing in a company without reducing or eliminating their ownership stake.

Dividends also have a high degree of correlation with shareholder returns. In a previous analysis, I examined the long-term (2000 to 2015) correlations of a variety of financial metrics and total returns.

You can see the results of that analysis below.

Dividend Correlation Analysis

Source: Publicly Available Financial Statements

Dividend payments demonstrated higher correlation with total returns than any other financial metric – even earnings per share.

The outperformance of companies that consistently raise their dividends can be seen when looking at the Dividend Aristocrats Index, which is comprised of companies with at least 25 years of consecutive dividend payments.

You can see the list of all 51 Dividend Aristocrats here.

The performance of the Dividend Aristocrats is compared to the S&P 500 Index below.

Dividend Aristocrats Historical Performance

Dividend Aristocrats Performance Table

Source: Dividend Aristocrats Fact Sheet

Over the past 10 years, the Dividend Aristocrats have returned 10.14% per year while the S&P 500 has returned 7.62% per year – an outperformance of 2.52%.

When searching for shareholder-friendly stocks, dividend payments are one of the most important (and most straightforward) signs to look for.

Final thoughts

Shareholder-friendly companies will make better investments than those that are not, all else being equal.

Fortunately, there are many telltale signs of a shareholder-friendly stock:

  1. Reasonable levels of executive compensation
  2. High levels of insider ownership
  3. Clear communication with shareholders
  4. Acceptable use of adjusted financial metrics
  5. Share repurchases
  6. Dividend dayments

Incorporating these signs into your investment process can help identify companies with management teams that have shareholders' best interests in mind.

Disclosure: I am not long any of the stocks mentioned in this article.

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About the author:

Ben Reynolds
I run Sure Dividend, a website that finds high quality dividend stocks for long term investors using the 8 Rules of Dividend Investing.

Visit Ben Reynolds's Website

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