Stock investing involves agency risk, as outside investors essentially delegate their capital to corporate executives to generate business returns without active participation in the management.
At Hillside, we like to regard managers of our (partially) owned companies as trusted partners. We look for owner-oriented stewards that treat shareholders fairly (instead of benefiting themselves at others’ cost). There are some easy-to-grasp gimmicks that we can leverage to gauge this factor.
An intuitive approach is to find a decent alignment of interests between management and shareholders. This can be easily achieved if the management has their skin in the game. Now that it is not uncommon for executives to own some equity stakes these days (many through the so-called Long-term Incentive Plan), the question has become how much insider ownership is enough. In this regard, we can compare the executive’s personal shareholding wealth to his/her annual package. The end goal for us is to gauge the financial incentive of the management.
Let’s take Credit Acceptance (CACC, Financial), one of our portfolio companies, as an example. According to the filing, the company’s long-time CEO Brett Roberts (who retired just recently) received a total package of just over $1 million in fiscal year 2019 compared to more than 300,000 shares under his name. Assuming a share price of $350, we would come up with a position worth nearly $100 million – that is, 100 times his annual pay. In history, the long-term average total return of the total equity market is around 6% to 7%. Therefore, it can be rationally indicated that Brett’s primary monetary motivation for the job is to grow the equity value of the business (for owners, including himself) rather than the salary, which we would applaud. It should not be surprising that Brett and his management team frequently displayed their shareholder-oriented mindset: e.g., a great emphasis on return on capital and repurchase shares only below fair value, both of which have become ultra-rare among today’s public companies.
So insider ownership is crucial. But even with that checked, how do we evaluate the fairness of executive compensation? One quick method that we often employ is to look at the ratio of the management pay to the corporate profit. For example, Credit Acceptance earned a profit of $656 million in fiscal 2019, and hence, the ratio for the CEO for that year would be less than 0.2%, which is a fairly low number for a company of around $8 billion in market cap.
By contrast, the CEO of Chemed (CHE, Financial) (another U.S.-based mid-cap business) was paid over $10 million (including bonus and share-based reward) in the same year – that is, approximately 4.6% of the company’s earnings. That ratio reads consistently high at 4.3% and 8.1% in fiscal 2018 and fiscal 2017, respectively. What’s the implication for Chemed’s shareholders here? The return on equity at the company averaged nearly 30% for the last five years. During the period, the company was able to take advantage of reinvestment opportunities (including acquisitions) to deploy roughly 50% of its operating cash flow. So basically, without the CEO, not only could the shareholders have earned 4% more every year, but also they probably would have compounded more capital at an even more attractive rate of return over the long run. Of course, every company needs a CEO. But the question is whether they are worth the price.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. I/We have position(s) in any of the securities referenced in this article.
This article was written by the author and first appeared in Hillside Wealth Management's monthly newsletter.
