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Geoff Gannon
Geoff Gannon
Articles (292) 

Can Overpaid CEOs Ever Be Worth It?

The more free cash flow a company's CEO must allocate each year, the more value he can either create or destroy. Good capital allocaters can more than justify their enormous paychecks

March 11, 2017 | About:

Someone emailed me this question:

“How do you determine the company’s executives are not overcompensated and their interests are along with shareholders? As related to that, what are your general thoughts on stock compensation?”

It is very difficult to tell if the top executives of a company are overcompensated. This is because certain people – the head of a key operating unit, the CEO, the chief financial officer, the head of marketing and the chairman specifically, and the board generally – can potentially have a very big influence on the company’s long-term stock performance. Most importantly, some of these people have a great deal of influence over capital allocation. They can also have a lot of influence over the company’s moat (such as a sustainable cost advantage), its culture and its brand. These are key long-term concerns for a lot of companies. Any action that imperils those things will be much more costly than any savings you could get from hiring a cheaper executive.

You also have the problem of continuity of leadership. If you are a long-term investor, you are going to want the successor to your company’s current CEO to be a good choice. This means the successor has to be willing to work under the top person. It also means the successor probably needs to be well compensated and entrusted with an important task just to keep them at the job. You may have a situation where the company’s CFO is overcompensated for the work they do as CFO – but you, the company’s shareholder, hope the CFO will be promoted to CEO when the current one leaves. In that case, some of the payment to the CFO can be seen as a retainer to ensure the future services of that person as CEO. When it comes to capital allocation, I do not think a great chairman and CEO really need a great CFO to get the job done. But it is very possible a company needs a CFO who has worked with the chairman and CEO for years as the best replacement once that person is gone.

There are a few things a great company I own can do to get me thinking about selling the stock. One is buying a business unit that is different and worse than what the company had already been doing. The other is hiring an outsider either as the new CEO or to fill another top position at the company. Why would a good company ever need to hire an outsider as the CEO, CFO or any of the other top positions? For example, why would a good bank ever need to hire someone from another bank to be president, the top person in the loan department, etc.? That would be a terrible sign. When you see a list of the top five people by pay at a company – you want to see that all five of those people have been with the company for a long time. Obviously, if you invested in a company – you like that company’s culture. Introducing any outside elements might change the culture. So, you never want to see a company hire an outsider.

There are exceptions to this. For example, there was a planned merger between Publicis (XPAR:PUB) and Omnicom (NYSE:OMC) that never went through. I think Publicis shareholders would have been better off if the top positions at the combined company were filled by people from Omnicom – because I do not think Publicis has a very good record compared to its global peers in the ad business when it comes to how well the company has been run at the corporate level. Likewise, I think if Unilever (UN) had sold out to Kraft Heinz (KHC), the company could have been improved by management from Kraft-Heinz. I wrote about a bank called Prosperity (NYSE:PB) in Texas. I think the bank’s management improves the businesses it takes over. So, it is possible you have – for whatever reason – invested in a business you like with a management and a culture you do not like. In those cases, I suppose hiring an outsider would be a good thing. I cannot really think of any situation where I was pleased about a company I owned stock in hiring an outsider for any of the top five positions.

Therefore, it is important that top insiders are compensated well enough to keep them, work for people who are good enough to get them to stay and be given enough autonomy to keep them interested in staying at the company. I like companies where the current CEO has been running the place for a long time and I think he will keep running it. That does, however, introduce the problem of the people who report to that CEO all eventually leaving for other companies they can run themselves. For example, the son of the founder of Luxottica (LUX) ended up leaving to run a company that became the owner of Brooks Brothers. Luxottica would have been better off keeping the founder’s son, but it can be difficult to keep someone at a company for decades who knows he is not going to get a chance to run the whole place while the founder is still alive.

It is easy to know if a company’s management has interests that are aligned with shareholders. Long-term stock option grants, or compensation tied to the long-term performance of the stock, will do this. I mentioned Copart (CPRT) in a previous article. The top two people at that company did not receive a cash salary from about 2009 to 2014. Instead, they got five-year option grants. That aligned their interests with shareholders. It made me more confident they would spend the company’s free cash flow on buying back stock.

The easiest way to have management’s interests aligned with shareholders is to have management be shareholders. If I was creating a compensation plan for top management, it would probably be just to create a bonus pool based on something like EVA (economic value added – or return on capital over a minimum value) that would then be used to buy stock in the open market to be held for as long as the executives worked at the company and then bought back from them at the market price when they finally left. I do not think base salaries over a couple hundred thousand dollars a year can ever make sense because no one should need that much money in cash each year if they are being compensated in some other way.

I do not like stock option grants. I think it is best for everyone at a company – even the lowest level employees – to think like owners. I also like incentivized compensation, based on targets employees have some control over hitting, over large base salaries. I would always prefer almost all compensation at a company be in the form of bonuses and stock instead of in the form of a guaranteed salary. The worst form of compensation is, obviously, a large guaranteed salary paid in cash instead of stock.

I do not like stock options because they dilute existing shareholders, often make the company’s earnings and free cash flow reports somewhat dishonest and are usually short-term in nature. There is also the argument they create “moral hazard.” Frankly, this argument is mostly theoretical – and not supported empirically by the facts. Employees lose their jobs if the companies they work at go under. CEOs are also subject to public humiliation if they bankrupt a company they are the sole head of. It is silly to take the idea of moral hazard – that a CEO will play Russian Roulette with shareholder money – too seriously. If you look at the failures of many financial companies, the people at the top often had as much ownership or more than companies that survived. So moral hazard does not really bother me. I have always said risk habituation is a better explanation of self-inflicted failures by a company's top management than moral hazard. Essentially, repeated risk-taking that does not result in harm eventually leads people to become desensitized to risks that no longer seem novel, even though they are at least as risky as when the person first started engaging in them.

I have invested in companies where management is very well compensated. I owned stock in Omnicom. John Wren is often accused of being really, really overpaid. It is difficult to know who made what decisions that led to better or worse returns on a stock. Say Wren is usually paid about $25 million a year. I am just picking that as a round number. The latest proxy statement has him at something like $22 million or so in total compensation, but it is performance-based and some of it is in stock rather than cash – so that is not a reliable, normalized figure. We will use $25 million. The company has about 234 million shares outstanding. If Wren gets $25 million a year – that is less than 11 cents a share before taxes. We will just call it 11 cents a share for this example and forget about taxes. Omnicom stock has a price of about $84 right now, so 11 cents divided by $84 equals 0.13%. Wren is being paid something in the order of 0.1% of the company’s share price each year. Can he take actions that result in a 0.1% annual improvement in the stock price? Sure. In fact, I would say that with a different management team, Omnicom’s share price would have at least a 1% different annual return over the decades Wren has been the CEO.

We could compare Omnicom to Interpublic (IPG) over the last 20 years or so – but that would be a ridiculous comparison. Interpublic has returned around 2% a year versus around10% a year from Omnicom. That is not due to a difference in the quality of the businesses. Interpublic far outperformed Omnicom for many years before then. What can you attribute to the CEO, CFO, chairman and board of a company versus the various business units that operate fairly independently at a corporation like Omnicom? I do not know, but it is probably a lot more like 1.3% of the market cap than 0.13%.

If you asked me – purely economically – whether top management at Omnicom was overpaid by about $20 million or underpaid by about $200 million – I am not sure I could answer that question. Theoretically, top management really can make decisions that add or subtract $100 million a year from what the stock’s intrinsic value would otherwise be. So if you said the top people at Omnicom should collectively be paid $30 million a year, I would say that is fine. If you said they should be paid $100 million a year – I would say that sounds expensive and I would rather not pay it. If you asked if I would rather keep the people who are already at the company and pay them $100 million or swap the team out for the head of one of the its global peers and pay them $30 million – the truth is, I would rather more than triple the pay of the top people at Omnicom and keep them.

Now, to be fair, I have picked a very, very unusual example. Top management at a company like Omnicom has an amazingly outsized influence on the performance of the stock because they are reallocating a huge amount of money. If we look at the last three years, GuruFocus has Omnicom’s free cash flow at $1.25 billion to $2 billion. Somewhat conservatively, about 75% of that free cash flow is completely discretionary in the sense it needs to be allocated at headquarters and not retained by any of the operational managers. So headquarters has to allocate a little more than $1.2 billion a year on behalf of shareholders. You could argue that is not a hard job. It is, however, a very, very important job. Paying a group of managers and the board something like $30 million to allocate $1.2 billion is about 2% to 3% of the total they are allocating. Is the difference between choices of how to allocate the capital about 2% to 3% (forever)? Yes. That is exactly the sort of difference in returns we are talking about.

This might be a controversial thing to say – but I cannot prove top management at a place like Omnicom is overpaid. Additionally, it is hard to come up with a way to reduce the pay of these people that would benefit shareholders. It is purely a negotiating issue. In addition, I do not know what would cause them to stay and what would cause them to leave. Do I suspect they would work for 50% less if they knew their counterparts at other global ad companies were willing to work for 75% less? Yeah. I think the pay of these people has nothing to do with the absolute amount of money they are making and everything to do with how much they are getting paid versus other top executives in the ad industry. If they think they are the best – they want to be the highest paid. That is what sets their demands. A public company’s board is not usually a very good negotiator when it comes to getting an executive to accept as little pay as possible and still retain them.

So is Omnicom’s management overpaid in the sense they would probably work for less? Yes. Is Omnicom’s management overpaid in the sense that shareholders get less from management than they pay them? No. I do not think management’s pay is greater than their value creation at Omnicom.

Frankly, the very best management teams at a true investment-type holding company (like the advertising giants really are and Berkshire Hathaway (BRK.A)(BRK.B) is), a bank or an insurer are almost always underpaid rather than overpaid. Some of the people on those annual lists of the highest-paid CEOs are – in my view – underpaid in the sense they create more value than they collect for themselves. Management has such a huge influence over any company with a ton of capital to deploy that it is never worth taking the low bid and getting a management team you like less. At an insurer, the best underwriter and the best investor are never going to get paid as much as they are actually worth to that company’s shareholders.

My advice is you should look for the best management. The best manager is usually a company’s founder. A company’s founder usually owns stock in the company. That means your interests are most aligned with management when you invest in a public company that is still run by the founder. It is a really good idea to try to invest with founders and big shareholders whenever possible. All the other sorts of incentive schemes with their bonuses and stock options and so on are really just attempts to get an owner-oriented management team.

A CEO’s big jobs are usually allocating capital, preserving the company’s culture and strengthening the brand. In essence, you want someone who is long-term oriented and who thinks like an owner while caring about customers. What you really do not want is someone who is short-term oriented and cares a lot about employees. I say this all the time, but employees get way too much consideration at most companies. Running a company in a way that pleases customers while creating the profits that owner’s like will end up pleasing a lot of people – including employees – over the long term. This will happen because a lot of value is created.

Running things in a way that generates an insufficient return on investment (so it displeases owners) or makes customers think less of the company can only have benefits in the short term. Even employees who think those sorts of decisions benefit them will end up being wrong if they stay for the very long term. A company needs to be self-financing its growth and continuously pleasing customers more and more each year. That is always what you are looking for in top management.

I am really bad at catching companies undergoing a turnaround. When I look for a good manager, I usually mean one who is going to continue capital allocation policies I already like. He is also going to preserve the company’s culture. I look for these characteristics because I am not going to invest in a company unless I like what they have done historically. Maintaining the company’s culture while allocating capital as if he was himself an owner is what you need from a CEO. That means you will do best with a CEO who is a founder and majority owner of the company you are looking at. If you cannot get that – you just want to find whoever comes closest to the ideal of founder or majority owner.

As far as whether or not you can tell if management is “overpaid” – there are two ways to answer this question. One, is the board paying the CEO more than what it would take to keep him at his job? Answer: almost always yes. The other question is whether the CEO – net of his pay – is creating or destroying value at the company. Frankly, the “pay” variable in that equation tends to be the least important part. Executive pay is a really popular topic in the media because of how unfair it is. From a purely rational, purely unemotional shareholder perspective – having the right manager is so much more important than paying him the right amount. This has nothing to do with how hard the job is to do. A job can be easy to do, but very dangerous if done badly and very profitable if done well. I think it is easier to be an advertising industry CEO than the CEO of a fashion retailer. The ad industry CEO will create more value for shareholders. At a retailer, a lot of the most important decisions will not be made at the top. In fact, a lot of them will be dictated by competitors rather than anyone inside the organization. In addition, a lot of the free cash flow will not really be free. It will have to be used on refurbishing stores, advertising and other costs just to stay in place.

In conclusion, I would say being a really smart CEO who has a really difficult job and being a really valuable CEO to shareholders have nothing to do with each other. The CEOs who create the most value for shareholders tend not to have the toughest jobs, and they probably are not the smartest people around. They are just positioned in such a way they can create a lot of wealth if they make a few simple, correct decisions each year. This is not what shareholders want to hear. I think shareholders want to believe the CEO of the company they invest in is paid a “fair” amount. In terms of your own portfolio’s performance though – fair is not important. Avoiding big capital allocation mistakes, screwing up a company’s culture and value creation is what matters.

If a company you are invested in has the chance to hire an outsider at 80% off what the company’s current CEO is making and you know that outsider is at least as smart and competent – I would tell you not to take the deal. It is a bad gamble. Saving a fraction of one percent of the company’s market cap is not going to be a big enough offset against the risk of changes to capital allocation policies or to the company’s culture. You do not need brilliance from a CEO. What you need is preservation of the company’s culture and sound capital allocation. A CEO can be very highly paid and still create value for you if he delivers on those two things.

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