Tuesday, March 30, 2010

Pantry Gets a Heads-Up from the Globe

The Pantry just received a mention in a blog that is part of Toronto's Globe and Mail, essentially Canada's version of the Wall Street Journal.

The article, On the Hunt for 'the king of value factors' highlights price to sale ratios. At the top of the list is The Pantry.

Just a word about price to sales ratios. Be careful in using them. A company with very poor profitability but big time sales will appear attractive on these screens. If they can develop some operating margins that are respectable, then these companies can be huge winners. But if they can't, they merely churn through sales dollars without adding much value for shareholders.

Monday, March 29, 2010

Is "The Pantry" Bare?-Piotroski Says No

"You can't buy what is popular and do well" is one of the great Warren Buffett quotes. Though over time, I have learned to be far more comfortable investing in quality businesses that throw off lots of free cash flow and earn superior returns on invested capital, many value investors start their search for cheap stocks with the new low list and those that are making news headlines that portray disappointment. Contrarianism does work, as Buffett says, there are many ways to get to "financial" heaven. As is obvious, the real challenge for us as investors is separating those businesses that have been unfairly beaten down because of Street overreaction from those that truly deserve to be disregarded and ignored. "Moribund and poorly run businesses deserve to languish" as the great mutual fund investor, John Neff once described.

So how do you separate these businesses? For many years, academics focused on low price to book value companies (or put another way, high book to market companies) as a place to seek superior returns. As it turns out, these companies demonstrated an anomaly to the prevailing capital assets pricing theory. Subsequent analysis showed that a low price to book value ratio implies that prices contain expectations of low ROE expectations. Such companies, at current prices are generally expected by the consensus to be poor performers and therefore considered risky.

In a Seeking Alpha article earlier this year, John Reese of Validea highlighted an enhancement of this value investing screening technique developed by Joseph Piotroski of the University of Chicago. These refinements focused on generation of operating cash flow (as opposed to earnings), improvements in liquidity or leverage, as well as some signs of improving profitability and turnover. As John described it earlier:

Piotroski thus applied a series of additional tests of financial strength to identify a set of criteria that did lead to market outperformance. I've listed the 10 criteria below.

  • Book/market ratio
  • Return on assets
  • Change in return on assets
  • Cash flow from operations
  • Cash compared to net income
  • Change in long-term debt/assets
  • Change in current ratio
  • Change in shares outstanding
  • Change in gross margin
  • Change in asset turnover

In essence, this is contrarian investing with a wrinkle, some sign of internal improvement, cheap but with some light at the end of the tunnel. Rather than seeking excellence, Piotroski looks for encouragement. Most investors tend to "over-extrapolate" past performance trends, as I like to say, extrapolate short term trends into the hereafter. Overly pessimistic extrapolations do tend to reverse as the reality of changing actual earnings hit the tape. Ditto for those companies with a positive bandwagon…overly optimistic extrapolations reverse as well.

Having done some recent work on retailing (Tiffany's Valuation Looks Too Rich), I thought it may be of interest to look at a retailer at the other end of the spectrum, one that was bumping its bottom in the new low list, and with apparently few friends, The Pantry Inc (PTRY) .

The Pantry operates a convenience store chain in the southeastern United States. Its merchandise products include tobacco products, packaged beverages, beer and wine, general merchandise, health and beauty care products, self-service fast foods and the usual snack and grocery items. As of December 2009, it operated 1,668 convenience stores in 11 states primarily under the banner, "Kangaroo Express."

Like most convenience chains, gasoline and fuel sales drive overall sales but contribute significantly less to gross profits (data per Gridstone Research)

Pantry Inc







Gasoline Sales







COGS Gasoline






Gross Profit -Gasoline













Merch Sales













Gross Profit-Merch













Gasoline as % of Total Sales






Gasoline as % of Total Gross Profits






In terms of some ratio analysis (again, per Gridstone), here is how the business has developed:

FYE Sep-05

FYE Sep-06

FYE Sep-07

FYE Sep-08

FYE Sep-09

[ST] Gross margin






[ST] Operating margin












[ST] EBIT margin












[ST] EBITDA margin












[ST] EBITDA margin (TTM)






[ST] Pretax margin






[ST] Net margin






[ST] Effective tax rate






[ST] Return on equity






[ST] Return on assets






[ST] Return on invested capital






[ST] Net operating profit after tax






[ST] Cash flow from operations to Sales






Obviously, this is a business whose metrics are far less appealing at first brush to most investors having just salivated at the metrics of high end retailing.

Yet, there is some evidence of improvement in operating margins, in returns on assets and equity, and invested capital.

There are certainly some issues here that are disturbing, a lot of debt, for example, with $1.67 billion in total liabilities versus $440 million in equity. Interest coverage is about 2.7 times. Leverage has often been high in this consolidating industry, and in particular at PTRY where some heavy acquisition years of 2006-2007 impacted the balance sheet. Given the significant assets here and the relatively low equity base, the hunter may well turn into the "hunted."

Standard and Poors recently affirmed its corporate credit rating announcement of The Pantry as a "B+" and noted:

"Credit measures deteriorated, with total debt to EBITDA at 6.6x compared with 4.9x one year ago. Although we expect some improvement in fuel and merchandise margin through 2010, credit measures are not likely to improve to levels needed to support a higher rating. We revised our rating outlook to stable from positive, and affirmed our 'B+' corporate credit rating on Pantry Inc."

Of note, there is $180 million in cash on hand as compared to a market cap of only $278 million as well as availability of an additional $142 million through its revolver. The next tranche of debt that comes due is convertible debt due in November of 2012.

Book value is about $19.50, most of which consists of goodwill, hence, at current market prices, PTRY trades at about 60% of book, certainly "qualifying" it for Piotroski's scrutiny. Five years ago, this stock sold at almost four times book value at a time when ROE was near 30% and ROA was about 6%. These metrics seem impossible now.

Taking a somewhat more recent perspective, consensus earnings are now around the $1.27 area having dropped down from $1.66 some nine months ago. Certainly this represents a different trajectory for expectations than most retailers have had in the same period. Sales per share is enormous at over $300 per share…there is tremendous operating leverage…both ways primarily because of gasoline sales. Even looking at just the non-gasoline sales, these represent over $80 per share in sales.

Though not a perfect demonstration of Piotroski's criteria, (shares outstanding have increased YOY and asset turnover has yet to show improvement) most of the other parameters have been met.

Though not a name I would want to stake my retirement assets in, I think The Pantry is a worthwhile speculation at current levels. High risk but potentially high reward.

Please find an investor presentation by The Pantry management at the Bank of America Merril Lynch Consumer Conference of March 10th, 2010.

Disclaimer: I, my family and clients do not currently own a position in PTRY.

Tuesday, March 23, 2010

Tiffany & Co-Valuation Seems Generous to Me

On Monday, Tiffany & Co reported what seemed to be somewhat disappointing earnings of $1.09 versus a street consensus of $1.13. TIF actually has had a fairly good history of positive earnings surprises in recent quarters (data courtesy of Reuters):

Quarter Ending

Percentage Surprise


- 3.63%






+ 0.42


+ 6.61








+ 5.09

As you can see, the negative surprise was not hugely negative either. What went right and what went wrong?

The fourth quarter was actually surprisingly strong on a sales basis. The breakdown by geographic segment looks strong across the board for the fourth quarter:

For the Americas:

+14% versus a drop of 29% the previous year

For the US+12% versus a drop of 33% the previous year

For Asia Pacific:

Sales were also strong throughout with exception of Japan, rising 14% in dollar terms. Outside Japan, sales were robust at +38% in constant currency. Japanese sales in the fourth quarter were down 9% in constant currency.

For Europe:

Particularly strong sales here +18% on a constant currency basis.

Tiffany was quite defensive through 2009, reducing headcount by 900 people and opening only 10 stores, taking capex down to $75 million from a more normal level of about $200 million. Ex one time items, it appears that SG&A positively leveraged by 140 basis points in the quarter to 35.7%. However, the dollar amount of SG&A was increased by 12.7%, as the company indicated, largely tied to incentive compensation. Strong cuts through through the year seem to have come somewhat unglued in the fourth quarter due to incentive payments.

Given a fairly aggressive plan for new store additions (adding 17 stores) and increased marketing spend, management is guiding for 10% SG&A growth in 2010. With marketing growing faster than sales, TIF is going for market share, perhaps not an unwise strategy when small independent competitors may be having difficulty securing financing for their expensive inventory.

Nevertheless, incentive compensation seems to be driving SG&A growth at Tiffany and I wonder about how well this will leverage into earnings per share. Consensus earnings per share estimates for Jan 2011 are already at $2.47 up 21.0 % from this year's $2.04. It is interesting to note that earnings estimates for the upcoming year were $2.01 just six months ago.

I have provided a spreadsheet compiled from Gridstone Research analysis at the following link:


As the analysis indicates, return on equity has gone up to 15.3% from 13.5% in 2007 largely due to the use of higher financial leverage. Tiffany has purchased over $1 billion in common stock in the last three years (generally at higher prices than current.) About $400 million in new long term debt was issued last year. Asset turnover and operating margins worsened over this period.

Considering other benchmarks for management's performance, the return on invested capital remains lackluster despite what seemed to be a reasonable year. ROIC was 12.2% up from last year's 10.7% but not up to the 2008 and 2009 levels of 12.7% and 15.9%.

EBITDA margins have fallen to 16.3% in 2010 down significantly from last year. Surprising! Capital intensity (the amount of capital it takes to generate sales) has also moved up slightly from prior years. As well, one of the most important missions for a retailer is working capital management. In the quarter, strong inventory controls were very evident with inventory falling 10.8% versus last year relative to the 17% revenue gain. Yet, working capital management turnover was 1.65 times for 2010 down from levels generally better than 2 times in the past.

Tiffany at 19.3 times forward estimates which presume 21% growth seems expensive to me.

Disclaimer: Neither I, my family or clients have a current position in Tiffany.

Sunday, March 21, 2010

Traits of the Successful Investor and the Changing Nature of Brand Loyalty

The year 2010 seems to be progressing as a positive experience following the shaky start in January. The subsequent rally that has transpired since that time has caught many people flat-footed, but that is the price of erratic trading. Most of us are bombarded with an onslaught of noise portraying itself as information. We are encouraged to make massive shifts from sector to sector, from stock to stock, even from currency to currency. Our exposure to information and communication technology in real time has advanced well beyond the advancement in our human judgment for most of us.

I think successful investors accept the rapid pace of trading with a great deal of humility. Many of our worst problems in investing stem from the hubris of imagining, if not actually believing that we are that super-brain that can predict short term fluctuations in the market. Most successful investors approach the market with a great deal of humility and a fundamental understanding that the short term is incredibly random. How many six sigma events do we need to endure in a decade to understand that the market can fluctuate completely unexpectedly? Expecting to catch every short term ripple can only lead to frustration and discouragement.

In order to profit from the market, we simply must be there at those times when the probabilities of success are on our side. Though having an eye for value is a key attribute of success, there are many places where investors gain an edge.

Cheapness, in and of itself is not a sufficient condition for investing. Think of the disastrous results of many value investors in the last couple of years who bought book value “bargains” in the financial services sector. I think great investors are extremely conscious of the quality of balance sheets, both from the quality of the asset side as well as the nature of the liabilities and especially the off-balance sheet liabilities. How often have I been approached by a young analyst who insisted that some retailer was debt-free without regard for its heavy schedule of operating leases? How often do we forget the impact of assumptions in the pension plan liability or the retirement health care benefits? How little attention or regard did some analysts have for the obligations of banks as issuers of securitized assets? The truly great investors recognize "iceberg" risk, that is, those risks that are not obvious to initial scrutiny but lie beneath the surface. Understanding these sorts of obligations, such as the domino impact of a drop in credit rating on securitization differentiated the most successful investors in financial services from the book value bargain shoppers.

Great investors have a strange capacity to suffer. And the best returns develop from those times when you suffer the most. There is rarely a bell-ringing moment that tells you are looking at a bottom. Fight the complacency that we succumb to in bear markets, that feeling of why bothering to do anything, because next month the price will probably be cheaper. Whether it is dollar-cost averaging in getting a lower basis cost for a position, or just a commitment to maintain equity weighting at a higher than average level when bargains seem to abound, great investors have an ability to drage their guts through the gravel and maintain commitment to an investment plan regardless of the popular "wisdom."

In strong markets, stay disciplined and don’t try to be too creative. Unusual takeover activity in a sector should encourage you to sell investments in that sector rather than seek “the next target.” We were fortunate to have a position in Pall Corp (PLL) which reacted strongly to the announcement of the Millipore (MIL) takeover. Pall hit our target price and in our determination was fully valued unless some strategic buyer chose to pay the same sort of multiple as Millipore enjoyed. Possible, but I choose not to roll the dice and play a game of hope. Pall is sold and gone from our portfolios. Maybe I’ll look stupid in the coming weeks, a chance I am willing to take. A corollary of risk control is always leaving something on the table, both at the bottom and the top.

Taking a bit of a 30,000 foot view, what is the source of a successful investor’s edge? Can this apply to the average “home-gamer” as Cramer refers to the retail investor? I divide edges into four types:

Informational Edge- Do you have information that nobody else has? As a rule of thumb, having insider information and acting on it will get you into prison. Rule FD leveled the playing field so that analysts with long standing relationships (but not ethics abiding CFAs) could not receive special insight. Information had to be disseminated democratically.

Analytical Edge- I view this as coming to a different conclusion than the consensus viewpoint based on the information that is there. For example, John A. Paulson made a fortune in betting against residential real estate and the mortgage markets based on his understanding of the sub-prime markets and the exposure of various banks to this market. Sometimes an analytical edge can be garnered by using the same inputs everyone else has but weighting them differently. For example, a great business run by capable managers may extend its franchise to other geographies where markets are under-penetrated. This incremental growth might not be priced into the current price of the stock. A problem subdivision which represents a sideshow or a distraction, at worst a short term problem can become an overwhelming distraction for Wall Street and hence, most investors.

Behavioral Edge- As Buffett described it, be fearful when others are greedy and greedy when others are fearful. This is an incredibly difficult attribute to develop because for most of us, we are falsely comforted by a consensus viewpoint. We often ask for advice from people who will affirm our own views. The frenetic investment in bond funds last year seemed to be more of a movement to avoid the pain of stocks rather than an endorsement of the fixed income markets. Another example, Administaff (ASF) announced a dreadful fourth quarter on February 11 which clocked the stock from $23 to $16 and change in the next two days. It appears at least superficially to be based on a non-recurring one-time issue. In decent times this has been a mid 20’s return on invested capital, but in two days, almost 30% of the company’s shares outstanding traded hands, dismissing the past entirely. Currently, the stock is back to level of $21 plus once again. An important part of the behavioral edge is the ability to actually execute, not merely to theorize and wait. When the "fat pitch" crosses the plate, be sure you are ready to swing for it. If it ain’t on the tape, it ain’t in the portfolio and no one has gotten rich on paper profits.

Time Horizon Edge- Having the ability to take a longer term perspective, having the comfort of waiting for the fat pitch, having the ability to avoid the misinformation is another important edge that some value investors enjoy. Great ideas deserve a disproportionate part of your capital, but make sure you are safe. Too short a time horizon and you’re in danger of not letting your thesis unfold. But look at and stress test your portfolio all the time. Being married to too big a view can be dangerous however. Being too dogmatic and inflexible can be dangerous. For example, one of my former partners was married to a view that the S&P 500 could not possibly trade at more than twice book value because historically this represented dangerous ground. Needless to say, as share buybacks became prevalent, and write-downs eroded the value of equity, his dogma became nonsensical.

Though it is difficult for the average retail investor to develop an informational edge, I believe that it is certainly feasible for this person to develop and utilize any of the others. It is vital to develop this edge in my view. If you approach the markets without a model or a philosophy, your odds of being doomed are very high. If you don’t have a framework anchored on objective measurements (in other words not just a gut feel) you will be ground down by the uncertainty of markets. As individuals, it is tough but not impossible…we are neurologically not wired to make rational decisions, with emotional decisions anchored in animalistic “fight or flight” wiring. If you think like an owner, you will remember that the investment is locked up in the business rather than the stock price.

Someone once said that successful portfolio management was a little like taking friends and family out on a fishing boat. The paramount responsibility is everyone’s safety. Cluttering and overloading the boat is a dangerous practice in boating just as it is in portfolio management. Heading out into an oncoming storm can be disastrous for the boater and investor alike but storms pass and smooth sailing will follow.

I have been giving a lot of thought to Berkshire Hathaway as the annual meeting approaches. Buffett’s annual letter reads like a value investing primer, much of which is knowledge that has already been presented in prior letters. Buffett's investment approach over these many years has evolved from Graham and Dodd net working capital exercises to the purchase of incontrovertible brand name franchises that have long periods of competitive advantage. I think the last few years of investment involve some new thinking and a different perspective: especially the regulated utilities and Burlington Northern investments , and how it seems that Buffett is showing less and less interest in brands. I sense some changes in brand loyalty are occurring. Is this driving Buffett's seeming lack of interest in buying additional brands? Why is this?

The common ground for consumer brands and his forays into the railroad and utility worlds is recurring revenue. Though cyclicality is present in every aspect of business, it strikes me that over the long run, all of these chosen industries enjoy a competitive advantage. Certainly rails and utilities are unlikely to be displaced by substitutes and the amount of capital for a new entrant to achieve share is enormous. But are brands becoming less valuable over time?

It seems that a number of factors have proliferated which have governed brand loyalty are getting more difficult to attain. These new, and developing, challenges include:
  1. The recession has caused a significant and perhaps more than a temporary change in shoppers’ behavior. The consumer seems to be making her choices using different criteria than in the past. Though recently, we seem to be going through a period of frugality fatigue as shoppers have perhaps started to step up slightly from the bargain counter, it seems that for many of us, the need to cope with less discretionary spending is putting many brands through an ongoing review, scrutiny and re-evaluation.
  2. Consumers seem to be more willing than ever to try new brands. This movement toward experimentation seems to have diminished historical fierce brand loyalty and has encouraged switching between brands. Some people refer to this as brand promiscuity.
  3. Private labels are starting to emerge as brands in their own right, and offer a strong incentive to switch to a retailer’s products. Some years ago, President's Choice became a branded generic product (in Canada as well as migrating into the States) that achieved favor through offering consistently high quality than what consumers expected. The strategy for competing against a retailer controlled brand (especially with Wal-Mart and Target) is likely quite different from competing against other national brands. Target has been especially successful in developing identifiable women’s brands that offer style at a reasonable price.
  4. Are brand lives shortening? Is the consumer’s tolerance for quality mistakes dropping? It seems that consumer expectations of their branded products have risen. It is not just a matter of quality or value that today’s consumer expects; how does the brand resonate with the consumer in terms of its reputation? What is the corporate ethic of the company behind the brand? As we look at Toyota, some would argue that the brand has been diminished by the reduced quality perception of cars out of control. Yet, on the other hand, no other auto manufacturer has ever shut down production in order to search for an answer to an engineering problem. All these factors mean that it is easier for a brand not to deliver against consumer expectations. Our expectations are higher, and ergo so must the brand’s standards improve. Brands which do not continually improve their standards will be dropped. Consequently, brand lives may be shortening and importantly, the spending to support a brand may be increasing.
  5. Brand image is no longer passed around by word-of-mouth or by traditional advertising. Twitter, Facebook, and social media is changing the brand management landscape. Good experiences as well as bad experiences impact reputation quickly by virtue of social media.

Don’t get me wrong. Traditional brands still are worth a great deal. A look at Nike’s (NKE) results the other night are telling. Great numbers, better than expected, great brand, lots of momentum. But SG&A was 33.0% as compared to the previous year’s 30.4%. Sales were up 6.6%, so there was no leverage in the SG&A line. Nike is still a great brand, largely because it carries a lifestyle image to its consumers. In short, Nike is cool! Proctor and Gamble (PG), the quintessential consumer brand company reported in February that fourth quarter sales had grown 5% in line with revenues, but SG&A was up 170 basis points. Again, no sales leverage in SG&A. I suspect that care and feeding of brand companies will continue to require more upkeep (= dollars) and consume more margins over time.

Perhaps the paragon of today’s brand is Apple (AAPL). In early days of cell phones, brand loyalty was essentially non-existent. Before the iPhone, loyalty was low for both handset manufacturers and for network providers. In the past, consumers often switched handsets repeatedly, and often tried handsets from a variety of different manufacturers as a result. Before the iPhone, cell phones were very much commodity items, competing on price largely based on the number of functions that were offered. Reliability was not a particularly relevant consideration since phones came and went based on the length of the network’s contract. Nokia (NOK) had some edge and loyalty largely because of functionality considerations, not because Nokia was a “lifestyle brand” which helped consumers have more fun from their phones. Networks were a very secondary consideration for most of us who stayed within close geographic proximity. In fact, networks were often viewed negatively as the high cost, recurring part of cell phone ownership with not especially reliable functionality.

The tons of apps that are offered for the iPhone have changed everything. Consumers accessed a highly functional service which is both fun, allowing them to use the products in new ways (remote access to turning off the lights at home) and all sorts of practical and not so practical experiences. Powerful stuff!

Even more powerful is Apple has captured the heart and soul of its consumer by engaging with him/her. Ongoing development of apps (generally by someone other than Apple) increases its interaction with the consumer and modifies and improves the brand with every interaction. For most products, our interaction is established at time of purchase, but with Apple, the interaction is not limited to the retailer, the manufacturer can still build an ongoing relationship with the customer for more than simply providing information (or doing recalls!).

So it seems that brand loyalty in the future will be derived largely by the post-purchase interaction. This is quite different than the traditional consumer brand development of “new and improved.” Social media ensures that the consumers’ views and experiences will be monitored by all of us, and especially the owner of the brand. Online transparency will force brands to ensure that their credentials stand up to scrutiny.

Social media opens up a two-way communication with the consumer…the basis for post-purchase engagement. This means that transparency is a key watchword for brands when developing post-consumer engagement – by inviting consumers to be more involved with your brand they are likely to take a longer, deeper scrutiny of what the brand is doing and what it represents.

Brand loyalty is still something to look for in investments. However, both capturing it and maintaining it has become a new discipline. However, many brands with a long heritage and consumer trust have survived the recession better than middle brands, and have invested to ensure that they come out of this period in a stronger position to continue growing. But just as the consumer is constantly assessing and re-evaluating these brands, so must we as investors.

Disclaimer: I, my family, and or clients have equity or fixed income positions in Berkshire Hathaway, Apple, Nokia, and Toyota.

Thursday, June 11, 2009

The Developing Compensation Philosophy of the Treasury Department

Here is a link to Gene Sperling's opening statement: http://www.treas.gov/press/releases/tg166.htm#_ftnref3

There are some very interesting quotes that help to frame Treasury's philosophy re systematic risk and executive compensation in this statement.
Compensation structures that permitted key executives and other financial actors to avoid the potential long-term downsides of their actions discouraged a focus on determining long-term risk and underlying economic value, while reducing the number of financial market participants with an incentive to be a "canary in the coal mine."
The testimony describes one investment bank which acknowledged the skew in its incentive structures:
Simply measuring bonuses against gross revenue after personnel costs with "no formal account taken of the quality or sustainability of those earnings."
It is clear that Treasury intends to broaden itself beyond its initial focus on financial services:
But what is important for our economy at large is the topic of this hearing: understanding how compensation practices contributed to this financial crisis and what steps we can take to ensure they do not cause excessive risk-taking in the future. And while the financial sector has been at the center of this issues, we believe that compensation practices must be better aligned with long-term value and prudent risk management at all firms, and not just for the financial services industry.
Here are the principles that were outlined in the "way forward":

Compensation plans should properly measure and reward performance.
- In other words, performance metrics should not just be based on stock prices but also relative performance and adherence to risk measurement. "Don't confuse brains for a bull market."

Compensation should be structured in line with the time horizon of the risks.

- The testimony discussed the trade-off of large short term gains that presented a "tail-risk" of large losses. Hence, the notion of stock compensation that is required to be retained for a long period of time, even beyond retirement, is being introduced. Also suggested that bonuses could be "at risk" and withdrawn if a poor year follows a good year.
Here is an abstract regarding executive pensions and their role in long term compensation.

Compensation practices should be aligned with sound risk management.
- The testimony refers to The Financial Stability Forum's Principles for Sound Compensation Practices. The authority and independence of risk managers is "all the more important in times of excessive optimism when consistent -though unsustainable -asset appreciation can temporarily make the reckless look wise and the prudent look risk-averse." The context of risk management is broadened to include all employees, not just executives, that may be incentivized for excessive and imprudent risks.

We should reexamine whether golden parachutes and supplemental retirement packages align the interests of executives and shareholders.
-The testimony describes that golden parachutes were in place at over 80 percent of the largest firms as of 2006.

We should promote transparency and accountability in setting compensation.
-According to one Congressional Investigation, the median CEO salary of Fortune 250 companies in 2006 that hired compensation consultants with the largest conflicts of interest was 67% higher than the median CEO salary of the companies that did not use consultants with such conflicts of interest.
House Committee Report on Executive Pay Also see blog for additional discussion.
Also please see Ferri and Maber abstract which describes the change that "say on pay" has made in making CEO compensation in the UK more responsive to negative results.
Also please see the CFA Institute survey's response to "say on pay"
Also please see "Shareholder Say on Pay:Ten Points of Confusion"

Executive Compensation-Government is Not Going Away

Corporate governance is a topic that many of us tend to ignore, leaving it to the institutions or corporate raiders that are looking to influence the strategic direction, the capital allocation, the corporate structures or the compensation structures of business.

Yet, the way business is run should matter to us all. We need the goods and services it produces, or the employment it provides. As shareholders, whether directly or through our 401-Ks or pension plans, the long term wealth that corporations create is important for our old age dignity and in fact, the national prosperity. Hence, the governance of corporations affects us all whether customer, employee, citizen or shareholder. The effectiveness of corporate governance is indeed a factor in determining whether companies survive and prosper or stumble and fail.

Some years ago, Jonathan Charkham noted in his book, Keeping Good Company :

“It is difficult to escape the conclusion that government has a role here as it is the only power in any land which can strike a balance between the conflicting wishes of competing interests. Furthermore, the framework within which these interests compete is one of government’s own making. Everywhere the corporation is a creature of statue not nature, designed to encourage the continuity of power that the sophistication of modern economies require. It is not government’s role to double-guess individual commercial decisions-but to ensure as best it can, that the structure it creates for companies contains checks and balances that are effective in resolving the tensions between differing legitimate claims.”

One does not undermine one’s dedication to capitalism by believing that companies are more than just engines to maximize return on capital. After all, one could repeal child labor laws, ignore plant safety, ignore anti-trust and thereby maximize profitability, but at what cost to society?

Playing for very high stakes has been an ongoing theme in American capitalism probably since Alfred Sloan of GM declared that “The business of business is business.” Excessive and sometimes fraudulent risks, competition, and the increasing size and complexity of organizations: these three factors have been at the heart of every corporate breakdown and crash and burn. The call for greater regulation and greater scrutiny has followed every scandal, for example, the salad oil scandal of the mid-1960’s resulted in more stringent commodity trading regulation after nearly taking down American Express and causing significant loan losses in the banking system.

So it is little wonder that the Obama administration has begun to scrutinize certain aspects of corporate governance, in particular, an effort to rein in executive compensation. Though far from setting executive pay ceilings at all corporations, the new compensation czar – lawyer and mediator Kenneth Feinberg – will have broad discretion to set the pay for roughly 175 top executives at seven of the country's largest companies, which received billions in government loans. He will set the salaries and bonuses of some of the top financiers and industrialists in the United States including Fritz Henderson (GM), Vikram Pandit (Citigroup), and Ken Lewis (B 0f A).

The Obama administration argues that poorly designed compensation packages encouraged some Wall Street executives to take on excess risk in the mortgage market and elsewhere, which in turn helped trigger the financial crisis and a global recession. As Barney Frank, chairman of the House Committee on Financial Services observed (bolded words are my emphasis):

“It is not the role of government to set policy regarding the amounts that are paid in compensation to top executives, nor to deal with the question of how that compensation is allocated among salary, bonuses, retirement packages, etc. But as Secretary Geithner’s remarks recognized, there are two very important points that we should address.”

“First, shareholders must be empowered to have a major role in the process of setting overall compensation. While it is not the government’s role to say that a certain amount is too much, it is very much the right of the people who own the company to speak out if they think excessive compensation is being proposed. The system of say-on-pay that was piloted in England is a reasonable way to do this, and I was proud that the House adopted the bill that came from the Financial Services Committee to institute this in 2007. Unfortunately, the bill did not go forward in the Senate, but I am optimistic that with the support of the President, we will be able to enact this important principle into law. Recent evidence in England shows that when shareholders are in fact troubled by excessive compensation, say-on-pay is an effective tool for them.

“I also agree with Secretary Geithner’s annunciation of the principles that should guide the structure of compensation – not the amount. But I differ with his view that this can be accomplished by strengthening the independence of compensation committees. Given the inherently close relationship that exists between CEOs and other top executives on the one hand, and boards of directors on the other, it is very unlikely that you will ever get the degree of independence that will allow the boards of directors to be left completely on their own to set compensation. That is part of the reason for say-on-pay. But it is also the reason why legislation should be adopted that instructs the Securities and Exchange Commission to set principles which prevent boards from providing compensation systems that lead to excessive risk taking.

Many proxy statements this year contained “say on pay” shareholder proposals, almost all of which were opposed by managements. I am strongly in favor of such proposals which now appear to become the law of the land. Though these proposals are not enforceable per se, they do provide moral suasion and have had influence in European countries that have adopted the practice for example, Royal Dutch Shell. See also the recent impact in some UK retailers.

Proxy statements frequently contain a report from the compensation committee which generally outlines the company’s philosophy of compensation, what it uses as its peer group for a model of compensation, and what sorts of behavior are being rewarded both short and long term. In general, the compensation committee charter suggests that compensation should align managers’ interests with those of shareholders. An excellent template for what should be part of the compensation committee’s report was recently produced by the California State Teachers Retirement System. Among the points that CSTRS suggests is some specificity regarding the role of risk in incentive compensation:

The role of risk in the context of the executive compensation program, which should include both a defensive perspective (how the committee ensures potential compensation does not incentivize excessive risk), and an offensive perspective (how the program is designed to incentivize appropriate risk and aligns the interests of management with those of long-term owners)”

Our summer intern, Drew Levine, recently completed a study of proxies that we have voted at our firm and run some statistics on components of executive compensation trends versus share price performance. If shareholder and management interests are truly aligned, one would expect some degree of correlation between comp and share performance. Sadly, that has not been the case. Here are some of Drew’s observations:

After conducting analysis of executive compensation data, it is safe to say that there is little to no correlation between stock price performance and compensation. The data compiled is from a tumultuous time in the stock market where nearly all of the companies we voted on stocks were down. One would think that because the company's stock performed so poorly the executives pay would subsequently suffer, but that was certainly not the case in some instances. The strongest correlation in the data was the percentage increase or decrease in bonus compensation in relation to stock price performance. However that measure of correlation was still extremely low at .21 for the CEO and .16 for the CFO. It's shocking to see that there really is no correlation between pay and performance because one would think that would be the most basic and truest basis for compensation. What I found most surprising was the average salary and total compensation growth from 2006-2008. It is amazing to see that although the majority of these companies were struggling with the economic downturn, the average salary growth for the CEO in 2008 was 74.9% and their total compensation growth for 2008 was 25.7%. What this indicates is that executives are increasingly taking more base pay with the knowledge that because their company's stock won't perform well, they will not get the oversized bonuses that they were used to receiving just a few years ago. Although, when looking through the data, it was relieving to see that in most of the companies the executives did not receive bonuses for 2007 and 2008.

In 2007 and 2008, we surveyed 79 and 92 CEO's respectively, and 55 and 81 CFO's respectively. This was due to new hires and fires at the executive positions. From year end 2006 to year end 2007, the average stock price of the company's surveyed was up 26.7%. From year end 2007 to year end 2008, the average stock price was down 40%. The average salary for the CEO in 2007 and 2008 was just over $1,000,000 and the average salary for the CFO during the same time frame was around $600,000. The average bonus for the CEO and CFO in 2007 was over $1,000,000 each with that number decreasing to about $450,000 for the CEO and $300,000 for the CFO in 2008.

For the 2009 proxies we voted, we emphasized voting for "best practices" such as shareholder's votes on executive compensation (say-on-pay) and shareholder's ability to call special meetings. Many people forget that the shareholders are the real owners of the company and that management is working for us. For that reason we find it important to vote every proxy for companies which our clients hold shares and not just throw them away like many shareholders do.

Looking at total compensation for the CEOs rather than just bonuses, the correlation to share price performance is non-existent at -0.03. Apparently, CFO total comp has a somewhat stronger link to share price performance at a still rather weak 0.19. Here is a spreadsheet of our compensation study and the statistical correlations that we observed.

Last year, the CATO Institute published a paper on Executive Pay Regulation versus Market Competition by Ira Kay and Steven van Putten which argues that: “The misperceptions that drive regulatory efforts are grounded in the idea that the market for executives is not competitive and that pay levels do not reflect supply and demand for talent” (pg. 1). Kay and Van Putten argue that the “myth of managerial power”, executives control over the board which sets their compensation, leads to greater regulation because lawmakers believe that the market is rigged as they put it. The authors present evidence to the contrary that says that the market is actually competitive and that the appropriate level of executive compensation tracks performance.

This may well have been the case but we face a new reality. We had better become accustomed to the idea of big government as regulations to restore financial order come into force. Jeff Immelt, in a recent address to the International Economic Forum in Montreal stated it most succinctly, “The government has moved in next door and it ain’t leaving. You could fight it if you want but society wants change. And government is not going away.”

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