Tuesday, January 24, 2006

Putting Executive Pay in Perspective

I'm often asked what I think about executive pay. The consensus is that executive pay is too high. What good would it do you to have me tow the line? I'm not an activist. And I'm not going to do someone else's activism for them. What is too high anyway? That's a subjective statement. Don't take me wrong; you'll never hear me defend excessive corporate greed. But, even 'excessive' is a subjective term.

If you want my opinion I'll give it, for what it's worth. I think that complaining about high executive pay without backing up complaints with evidence to support a specific problem related to it is a socialist mantra and I don't like it. I don't want anyone telling me that I can't make more than a specific amount of money. Unlimited income potential is probably the single greatest motivator that this country has.

And the term public company does not mean that a company is owned by the public and reports to the public, as has been implied. Rather it means that anyone can buy shares in the company so long as someone else is willing to sell their shares in the open market. We say all the time that companies answer to their shareholders. Well not really. There are certain things that a company has to go to the board for permission, which consists partly of shareholder representatives, but generally speaking a companies executives are perfectly free to screw the company up. Shareholders may then, after the fact, let it be known that they are dissatisfied either through their representatives or by selling their shares in the open market and disassociating themselves with the company.

To put some more perspective on this somewhat thorny issue, which I think is much less of an issue than it has been made out to be, consider however unlikely you are given the opportunity to make corporate CEO sized pay. And there may very well be some readers making just that. First off, many people, most people would not be willing to step into the typical CEOs shoes. Let's face facts, most CEOs can't be what they are and be good family men, yet they are expected to have pictures of their perfect families on their desks demonstrating that they understand the plights of their employees, work/life balance, and all that mumbo jumbo. It's a façade. There kids are privileged to have just about anything they want, except a dad. They put on an air of normalcy, but under the surface you'd find among very many of them drinking problems, problems with the opposite sex, and the coke habit that keeps them going 18 of 24.

The truth is that it's easy for everyone else to say that they would trade lives, but the reality is that they aside from the money, most of their lives, in my opinion, suck. And most people would drop out of the running long before they get to that level because for many of them getting there meant that the company came before everything else every step of the way up even when they weren't making enough money to justify the obsession. Consequently, there really aren't as many people capable and willing to do that job, as we would like to think.

But let's just say hypothetically you could get there without making any tradeoffs. Who wouldn't take the money under those circumstances? And once you got it, would it then be too much? Even the anti capitalist activists would take the money so they could play socialist dictator and reallocate it to their favorite causes. Most of us would do the same things as any other CEO, buy big homes, buy a couple of vacation homes, etc… Don't say you wouldn't. We'll all know you're a liar if you do. All of a sudden CEOs don't make too much money.

Another truth is that most CEOs don't just suddenly make many millions. They got there incrementally, except in a rare extreme cases. Consider that a person who starts a business of their own, a private business with several hundred employees, gets to keep all of the profits and do whatever they want with the money. They have no shareholders yapping at them. They can make a lot of money without any of the hassle. That's reality and it's not uncommon. A person in that position might make quite a bit more money than the average CEO of a small to medium sized public company. That's the baseline. CEOs of public companies need to make as much as they can make running private companies, otherwise there'd be little reason to take a company public in the first place. Consider why people start companies in the first place. To, hopefully, make a lot of money. When they go public it's not just to grow the company, it's to grow the company so they can make more money.

I also think that most high-level corporate executives are greedy slime balls who'd cheat and screw just about anyone over that got in their way. Many are egomaniacs and habitual liars with psychopathic tendencies who are all too often willing to justify doing bad things, whatever those things may be. The upper ranks of corporate America are filled with a lot of bad people. But you don't have to look too hard to find sick, twisted, and demented parents with alcohol and drug problems at any rank of society.

But that's all just my opinion. Now for some facts. There are mechanisms in place to measure excessive corporate greed. The success of a company is related to how well it manages its revenues and reinvests profits. Salaries come out of sales. They take away from profits, which leaves less money to reinvest or return to shareholders. Although it might not seem to be the case, there's an force gravitating towards equilibrium that constrains truly excessive executive pay. It's called competition. If a company gives too much of its profits to executives it won't compete well with companies that are reinvesting their profits. Chances are some company that's managing its money better will buy up the inefficient company and fire the overly greedy executives. Obviously, these things happen after the fact, happen slowly, and sometimes never happen. So we are exposed to a lot of injustice along the way.

It's also important have some rational perspective on the issue. To say that executive pay is too much is a subjective statement. Transparency and data collection on executive pay is relatively new. Time series data is not readily available going back very far. Outside the U.S. data is virtually nonexistent, just as foreign executives would like to keep it. Consequently, it's difficult to put executive pay in the proper perspective. Important questions remain unanswered. Is executive pay rising? No doubt! But a better question is whether or not it's rising as a percentage of revenues. How would that compare to previous periods going all the way back to say the 1920s? It may actually be the case that CEOs were paid more before transparency became standard.

How efficiently do American companies operate compared to their foreign counterparts? You know I'm about to wave the flag. Darn right I am, and with good reason. U.S. companies flat out kick their foreign competitors buts when it comes to operating efficiently. U.S companies have better margins at every point on the balance sheet despite the fact that we supposedly pay our executives outrageous sums of money. Ironically, Microsoft, ran by the most widely targeted CEOs, maintains one of the best margins of any major company, foreign or domestic.

Of the 100 largest companies by market capitalization that trade shares on U.S. exchanges roughly half (55) are U.S. based companies and half (45) foreign companies trading as ADRs trading on either the NYSE or the Nasdaq stock markets. The U.S. companies have a gross margin 11% greater than comparably sized foreign companies, pre-tax margin 15% greater, and a 21% larger overall net profit margin. In other words, U.S. companies pay out substantially less to produce their goods and services overall and therefore they have more left over to reinvest.

My belief is executives of comparably sized foreign companies are actually paid more than U.S. executives, because they can without anyone knowing what they make. There's no transparency. The U.S. is by far the most transparent country in the world. No other country even comes close. Yet as soon as we have the information what do we do with it? We use it to lie with statistics. We say that U.S. executives are overpaid and Americans are all greedy capitalists. The French in particular like to point this out. But they don't know what their own greedy executives are making and they are not free enough to find out, so they express their frustrations through revolution by blowing up thousands of cars.

Just because we know how much our executives make, doesn't mean they make more than other executives around the world. The opposite is probably true if the relative inefficiency suggested in the balance sheets is any indication.

In the end profits are all that really matter. Individually, some companies operate on slim margins, as the nature of their business dictates. Wal-Mart has narrower margins than Target, but clearly Wal-Mart is the more successful organization. But the fact that average profit margins are much higher in the U.S. than elsewhere suggests that we're doing something right.

But how should this impact your trading? I heard an analyst come on TV this morning saying what a great company AIG is. It's cool to be contrarian these days. The way I look at is simple. There are thousands of stocks to choose from. Maybe AIG is oversold, maybe not. I'm not going to cry over a lost opportunity if it goes up say 50% in the next six months. I'd rather not go there. The fact that AMD has performed better than Intel probably has nothing to do with what Intel pays its executives and everything to do with the fact that everyone knows AMD chips are cheaper and the company is stealing away market share from Intel.

But company executives do often tarnish the reputations of the organizations they represent. Oracle came off looking pretty bad in the PeopleSoft deal thanks to Ellison, who does nothing to hide his hubris and egomania, which I think that rubs investors the wrong way. If the companies CEO is in the spotlight, that's usually not a good thing. Overstock.com's Patrick Byrne isn't doing his companies stock any favors with his lunatic fringe rants. Neither has Buffett's down with the dollar drivel done Berkshire Hathaway much good. By comparison you hardly here a peep out of Adobe's executives and the stock has done much better than Oracle. I just stay away from those noisy stocks. They are volatile, which equates to unknown risk that I don't need to take. I can find better risk reward ratios elsewhere.

posted at 12:03 PM