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Measuring and rewarding long term enterprise value instead of short term stock price


Source: New York Times, October 12, 2013 column

Fair Game

When the Stock Price Hides Trouble

WHEN a company receives criticism about its executive pay practices, a typical defense is to cite a rising stock price as justification of its pay. If total shareholder return is up, the theory goes, stockholders have no right to complain about what might otherwise look like outsize pay at their companies.

Fair Game

Gretchen Morgenson writes the Fair Game column for the Sunday Business section.

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While this pay posture is understandable, it raises a question: Should a rising stock price inoculate top executives from criticism over their pay? To more and more experts in corporate finance and pay issues, the answer is no.

Aswath Damodaran, a professor of finance at the Stern School of Business at New York University, is among those who think that too many companies rely too heavily on the performance of their shares when computing executive compensation. “I’m a great believer in markets, but sometimes we need more attention paid to what did this management do to the value of the company and less to what did this management do to the price of the stock,” he said. “I would like to see compensation systems where managers are rewarded based on what kind of projects they are working on and how big their returns on invested capital are.”

And yet, the focus on stock price appreciation as a benchmark for corporate performance and executive pay lives on. Companies still rely heavily on it and so do the powerful proxy advisory services that suggest how shareholders should vote on pay practices and director elections. The fact is, total shareholder returns are almost always among the performance measures — if not the single biggest consideration — used by companies to determine pay.

This focus doesn’t just leave out a wide array of measures that better capture whether a company’s management is operating in the interests of investors with a long-term horizon. It also allows top executives to reap the pay benefits associated with a short-term bullish stock market, which may have nothing to do with their company’s specific business or operations, pay experts contend.

“A statistic I’ve seen that makes sense to me is that 70 percent of executives’ stock option gains are attributable to the market’s movement as a whole,” said Nell Minow, a principal at GMI Ratings, a corporate governance analytics company. “We are basically paying C.E.O.’s for floating on their backs when we should be paying them to win races.”

The fault is not simply with executives themselves, of course. A failure to weigh a variety of performance metrics that can warn when a company isn’t creating long-term shareholder value is the responsibility of the company’s board.

Shareholders, too, have to hold themselves accountable for these failures, Ms. Minow said. Their support for pay plans that reward executives for just showing up or for being on hand while their stock is rising only reinforces a questionable reward system.

“This is something where we have to blame ourselves,” she said.

With that in mind, Mark Van Clieaf, an organizational consultant and principal at Organizational Capital Partners, is urging companies’ boards to use other measures to assess whether their executives are truly creating value for shareholders or destroying it. The best measure, he says, is a company’s net returns on its invested capital. That is, how much it is generating on its capital investments — plants and equipment, say — minus the costs of that capital, whether debt or equity.

“Management should be providing value that exceeds its cost of capital,” Mr. Van Clieaf said. “A company with a negative return on capital can’t generate enough free cash flow to pay dividends and enhance the value of the firm over time.”

In spite of this relatively simple concept, Mr. Van Clieaf said, few companies appear to use net returns on invested capital, also known as economic profit or loss, when determining executive pay. This is something of a disconnect, given that these returns are a crucial measure of how effectively a company is deploying its capital into projects that pay off, and are certainly figures that chief executives and their finance colleagues watch closely. Moreover, returns on capital are a useful measure across industries.

Neither do shareholders seem to be demanding such a measure when their companies’ boards devise executive pay. “Investors are looking at total shareholder return, but that’s not the be-all, end-all metric,” Mr. Van Clieaf said. “So just because a company had a positive say-on-pay vote doesn’t mean the system is working well.”

The trouble with relying on total shareholder returns is that these figures can rise even after a company has shown an economic loss — a negative return on capital — over an extended period. A focus on stock price, therefore, can mask a longer-term decline in a company’s financial footing.

AN extreme example of a company that had returns on invested capital that were below its cost of capital is WorldCom, the telecommunications darling that collapsed in 2002. According to “Foundations of Economic Value Added,” a book by James L. Grant, from 1993 to 2000 return on invested capital at WorldCom ranged from 2.23 percent to a high of 9.5 percent, but the company’s cost of capital was more than 10 percent throughout this time. For much of that time period, WorldCom’s stock price was rising.

WorldCom, of course, was in a category by itself. But the message is clear: a stock price does not always reflect real economic value. Mr. Van Clieaf labels these kinds of companies “value myths” because on the surface they are producing gains for shareholders but underneath they are generating negative returns on their investments in plants, equipment, acquisitions or other items.

To illustrate this point, Organizational Capital Partners generated a list of eight large companies that for each of the five years through December 2012 generated a negative net return on invested capital. The firm also looked at other metrics, like revenue growth or decline, total shareholder returns and cumulative executive pay over the period.

The analysis also includes the results of the latest shareholder votes on each company’s pay practices. These so-called say-on-pay votes are not binding on the company but represent shareholders’ views on the pay programs that are in place. Most of the companies received broad support for their pay practices from most of the shareholders voting at the most recent annual meetings. Only three of the eight — ConocoPhillips, Dow Chemical and Tenet Healthcare — encountered objections from more than one-quarter of their shareholders voting on the executive pay plans.

The list of eight companies that generated a negative net return on invested capital, ranked by the amount of executive pay, is above. Most of the companies are in basic industries like energy, chemicals and industrial products. Five of the companies had shareholder returns that beat the Standard & Poor’s 500’s returns over the five-year period. These were, in descending order, Tenet, Dow Chemical, Anadarko Petroleum, Johnson Controls and ConocoPhillips.

The remaining three companies — Apache, Devon Energy and Textron — had negative shareholder returns for the period.

I shared the Organizational Capital Partners findings with all eight companies. Some, like ConocoPhillips, Dow Chemical and Tenet Healthcare, did not respond to e-mail requests. Others, like Devon Energy, Anadarko Petroleum, Johnson Controls and Textron, declined to comment, referring me to proxy filings that outline their compensation practices. 

At Apache, the board is focused on getting pay for performance right and has been engaging its shareholders, said Sarah B. Teslik, its senior vice president for policy and governance. Investors like how much of the company’s executive compensation is tied to measurable corporate goals, she said, and the fact that the company has substantially reduced the pay that Apache executives actually realize, meaning it is not earned if the performance goals are not met.

Bob Dye, Apache’s spokesman, added that the company’s share price had been hurt in recent years by investor concern over its large operations in Egypt.

Given the shareholder support that most of these companies received in their most recent say-on-pay votes, it is clear that investors seem content with their pay practices. To Mr. Van Clieaf, this is a sign that investors are not digging sufficiently into the numbers to determine whether companies are creating long-term shareholder value.

Monitoring these returns is important work for investors, he said, because companies that do not earn positive returns on their invested capital may not be able to pay dividends to shareholders. And those dividends make up one of the bigger income streams that pension managers look for to meet their obligations to retirees.

HOW did some of the larger private money managers vote on these companies’ pay practices at their most recent annual meetings?

The proxy record of Fidelity Investments, Vanguard and T. Rowe Price on many of these companies shows broad support for management. For example, Fidelity’s Large Cap Stock Fund voted in support of Johnson Controls’ pay practices and the Fidelity Energy Central Fund supported Anadarko Petroleum’s executive pay program.

T. Rowe Price, another large mutual fund company, did not vote in lockstep with management, however. At the most recent meeting of Apache shareholders, for example, its New Era Fund voted against the company’s pay plan.

Finally, Vanguard’s votes by its huge S.& P. 500 index fund, which must own all those shares that are in the index, were supportive of all eight companies’ pay for performance plans.

Spokesmen for all three fund companies said they would not discuss how their funds voted on specific companies. Vincent Loporchio, a spokesman for Fidelity, says it generally votes to ratify companies’ pay practices unless the compensation seems unaligned with shareholder interests. When a company’s proposal doesn’t conform to the proxy voting guidelines, Fidelity may contact the company to discuss the situation and potential solutions, he said. It might vote in favor of a proposal if management commits to changes in governance and compensation practices, Mr. Loporchio said.

Fidelity voted against 24 percent of all equity plan proposals for the year ending June 30, 2013, he said.

At T. Rowe Price, votes on pay practices are made on a case-by-case basis, using a proprietary and quantitative scorecard initially, a spokesman, Bill Benintende, said. “We vote ‘against’ in cases where there is an unacceptable number of problematic pay elements,” he said, including poor linkage over time between executive pay and the company’s performance and profitability, or objectionable features like excessive retirement plans, golden parachutes or perquisites.

Glenn Booraem, principal and fund controller at Vanguard, said the fund company recognized that assessing pay based solely on total shareholder return was inadequate. “One of the places where we are more concerned than others is where the entirety of comp is tied to absolute stock price performance of the particular company,” he said. Each year, Vanguard has discussions with around 500 companies out of the 4,000 or so in its portfolios to discuss governance or compensation problems the fund company has identified. Many of these discussions result in changes that do not require voting against a particular pay package or other shareholder proposal, Mr. Booraem said.

Still, Ms. Minow says these and other investors have a great lever on pay that they are not using. “Investors are just now beginning to vote against companies’ pay plans,” she said. But voting against pay was not enough.

“You have got to tie together a vote against a pay plan with a vote against the compensation committee of the board,” she said. “Unless we focus on the comp committees, nothing is going to change.”

© 2013 The New York Times Company



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