Generally, I write very supportively of our capitalist system as in last September’s column, “Profit is not a four-letter word.” This time I will outline several items that often reduce shareholder returns and provide fodder for socialist attacks on the capitalist system that is responsible for our high standard of living.
Excessive stock option rewards
The storyline around stock option awards is they align executive compensation with shareholder returns. Let’s look at how option awards work to see if that argument is valid.
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Company programs vary but, in general, executives get new awards each year. If a stock is trading at $100 when the award is made, any gain above $100 will accrue to the executive. There is a minimum holding period before the award recipient is eligible to sell the option, which is referred to as the “vesting” period and is normally three or four years. When options vest, the recipient may sell to capture any gain above $100, hold for longer to a pre-set maximum of usually 10 years, or pay $100 for the actual shares to hold for longer.
If this third option was commonly used, I would agree the program aligns with shareholder interests. However, that is rarely used as a course of action. Generally, the options are sold after the vesting period and before the maximum option-holding period. This motivates short-termism, as executives try to hasten upward stock price movement so they can cash in their options as soon as possible with as much gain as possible. Short-term thinking is no way to build a company.
Options are a lottery compensation system, partially dependent on external factors like market sentiment or the price of an underlying commodity the company produces. Oil executives awarded options a decade ago wouldn’t have made much even if they did a terrific job of running the company through a difficult period, whereas executives awarded options three years ago would have made out like bandits even if they did a poor job running the company.
A Microsoft executive awarded options in 2001 wouldn’t have made any money even though profits quadrupled over the following decade with a static stock price. Another dislike, but a reason they are overused, is that option sale gains are tax-advantaged and treated like capital gains when it is really income, as recipients don’t use their own money to invest.
Share buybacks
Companies often buy their own shares to reduce share count, increasing profit per share. This is generally more tax efficient than paying dividends, and there is nothing wrong with the practice per se. However, as with many good things comes overuse, and companies can use this practice as a no-work way to juice the stock, especially when executives want to cash their stock options.
It is not unusual to see companies buy back shares only to reissue later at a lower price to raise funds during an economic downturn. This occurred a lot during the Great Recession and clearly destroys shareholder value. The activity has come under government scrutiny and is now subject to additional taxation. However, I would submit that buybacks are the symptom, not the disease. Stock options are the disease.
Excess executive compensation
There is a nebulous relationship between executive compensation and corporate performance, which begs the question of why they get paid so much? Warren Buffett is the worst paid executive with one of the best performance records. Granted, he is an outlier and there is a positive relationship between founder-led companies and stock performance. Maybe founders are more interested in building a company than short-term padding of their own wallets.
Following fads
Following fads rather than charting a unique course relegates many companies to mediocrity. Current fads include spin-offs and touting ESG (environmental, social, governance) credentials. ESG has morphed into an anti-fossil fuel movement with little emphasis on the social and governance aspects. As an example, Canada’s largest base metal miners, Teck Resources, sold its oilsands interests at a huge loss and announced spinning off its steel-making coal business so it can position itself as a green miner. Huh. There is nothing green about mining. That doesn’t make mining bad because the world needs minerals — and coal, too.
Corporate buyouts
Some companies are excellent at buying and integrating other synergistic companies. Others fail miserably, overpay and destroy shareholder value. The bigger the buyout, the more likely the failure. This ties back to the lottery stock option compensation system in a heads-I-win-tails-I-don’t-lose scenario. If the buyout goes well, executives take home big stock option rewards. If it goes poorly, they’re not out because it’s not their own money at risk, it’s mine!
All of these items are outside the control of small shareholders and are a frustration, but not something to be overly concerned about. Poor corporate behaviour manifests in poor financial performance and good corporate behaviour manifests in good financial performance, which is my focus.
As this is my first column after the fifth anniversary of the Titanium-Strength Portfolio, an update is in order. It is up 5.8 per cent year-to-date and 54.8 per cent over the five-year period and continues to perform through thick and thin (see at top). There has been a lot of thin over that time frame with three separate bear markets, including the current one still in place.
