By Michael Brush, MSN MoneyWarren Buffett once told me he doesn't believe investors ever need to meet with chief executive officers of companies to get an edge in the market. In his folksy manner, he said you can tell a good baseball team just by watching it from the bleachers.
I respect Buffett, but I doubt he was being entirely candid.
After all, meeting people in person helps you tremendously in sizing up how well they do their jobs. And the truth is that Buffett, in his interactions with CEOs at companies where he's made some of his best investments, has gone far beyond just meeting them. He has been their boss and has served on their boards.
You'll likely never enjoy Buffett's level of access, but with a computer and a little time, you can pick up a few secrets from the guys and gals at the helm. It's worth it, because it helps a lot in figuring out how good they will be at raising their companies' stock prices and making you wealthier.
What can you learn from a CEO
You just have to know what to look for and where to find it.
What documents to look at
Here are seven ways to learn from the bosses, without ever scheduling lunch.
1. CEO buying and selling
By far the easiest tip is to look at whether CEOs are buying their company stock.
Size matters. I consider only purchases by insiders, as a group, of more than $100,000 in a three-month time span. But above $500,000, things start to get more interesting. (To find proxy statements, type in the stock ticker at the MSN Money Investing home page, click on "SEC Filings" in the menu on the left side of the page and then select "proxy statements" in the drop-down menu.)
Big purchases at smaller companies carry more weight because CEOs generally have less money at that level.
Want some recent examples?
Landry's Restaurants (LNY, news, msgs) CEO Tilman Fertitta bought $4.9 million worth of his company's stock in September on a pullback to $12-$14. I took that as a sign he believed shareholders would approve his proposed personal buyout of the company at $21 a share. It seemed like a pretty sure bet, since he controls 40% of the stock and the board had recommended shareholders approve the deal. A deal was accepted on Oct. 20 but at a lower price of $13.50 a share.
Calpine (CPN, news, msgs) CEO Jack Fusco purchased $8.36 million worth of his company's stock in August. Insiders overall bought $10.86 million worth.
As for selling, remember that it isn't always a negative.
CEOs may unload stock to cover an expense -- like taxes on gains from exercised options -- even if they are bullish on their stocks.
How do options work?
2. Is the CEO paid like a king?
Many academic studies establish a link between CEO pay and stock performance. And it's not what you'd think, if you believe that only top talent earns top dollar. Generally, companies whose CEOs get paid too much tend to underperform. They are more susceptible to credit rating downgrades as well -- never a good thing.
Why is this? A board that gives a CEO too much of the company's money is putting the CEO's interests above yours. Remember, the board is supposed to work for you, the shareholder, by cracking the whip on management. If a board is ignoring your interests by overpaying the CEO, it's probably doing this in other ways, too.
Recent events support this theory. Many companies that did the most to help create the subprime mess had CEOs who stood to take home really enormous amounts of money -- as long as they hit performance targets. So they took on too much risk and led their companies headlong into subprime mortgages. (See "As banks broke down, CEOs cashed in.")
But exactly how much pay is too much? One trick is to look in a company's proxy statement to see what the CEO makes compared with the next four execs. If the CEO earns more than three to five times as much as his underlings, that's too much, says Paul Hodgson of The Corporate Library. (You can find proxy statements in MSN Money's SEC filings section.)
"No one person can run a company," Hodgson explains. "If you don't pay your team well enough, they won't work as hard as they would if you weren't constantly reminding them that you are the most important person in the universe and they are mere underlings."
For example, Gamco Investors (GBL, news, msgs) CEO Mario Gabelli in 2007 was awarded $70.9 million in total pay, according to the company. That was more than 10 times the $6.6 million awarded to the four next-highest executives. This pay imbalance belies other shortcomings that net Gamco Investors low corporate governance grades from The Corporate Library. The weak score suggests the board may not be fully committed to looking out for shareholders.
A spokesman for Gamco responded that Gabelli's pay was fair because he is the "creative genius" behind the company and because all of earnings are "variable pay" linked to how well he does things like bring in new clients and manage portfolios. He gets no fixed compensation or stock options.
But don't companies need to overpay to make sure they get the top talent? Not really.
Costco Wholesale (COST, news, msgs) CEO James
Sinegal often earns below-average pay for companies of similar size. Last year he got average pay -- $9 million compared with a median of $8.85 million for CEOs at Standard & Poor's 500 Index ($INX) companies, according to The Corporate Library. Yet his company has vastly outperformed the S&P 500 over the past five years.
Another trick is to compare a CEO's pay with the average for CEOs of companies of similar size. Here are some ranges to give you perspective.
Last year, CEOs of large companies, with a market capitalization of $12.5 billion and up, were paid a median of $12 million, according to a Corporate Library study.
CEOs at midcap companies, with a market cap of $4.7 billion to $12.5 billion, got $6.1 million.
CEOs at small-cap companies, with a market cap of $750 million to $2.6 billion, earned median pay of $1.2 million to $2.9 million.
3. The CEO mansion indicator
The idea here is that when a CEO pays millions for his own scaled-down version of the Versailles Palace, it's a sign he's got too much confidence that the board will love him no matter what he does. So he might not work as hard.
An academic study by one of the world's top experts on CEO pay bears this out. New York University's David Yermack looked at how stocks performed after CEOs bought mansions. The short answer: not so well. Stocks picked based on this theory and held for three years beat the market by an average 46%. (Read "CEO mansions: A stock indicator?")
CEO mansion indicator
4. Excessive perks
It can take some painstaking research of public records to track home purchases by CEOs. If you don't have time for that, looking for excessive perks instead can also help you spot CEOs living the high life on the company tab because they are too chummy with boards.
Perks are listed in the proxy statement, typically in a footnote to "other pay." When you see things like hundreds of thousands of dollars worth of corporate jet use for private travel, exclusive club memberships or even race-car driving lessons for the CEO's kid, beware. It's a sign that the board has strayed far from its mission to serve you, the shareholder, putting more emphasis on pandering to the CEO.
RiskMetrics Group (RMG, news, msgs) questions the strength of board oversight at Oracle (ORCL, news, msgs), for example, in part because it provided $1.4 million in home-security services this year to chief Larry Ellison, even though he earned $84 million.
Investors might also have similar doubts about boards at Ford (F, news, msgs) and IBM (IBM, news, msgs). Last year, Ford gave chief Alan Mulally $752,203 worth of personal use of the company jet -- which extended to friends and family members -- compared with a median of $121,676 in personal-aircraft use by CEOs at Fortune 100 companies, according to Equilar.
IBM chief Samuel Palmisano got $406,235 worth of personal use of the corporate jet.
"Ford's board requires Mullaly to use the company aircraft for business and personal travel because of security reasons and time constraints," a spokeswoman said.
IBM responds that Palmisano is required to use the corporate jet for security reasons.
And in fairness to Oracle, it has made acquisitions in recent years that brought three corporate jets into the company, and it sold off all three. The company also has healthy operating margins, suggesting it keeps an eye on costs.
5. Chummy business relationships
Look out for companies where the CEO has an interest in companies that do business with the one he runs. A recent example: In fiscal 2008, Oracle did $6.8 million worth of business with companies in which Ellison has a controlling interest, including LeapFrog Enterprises and NetSuite. This is one reason Oracle gets low grades for corporate governance at The Corporate Library.
It is an all-around no-no. First, it's an obvious conflict of interest. Do you really think anyone will drive a hard bargain with a company owned by his boss? And it has to be bad for morale to put underlings in this position.
Second, boards that feel confident enough to stand up to CEOs and frown on these kinds of cozy deals are probably doing a better job of looking out for shareholder interests in other ways, too. You can find out how much business the CEO does with the company on the side by looking in the "related party transactions" section of the proxy.
6. A CEO options bonanza
Excessive stock options hurt shareholders big-time. When CEOs cash in all those options -- and CEOs typically get most of them -- either they water down earnings by adding so much stock to the share count or the company has to use lots of cash to buy stock to offset the dilution. That's money that could have been used for research or dividends.
Albert Meyer manages Mirzam Capital Appreciation Fund (MIRZX), which avoids companies that overpay CEOs, and stays away from companies where outstanding options exceed 5% of the overall share count.
One extreme example is Cognex (CGNX, news, msgs), which has issued enough options to potentially dilute the shareholder base by 25%. CEO Robert Shillman has the lion's share of those options. (To do this calculation, first call up the 10-K report from the SEC filings section of MSN Money. Options outstanding are usually in a footnote on stock-option plans or shareholders equity toward the end of the 10-K. For shares outstanding, you can use the basic share count in the income statement of the 10-K.)
"Stock options have played a crucial role in the company's success by enabling us to recruit, motivate and retain the most highly skilled and productive employees," says Cognex finance chief Richard Morin. He also says that Shillman's options are only 5% of all outstanding options and that Shillman takes no salary or bonus and instead has the company donate an equivalent amount to charity.
7. Letter to shareholders
Finally, always check out what the CEO writes in the shareholder-letter section of the annual report, says Pat Dorsey, the director of stock analysis at Morningstar (MORN, news, msgs).
For an example of what a good shareholder letter looks like, read the one from Robert Silberman of Strayer Education (STRA, news, msgs). It offers a clear summary of strategies for growth and milestones along the way. (You can find it in the annual report here.)
But to see the true master at work, read the letters from Buffett to shareholders of his Berkshire Hathaway (BRK.A, news, msgs). They make national headlines whenever they're released. (Read one of his latest here.)
No CEO can touch Buffett for sheer sophistication of business analysis, humor, wit and, yes, honesty -- even if he isn't completely candid about how much hobnobbing with CEOs gives him an investing edge.
At the time of publication, Michael Brush owned shares of Mirzam Capital Appreciation Fund.
Published Oct. 22, 2008
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