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Stocks In-depth

Proxy

Introduction

The proxy statement gives you a look at management compensation, including options
You can also get a sense of the qualifications and of the Board of Directors
Issues that require a shareholder vote are disclosed in the proxy, as well

Details

Top jobs and the amazing technicolor dreamcoat
Estimating the cost of executive compensation
Analyzing the Board of Directors

Selected Works

A Tale of Two Cities
Great Expectations
Nicholas Nickelby

Introduction

The proxy statement gives you a look at management compensation, including options
You can also get a sense of the qualifications and of the Board of Directors
Issues which require a shareholder vote are disclosed in the proxy, as well

The proxy statement is both the most boring and the most interesting document you might find. Its carefully constructed legalize has the power to lull an angry rhino to sleep, but the lessons behind the language can be fascinating. How a management is paid tells a good deal about their priorities.
The proxy also provides information regarding the members of the Board of Directors. Remember, management works for the Board, and the Board works for the shareholders — in theory. The backgrounds of the board members give you some basis for judging their abilities and independence — the more successful they have been in business themselves and the more removed they are from any personal or professional ties to the CEO, the better. The number of shares owned by each board member is revealed, as well — it’s worthwhile to check how many on the board own significant positions.
When a company needs a vote from its shareholders — often to approve an increase in its option program (!) — the details are provided in the proxy. Shareholder-initiated proposals, which have met the requirements for consideration and usually seek to change business practices, are also included. If you like good odds, always bet that the company proposals will pass and the shareholder-initiated ones will not.

Details

Top jobs and the amazing technicolor dreamcoat
Estimating the cost of executive compensation
Analyzing the Board of Directors

Henry II cut right to the chase in The Lion in Winter when he noted, “God, but I do love being king.” Those who rise to the rank of CEO enjoy significant power and great wealth. If they worry about where their next paycheck is coming from, it’s only because it’s coming from so many different angles.

CEOs and other top executives are paid salary, bonuses, “other annual compensation,” restricted stock awards, company options, long-term incentive payments (LTIP), and “all other compensation.” The compensation of the top five execs during a company’s most recent three years is presented in the “Summary Compensation Table” in the proxy statement.
To estimate the cost of executive comp, first add up all the dollar figures listed for the last three years. Then, add up the options granted over that period and convert these to a dollar value by multiplying the option total by the value per option (available in the notes to the annual report; if unavailable, assume a value of $15/option). Add both dollar figures together and ask yourself whether you made the right career choice.Once you have determined how much is being paid, you can then consider when how much is too much. By comparing the company’s pretax income for the three years to the total compensation of the top five executives, you get a reasonable idea.

As a rule of thumb, the company’s pretax income should be at least twenty times the compensation for the top five managers. The ratio will generally be lower for smaller companies (less income / more growth potential) than for larger companies. Regardless, when the number gets below ten (more than 10% of earnings going to the top five employees), serious questions should be raised in an investor’s mind.

The proxy statement also provides details to help you judge the independence of the board of directors — remember, the board is beholden to the stockholders, not to the management. The first consideration is whether the CEO is also the chairman of the board. This is usually the case and it usually impairs the independence of the board. After all, when the top manager answers to a board which, in large part, answers to him, the concept of independence takes on an Alice in Wonderland quality. You’ll be hard-pressed to find changes at the corner office, even of significantly under-performing companies, unless the CEO isn’t also the chairman of the board. The recent upheaval at Compaq was initiated by Ben Rosen, a very independent chairman.
The proxy also includes a background summary of the various members of the board of directors. Determine how many board members have ties to the company, either directly as executives or indirectly as former employees, consultants or lawyers. These inside members should represent a minority, preferably a small minority, of the board.

Next, compute how many outside directors own more than $2 million in company stock. Finally, consider the qualifications of the outside directors — do they come from senior positions in successful companies or is their background in academia and government?

Your hope is to find a board of directors largely made up of independent, highly qualified individuals with a vested interest in the success of the company, people who are willing and able to act in the best interests of the stockholders.

Selected Works (Boring the Dickens Out of You)

A Tale of Two Cities
Great Expectations
Nicholas Nickelby

Let’s first examine the proxy statements of two technology companies: Cisco Systems and Network Associates. The Cisco Board of Directors is comprised of some of the most impressive tech personalities you could hope to meet. There are three inside directors and eight outside directors — of the eight, all own more than $2 million in stock and five have holdings that exceed $10 million. Further, the CEO, John Chambers, is not the chairman of the board. This clearly is a talented, motivated, independent board of directors.

As for executive compensation at Cisco, the top five execs received $9.5 million in direct payments over three years plus options valued at more than $80 million (not a misprint). This compares with three-year pretax income of $6.7 billion. Effectively, the compensation of the top five execs represented less than 2% of income.

At Network Associates, on the other hand, top five compensation, estimated at $100 million, represented about 16% of pretax income. That’s with the most generous possible accounting. Based on actual reported pretax income, top five comp represented over 30%. Moreover, the board here is comprised of only four people: the CEO who is also the chairman, the former CEO of a company that Network acquired, and two consultants (one of whom did run a computer peripherals company for 2 ½ years). Neither of the outside directors owns more than $1 million in stock, even though the options given to directors are extraordinarily generous.

[Please note: Since this article was originally written, a third outside director was added to the board. More important, on December 26, 2000, the company announced that William Larsen, chairman and chief executive, would be leaving Network Associates and its board of directors. The company also indicated that 4th quarter results would be disappointing.]
Now, let’s consider the proxy statement of Coca-Cola, our case study throughout these discussions. Doug Ivester serves as both the chairman of the board and the CEO. Ivester and his four most senior subordinates received 3-year compensation of $77 million. This comp package, while generous in an absolute sense, was minimal relative to Coke’s pretax income of $15.8 billion in the 1996-1998 period.

Some might argue that Ivester’s compensation of $20 million in 1998, his first full year as CEO, was excessive in view of the performance of the company and its stock. The lion’s share of that income, however, was earned through restricted stock that had been awarded years earlier. In addition, Coke’s results suffered from an unusually difficult operating environment, not from a lack of vision and execution at the top. As the environment improves, shareholders can expect a great future.

In addition to Doug Ivester, the board of directors is entirely represented by outside directors. Six of these eleven directors own more $2 million in stock; one of these, Warren Buffett, controls shares worth more than $13 billion.

Please note: As of February 17, 2000, the new chairman and chief exec of Coca-Cola is Douglas Daft, who has worked for the company since 1969 — his compensation package for 2000 has not yet been released.]
Buffett also directly owns some $35 billion of stock in his own company, Berkshire Hathaway, which under his leadership has risen in price from $15/share in 1965 to its current price of $73,000/share (also not a misprint). Along the way, Buffett has also set the standard for how managers should treat shareholders.

Like the intrepid Nicholas Nickelby (yes, we’re stretching here), Buffett has tried to highlight fairness, both in his writings and in his actions. Amazingly, he and his partner, Charles Munger, are each paid only $100,000 a year and they have never received any bonuses, long-term incentive pay-outs, restricted stock awards, or stock options. They both became billionaires by buying shares in the public markets, as any other person could have.

And their most recent Proxy Statement is all of six pages long.