Fat Cats

Excessive salaries for mediocre performance…sound like any CEO’s you know?

In the Railroad Age, the robber barons of business were fatsos. Diamond Jim Brady weighed over 300 pounds. J.P. Morgan and cronies were barely sleeker. Fat cats.

Today the barons of the business world call themselves CEOs. They are slim and fit. But as a class, they’d make Jesse James look good. Jesse meant to steal and advertised it truthfully.

You already know about the high-profile crooks – Bernie Ebbers led away in handcuffs, Ken Lay pretending he didn’t know a thing about Enron. They’re only the sharp edge of a huge problem. Most CEOs are not crooks, but many are incompetent and misguided about their jobs.

There are two problems we investors suffer at CEOs’ hands today: excessive salaries for mediocre performance…and the real booby trap, the golden parachute payoffs failing CEOs get when they leave.

The job of today’s CEO, as demanded by boards and shortsighted shareholders, is to increase stock price. Now. Every quarter. Period. And they will do what they can to make the price go up…even if it means burying employee options in the footnotes, taking serial reorganization charges, selling off assets, delaying expenses and using pension funds to pad the bottom line.

Overstated Profits: Smarmy Bookkeeping

But when you look at the important numbers, things look different. For the S&P 500 companies, sales have risen only 3% on average over the last year…but the companies have reported a miraculous 19% leap in net profits. That’s not brilliance; it’s bookkeeping at its smarmiest.

The return on equity for the S&P 500 looks fairly good at 14% on average. But that’s way overstated, too. If profits had risen only twice as much as revenues – which would be a feat in itself and much closer to the truth without accounting gimmicks – the S&P’s ROE would be closer to 5!

All in all, the performance is dismal at the business level, as opposed to the stock-price level. But this hasn’t hurt CEOs much, despite some news here and there of pay cuts and firings for underperformance.

Burson-Marstellar has done an extensive study of CEO salaries. Their conclusion: Average total compensation for a CEO is $16.5 million. Average worth of a CEO to the company is only $3 million.

Overstated Profits: Thank You, Jack Welch

Much of this compensation is hard to spot. You have to go to the proxy statements, which too few people do, to uncover CEO salaries, bonuses, and stock options and awards. Even then, other costs like contributions to their retirement, the retirement formula, perks and severance benefits may be missing. Especially retirement benefits.

Thanks to Jack Welch, former and famous head of GE, we have entered the age of shareholder value and CEO as superstar. Shareholder value, Jack’s mantra, translates to ‘make the stock price go up, no matter how you do it.’ And boy did Jack do it.

Adjusted for splits, GE stock went from around $4 a share in 1980 to a high of $60 in 2000. But Jack’s accomplishments are hollow at the core, and that’s the reason GE stock is down 50% from its high today.

While GE supposedly grew its earnings per share at 14.4% a year over the past 10 years, it did so with a lot of accounting help and asset shifting. Some of the money that fattened the bottom line came from the pension fund. Some came from selling off assets.

Standard and Poors has calculated that if you back out the extraordinary events, restructuring charges and such, GE only achieved an 8.1% growth rate over the past 10 years, not 14%.

Overstated Profits: Paying the Price

And even if it were 14%, famous Jack’s charisma sparked the price. Remember, GE was an industrial conglomerate before Jack made it an industrial and finance company conglomerate. As such, it should have been selling for a P/E ratio of 14-20. It sold for P/Es of 30-50 when Jack was king.

Investors who bought GE at the top are now paying the price Jack Welch wrought. That’s a done story. But it will repeat itself hundreds of times over in the next three or four years, as one company after another reaches the same impasse GE faced. You can only strip out shareholder value for so long unless you actually build a better business.

But whether or not they manage to genuinely improve their companies, CEOs are paid like so many kings. Today, even a middle-of-the pack CEO makes 475 times as much as his regular employees, and the top cats are off the charts. That’s an astonishing paycheck for a hired hand.

How did these wild salaries happen? Let me ask you a simple question. If you hired a window washer and told him to name his price, anything he wanted, do you think he’d say "eight bucks an hour"? No sir, you’d have yourself a $50,000 window washer.

Human nature doesn’t change as you go up the job ladder. These days, CEOs are colluding in setting their own salaries. All the folderol about independent boards and compensation committees studying competing salaries is so much sand in the eyes. Among the S&P 500 companies, 75% of the CEOs also serve as chairmen of the board. Do you really think the compensation is going to be stingy with the chairman and CEO? They pack the compensation committee.

But getting fired is an even better deal these days…and so is retiring.

Overstated Profits: Sneaky Deals

At E*Trade, former CEO Christos Cotsakos invoked shareholder fury over his $83,091,000 salary and bonus package in 2001. The company’s earnings were $291 million in the hole at the time. In 2002, Cotsakos ‘forgave’ $20 million of his salary as the company continued to slide and share prices dropped again. Finally, he retired under strong suggestion, but he didn’t go lightly. Cotsakos walked with an immediate $4 million in severance pay and another $5.1 million a year retirement. Guaranteed.

Meanwhile, regular employees didn’t get guarantees. They got a lot of E*Trade stock in their 401(k) accounts, which fell from $30 in 2000 to under $4 earlier this year.

No matter what the next CEO makes, remember that if you buy E*Trade shares, you will be paying Cotsakos $5 million a year until he dies. He’s only 50.

But the sneakiest deals don’t show until the bill comes due. Delta gave its CEO, Leo Mullin, credit for 25 years of employment when calculating his retirement plan. He only worked there for three years. Boeing CEO Philip Condit gets two years credit for every year he works in his pension formula. When he goes, his pension will be three times as much as his base salary for working.

All this is not to say that I’m against hefty salaries necessarily. Big pay for big performance is the American way. Even Bill Gates’ fortune is fine with me. He took the risk, put his future on the line and babied and bullied Microsoft to its market dominance. Without Bill Gates, Microsoft would be another also-ran company. In his lifetime, Bill Gates has taken a company from startup to growth stock to blue-chip growth…and introduced it into more parts of the world than McDonald’s.

Anyone else who can take a company from startup to one of the world’s most important firms in 30 years can name his price. The rest of you guys…$3 million a year if you’re good. Six if you’re really, really good.


Lynn Carpenter,
for the Daily Reckoning

August 12, 2003

Investing advisor and skeptical analyst extraordinaire, Lynn Carpenter has helped investors earn profits in everything from oil and steel to emerging technologies, defense stocks, Swiss annuities and commodities.

Sunrise begets sunset.

Stability begets instability.

Birth begets death.

Boom begets bust.

Information begets ignorance.

Inflation begets deflation.

Longtime Daily Reckoning sufferers will recall that we have our own philosophy. Essentialism, we call it.

It came to us neither as the result of logical inducement nor sober reflection. Nor was it revealed to us as a divine truth. Instead, we just took it up as a man takes up with a pretty woman; we thought we might have some fun with it.

But now we find ourselves married to her – and happier for it. After a few years, we find her as attractive as before, and more serviceable than ever. She guides our steps and keeps us from making a fool of ourselves.

Essentialism begins with the same insight as existentialism – that the world is so complex and so full of baroque exuberance that we will never be able to ‘know’ or ‘understand’ it fully.

But no sooner have we shaken hands with the existentialists than we part company. We leave them to their folly. For the poor bumblers then go forth, believing that even though they can’t understand how the world works they can nevertheless figure out how to make it work better! Thus do they want to control interest rates…economic growth…foreign governments…ingestibles…you name it. And thus do they throw away their dignity…and generally make a mess of things.

In the ’50s and ’60s it was all very hip to be an existentialist. It was avant garde.

But now almost everyone is an existentialist and almost every one of them seems like a pathetic boob.

We essentialists may be pathetic too, but we hope to maintain our dignity by observing the world rather than sweating to improve it. We content ourselves to try to fathom the essential principles, rules, and laws that keep the old ball turning.

‘You can’t get something for nothing,’ is a common example. We were too late on the scene to claim we coined the phrase, but when we found it we didn’t waste a minute putting it in our pocket, along with the other loose change of the essentialist’s fortune.

‘Love thy neighbor,’ is in there. So is ‘the borrower is slave to the lender.’

This last essential verity has been recently overlooked – along with most of the rest. But it came to mind after a news report explained that China had warned U.S. Treasury Secretary John Snow to lay off criticism of China’s policy of pegging its currency to the dollar. Keep it up, said the Chinese, and we’ll stop lending you money by investing in your damned bonds.

We’re sure Snow must have shot back with something like:

‘Oh yeah…well, we’ll just stop buying your cheap crap…’

But Snow’s comeback must have had a tinny sound to it, like a bankrupt who threatens to take his bank business down the street.

China’s trade is booming – up at a 33% rate in the first 7 months of the year. The average Chinaman still lives in a hovel, but it is a better hovel. They’re building luxury apartments in Shanghai and selling them as fast as they can get them up. And foreigners are lining up to learn to speak Mandarin, hoping to get an early edge on the Next Big Thing.

Of course, the Chinese will have their own mad booms and comic bust-ups. But the big boom of the last 200 years has been in America. The U.S. is the great success story of the last two centuries. Its thrifty, hard-working people built the greatest economy the world has ever seen. Now they enjoy the fruits of their labors; America has become the land of the freest spenders on earth. And they will continue to enjoy their good fortune…as long as the Chinese are willing to lend them money.

Over to you, Eric…


Eric Fry in Manhattan…

– The blue chips struggled for most of the trading session yesterday, before clawing their way into the black by the closing bell. The Dow gained 26 points to 9,217 and the Nasdaq added 1.1% to 1,661. But the bond market tanked again, as the 10-year Treasury yield jumped to 4.40%, close to its one-year highs. In the currency markets, the U.S. dollar slumped half a percent against the euro to $1.136, while gold jumped $5.40 to $363.30 an ounce. Inspired by the ancient currency’s sparkling performance yesterday, the Amex Gold Bugs Index jumped 1.7%.

– As long as bonds are tumbling and gold is rallying, equity investors will enjoy no serenity whatsoever…and they might even lose a ton of money. After all, soaring bond yields and soaring commodity prices are not known to be the stock market’s best friends.

– Nor is gold the only commodity that is kicking up dust these days. Crude oil and natural gas are both dancing higher as well. Crude oil traded to almost $33 last week, the highest price since mid-March. Then yesterday, natural gas for September delivery jumped nearly 2% to $5.13 per million British thermal units.

– "Each and every week in these most-unsettled financial markets is an adventure," remarks the Prudent Bear Fund’s Doug Noland. Looking out over the next few years, we wonder whether the financial markets will provide a "Disneyland" sort of adventure or a "Deliverance" sort of adventure. In other words, will equity investors be squealing with delight or terror, as their capital takes fright and disappears?…We’d imagine that both bond investors and stock investors will find the next few years far more chilling than thrilling.

– "Elliot Wave Financial Forecast reports a most interesting observation on the current stock market state of mind," observes Jay Shartsis, a professional option trader and friend of your New York editor. "If the bear market were over, advisors would be clinging to the fact that a 30-day certificate of deposit has returned a solid 3% over the last three years, while the S&P 500 has lost an average of 11.4% each year. Instead, low yields on CDs and money market funds are cited as the No.1 reason to invest in stocks and risky bonds.

– "In other words, at a major bear market bottom, preservation of capital will be the dominant theme, not Chinese Internet stocks. In August 1982, the last generational low for stock prices, interest rates were sky- high, but few thought that a 20+ year descent for interest rates was starting along with a gigantic bull market for stocks. We are probably now at the other side of the curve, as interest rates have put in a generational low and stocks are at a high point."

– If past is prologue, today’s unsettled financial markets will provide very fertile soil for commodities and resource stocks. These hard-asset plays – like buckwheat – tend to thrive in harsh conditions.

– Natural gas is a particularly promising commodity, according to John Myers, editor of Outstanding Investments. "I’ve been a fan of natural gas even longer than Alan Greenspan," quips Myers, referring to the Fed Chairman’s recent bullish comments about natural gas. "The supply/demand fundamentals are excellent," Myers continues, "yet natural gas stocks, as a group, are pretty cheap."

– Yesterday, the Energy Department reported that the nation’s natural gas supplies are only 2.1 trillion cubic feet, which is a hefty 461 billion cubic feet below the year-ago level and 234 billion cubic feet below the five- year average. Exacerbating the supply shortage, "gas output is expected to drop slightly in the U.S. this year," Barron’s notes, "following a 4% decline in 2002, and Canada, the nation’s main foreign supplier, won’t be able to punch up exports for several years, until new pipelines are completed."

– "Do the math," Myers concludes. "The U.S. needs about 3 trillion cubic feet of natural gas in storage going into the winter season, in order to keep a lid on gas prices. Since we’ll be well short of that number this year, rising gas prices seems like a low-risk bet."

The Daily Reckoning