North of Silicon Valley in San Francisco's Transamerica Tower, Kenneth Broad has become one of the disparate voices countering the technology industry's campaign against expensing employee stock options.
Broad, co-manager of the
Transamerica Premier Growth Opportunity Fund, has been studying the stock options issue for more than a year. Earlier this summer, he jumped into the fray with a column debunking what he calls "high-tech options myths" that was posted on CNET's News.com Web site.
In addition to his passion over the stock-options issue, Broad talks enthusiastically about the small- to mid-cap sector, which is his fund's focus. He notes it's far easier for companies in this sector to grow than for behemoths like
, with huge revenue bases.
Broad, who with co-manager Chris Bonavico looks for companies with a market cap of less than $5 billion, roundly rejects investments in any company with a large employee stock-option awards. Despite such conservatism, though, Morningstar calls the fund a "daredevil" because of its small number of holdings. Still, that style has led to considerable success. The fund outperformed its peers by 6.8 percentage points since the beginning of the year, winning it a spot in the top quarter of its category. Its trailing one-year performance bested 92% of the funds in its category.
How does Broad pick his stocks? How did he become embroiled in the stock options debate? And how has that interest affected his stock picks? Read on.
1. How did expensing stock options become such a big issue for you in the first place, and what did you do to study up on it?
It was actually one company that I was looking at called
They had very good cash flow, good margins, very strong balance sheet. Everything on their GAAP financials looked great. And then for whatever reason I actually took the time to look into the footnotes on their options program, and it was astounding. I mean it was over 10%: They granted in one year over 10% of the shares outstanding in the form of options.
Assets: $87 million
One-Year Return: -7.12%/Beats 92% of Peers
Five Year Annualized Return: 10.53%/Beats 97% of Peers
Top Holdings: Barra, Expeditors International, Techne
Fund info: http://www.transamericafunds.com
Sources: Morningstar, Transamerica. Returns through Sept. 12. Top holdings as of Sept. 13.
The sheer magnitude of it struck me that their financials can look great, but with an options grant of that magnitude it renders their business a lot less attractive than it appears on the surface.
From there, I really started trying to reconstruct the right way to look at and cost options and again that led me to reading academic papers, and debating with CFOs on the issue and basically reading everything I could get my hands on. So that's what kicked it all off. That was probably 18 months ago now.
2. In your essay, you say expensing options will end the charade of inflated financial results that enrich VCs and employees at the expense of unwitting investors. Are there any particular areas of most concern where such inflation is happening?
Probably the most relevant quote in my essay is options systematically inflate every aspect of a company's financial statements. I could just walk you through an example.
John Chambers at
, the CEO, is drawing a dollar salary and no cash bonus
this year. So literally on an after-tax basis his impact of his cash compensation on the income statement is 62 cents after tax. He was granted, though, 6 million options
in 2001 that had a fair value at the time of grant -- and again you can quibble with the exact fair value -- of roughly $80 million. The income statement is inflated as a result of that, and so the cash flow statement is inflated because net income is inflated, and also when employees exercise their options -- a lot of people don't realize this -- the company gets to deduct the difference between the strike price and the exercise price as if it were compensation, just for tax purposes.
So it doesn't show up on the income statement. But let's say those options of John Chambers ended up being in-the-money by $50 million down the road. He could exercise those options and the company Cisco would report $50 million of compensation expense for tax purposes and get roughly a third of that as the tax benefit. And so that shows up in the cash flow statement as a line item: tax benefit from options exercises. Those two items inflate the cash flow statement.
Then the company collects the strike proceeds when the options are exercised, and so that's literally an evergreen equity offering. That's literally like issuing stock every single year at below-market prices. So that's why you see so many tech firms with a lot of cash on their balance and not much very debt.
3. What about the argument that the Black-Scholes model is not perfect? I've heard the complaint, for instance, that companies with higher volatility are penalized more under the Black-Scholes model.
Well, they are, but let's think about that. As a shareholder, I don't like volatility. As an options recipient, if you're an employee at a firm, the more volatility, the more your options are worth. So options right there put me as a shareholder at odds with the employee.
Part of the reason the tech industry is such a heavy user of options is because the underlying businesses tend to be more volatile.
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4. But don't options make sense for a young startup trying to conserve cash?
The original use was for a very early stage startup, where it's trying to attract talent but doesn't have enough cash. It's been perverted into something used by large, companies like a
Options are most appropriate for a pre-IPO company that still has a large single investor or several investors in the form of VCs, because they're going to be cognizant of options dilution. But once a company is public, it gets such a diffuse shareholder base that it's so easy for companies to put on their proxy, "please approve the grant of so may options," and it typically gets rubber-stamped with no oversight.
5. You also note in your essay that expensing options is just a bookkeeping entry, a noncash charge like goodwill amortization that tech firms are already so good at pro-forma-ing out of existence. If that's the case, why even bother?
The question to the tech industry is, why are you so afraid? It puts a number on the value transfer from shareholders to employees. There are a lot of lazy and/or ignorant investors who haven't done the work to understand the value of how much is being conveyed to employees. Even though it's not an exact number, it gives enough magnitude of the number being conveyed. For firms like Siebel, it takes a $250 million profit to a half a billion-dollar loss. That's what the tech industry is so afraid of: people finding out how much money is being transferred.
6. How does your philosophy about stock options carry over into your stock selection for your fund?
Directly. There are companies like Siebel where the magnitude of the grant is such that we would never even consider investing in the business, regardless of how good we thought the underlying business was. It's one of the things we look at.
Anything over 5% I view as unreasonable, and unfortunately that describes a large chunk of the tech industry.
What else do you look for in a stock?
We look for very high returns and improving returns on invested capital, free cash flow generation, and growth. The businesses we favor are able to grow through internal funds. A strong balance sheet is a residual of that: high free cash flow.
We look for a management team that you would feel good handing over your grandmother's retirement to manage. That's reflected in reasonable compensation, including options. Also, defensible market niches that we can see these companies growing over a period of three to five years. We definitely invest with a three- to five-year horizon.
7. Your fund's highly concentrated style -- holding only 25 to 35 stocks -- led Morningstar to call it one of the mid-growth category's most volatile offerings. What's the reasoning behind that high concentration?
The high concentration is really just a residual reflection of how snobby we are in terms of our criteria. Options are one thing on a long checklist, and if the options grant is unreasonable, a large swath is removed from consideration. Even when we do find a company we like, it might not be a super-attractive entry point in terms of valuation. What we'll do is find a company -- like one of our top holdings,
-- and we'll take a big position.
To quote Warren Buffett, diversification is an excuse for ignorance. Everyone is trained to be well-diversified. But the marginal benefits of diversification start declining after 15 holdings. If we own 15 stocks in different industries, we capture 90% to 95% of the benefits of being diversified.
A lot of other funds focus on 50 to 75 to 80 stocks, but the marginal benefits of being that diversified aren't worth having that many more names to keep track of.
8. Can you talk about a few of your top holdings and strong performers and why you like them?
Expeditors is a logistics company, non-asset-based. They don't own any planes or ships. It's a very low capital-intensity but high barrier-to-entry business with huge growth prospects. This company has less than 5% market share in the huge business of global trade, and so they can grow at very high rates by taking market share over an extended period. They're what I would call an open-ended growth story with great management and great returns on capital.
Another top holding is
, the online travel service. It's a great example of where concentrated investing can pay off hugely if you get the fundamentals right. We took a position in it literally a year ago, right after the markets opened after Sept. 11. There was the perception that people would never travel again. We viewed it as good business model, with young aggressive management, excellent capital and a very tiny piece of the market.
is another one of our top holdings. It is in risk-management software, and it has a relatively new CEO focusing on core operations. It was diversified over the years, which was not successful, even including a hedge fund for a while. So the new CEO sold off its noncore operations and completely refocused on the core business. So it has close to a third of its market cap in cash, and it generates huge free cash flow with very minimal capital expenditures. And it's buying back stock very aggressively. We like companies that are reducing share count through repurchases, in contrast to tech firms, where every year the share count increases because of options. Microsoft is a good example. It spends a lot to repurchase shares, and yet the share count still goes up.
9. Another top performer for you this year was Dreyer's Grand Ice Cream (DRYR) . Can you talk about this one a little bit?
A lot of food companies like
are large-cap because they need scale. But ice cream is a niche because it needs special distribution. Dreyer's dominated in direct-store distribution, which gave it a huge advantage. That's why
paid a huge multiple for it and then it went up. The buyer said you own a unique asset and we're willing to pay huge premium for it.
A lot of small- and mid-cap funds tend to focus on exciting areas like medical and health care and technology. Dreyer's gets back to the idea you can have a concentrated portfolio as long as it's diversified. We had online travel, ice cream and transportation.
10. What about any stocks that have hurt the fund?
is a great example. That's one where it had been a great business, very high return, internal growth. The former CEO, who was very charismatic and responsible for building the company, retired. A new CEO took over and shifted to more of an acquisition stance, and they immediately tripped with poor results after making an acquisition.
I think we probably lost 50% of our investment. Oftentimes if the thesis hasn't changed, we'll double down and actually buy more. In this case, the original reason for the investment had changed and so we sold the position at a loss.
We very much focus on internal growth as opposed to acquisitions, because internal growth tends to be higher quality. There's lower risk of integration, culture clashes, etc. Probably a great quote from the CEO of Expeditors on internal growth is, "Why buy what you can kill," which I think kind of sums up the attitude and the argument for internal growth.