The following commentary is from an investment professional with Clear Harbor Asset Management who is a participant in TheStreet's expert contributor program.
NEW YORK (
) -- The recent parade of corporate chiefs rewarded with vast riches in return for abysmal failure has vaulted the debate over executive compensation practices and corporate governance into the arena of mainstream political discourse. But don't count on our broken politics to bring sensible policy solutions in this area. Discerning investors have long had some ability to protect themselves from these potential pitfalls.
After all, if you avoid owning stock in companies with spineless boards of directors and flawed compensation practices, then you will minimize your risk of having your investments plundered by management teams that are either incompetent or have misplaced priorities.
Securities and Exchange Commission
requires public companies to disclose details about their executive compensation policies and practices annually in their proxy statements for good reason. The information provides an imperfect but often revealing portrait of a board of directors' ability to do its job -- namely, to represent the interests of shareholders.
Meanwhile, corporate executives and board members are required to disclose their own equity ownership levels in the companies they're running, which demonstrates the degree to which their interests are aligned with the shareholders at large. This too is a crucial piece of information for investors, but it's also imperfect. It's a good sign when corporate executives own a substantial equity stake in the company they run, but still, their interests don't always line up well with outside shareholders, and it's the duty of the board of directors to account for this.
Shareholders are the owners of corporations, and the directors they elect to oversee their corporations are tasked with assembling and maintaining quality management teams that are properly incentivized to work for shareholders and execute a strategy that will generate superior investment returns.
This basic concept is one that is too often ignored. It is, however, as fundamental to capitalism as the separation of government powers is to democracy. But while disenfranchised citizens in a democracy often face long odds in overcoming their predicament, shareholders that lack the resources to wage an effective proxy fight to oust members of a delinquent corporate board can always just sell their stake in the company and move on to greener pastures. They may have to swallow a loss, but that's not exactly persecution -- particularly if it can be used to offset gains for tax purposes.
Ideally, investors should avoid getting caught in that situation altogether by holding up a prospective equity investment to proper scrutiny before becoming a shareholder. In addition to evaluating a stock's intrinsic value relative to its price, investors should also seek some level of assurance that a company has a healthy system of corporate governance, an independent board of directors and a track record of making the best interests of shareholders a top priority.
Believe it or not, these qualities can be hard to find in corporate America. One place to begin looking is with a careful reading of a company's most recent annual proxy statement, and a look at the equity ownership levels of its top executives -- particularly the CEO. Are ownership levels low or shrinking? Those are red flags that should be cause for concern and further investigation. They could signal either a lack of confidence in the company's prospects by the people who know best, or a lack of motivation on the part of management to deliver attractive returns to shareholders.
On the flip-side, investors should be wary of a management team that demonstrates an unhealthy obsession with the short-term fluctuations of their stock price or manages the quarterly expectations of Wall Street as a game with the objective of raising their stock price. The daily gyrations of the stock market should be of no concern to a business leader that is busy creating real value, and an executive who displays such concerns may be driven by a poorly devised stock option or bonus incentive plan. Or worse, they may be more concerned with creating an appearance of success rather than actual success, an approach that usually brings disaster.
And what about compensation? Is a management team that has failed to deliver real returns for investors reaping outsized cash windfalls annually?
This situation often results from a board that is too cozy with management.
once compared a director that questions executive compensation levels in a board meeting to a dinner guest that belches at the table, but shareholders need directors that aren't afraid to offend their hosts in order to hold management accountable for things like deals gone awry or other misguided asset allocation strategies. Many executive compensation policies are too loose, allowing management to win large incentive-based compensation despite a lackluster performance in key areas.
Also, read the fine print in search of excessive perks or so-called golden parachutes or other benefits that look more like a sweetheart deal for executives than an investment made in the interest of the shareholders.
In the end, the intelligent investor will take these observations alongside a host of other factors when evaluating a stock and make a qualitative decision about whether to buy or look elsewhere. There are times when one should overlook some shortcomings in these matters in order to invest in an otherwise great or cheap company. Anyone who passed over on
shares due to the backdating of stock options scandal that erupted at the company in the last decade missed out on a great ride.
Still, investors who ignore these issues do so at their peril. Next week, we'll look at some specific companies that have succeeded with the use of modest but well-designed compensation structures and policies.