Integrity Counts


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The corporate world has long justified multimillion dollar salaries for executives as fair compensation for talent. But Albert Meyer, Portfolio Manager of Mirzam Capital Appreciation Fund (MIRZX), says executive stock options programs harm investors and even border on fraud. His fund invests in stable companies that largely eschew stock options for executives. The strategy has led the fund to the top 9 percent of its category and garnered it a five-star rating from Morningstar. Meyer spoke to us about how investors can steer clear of corporate fat cats while booking fat profits.-- John Bishop

Integrity Counts

Please explain your investing strategy.

We outperform the market by investing in companies with no stock options programs or very modest options grants. However, the process doesn't start with evaluating compensation or corporate governance, but by screening companies on a number of metrics including price-to-earnings ratio.

When we find a promising company, we do an abbreviated financial analysis. Then we look at the proxy statement and examine how management is compensated. If it takes 40 pages to explain why the CEO needs to earn $20 million a year, we'll move on.

The next step is to study the company's 10-Ks and 10-Qs. We study the business model, the industry and competitors, and analyze 10 years of financial statements and five years of quarterly results. If you do your homework up front, you can find companies to buy. And if a company's worth buying, its worth holding. That's why our turnover is so low, about 2 percent.

One example of a company this strategy led us to is Southern Copper Corp ( SCCO ). Copper is often in the news but Southern Copper is rarely mentioned, even though it's a $30 billion company. It's the world's fourth-largest copper producer and holds the world's second-largest copper reserve. The CEO's basic compensation for the past three years fluctuated between $450,000 and $495,000, with cash bonuses of $2.3 million. On average he earned about $1.3 million each year.

What's wrong with stock-based compensation?

Show me a company with a stock option overhang of 20 percent, and I'll show you a company that has brought nothing but pain for investors and huge windfalls for management. The option overhang is calculated by dividing the options outstanding by the number of shares outstanding. By conventional wisdom a 20 percent overhang should indicate a favorable alignment of management and shareholder interest, but nothing could be further from the truth.

Cisco Systems' ( CSCO ) CEO John Chambers took out $127 million dollars in option gains this year from February to May, but Cisco's stock is down 15 percent. Option-laden companies are plagued by insider sales, and while executives receive huge option grants, their ownership interest rarely increases. John Chambers has a smaller interest in Cisco today than he had 10 years ago, yet he's received millions of options.

It's an alignment of interests only in theory. In practice it's just a massive wealth transfer scheme from shareholders to management.

Would you invest in a company with a CEO that makes over $5 million?

We look at each company on its merit. Our portfolio is full of large-cap companies that dominate their markets. But it's true that the average CEO compensation of our portfolio holdings probably isn't much higher than $5 million. But we don't have a rigid cap. We own Johnson & Johnson ( JNJ ), which has an option overhang of close to 5 percent and a CEO who earns about $15 million a year. We don't mind if a CEO is paid a salary of $20 million. We care about how they're being compensated.

Should Oracle ( ORCL ) CEO Larry Ellison be rewarded with $1.8 billion in stock options gains over the past 10 years, while Oracle shareholders have seen a 1.3 percent negative return without dividends? John Chambers has taken more than $50 million per year in stock option gains for the past 10 years but Cisco shareholders have lost about 8.4 percent per annum.

ExxonMobile Corp's ( XOM ) CEO receives about $20 million per year. Meanwhile, Norwegian energy firm Statoil (STO) pays its CEO about $900,000 in cash only; the Norwegian government says stock options are akin to criminal activity. Yet Statoil has been a public company for nine years and has given shareholders a 19.2 percent per annum return. Exxon has returned 8.4 percent per year. 

Here's one more example that will demonstrate the idiocy of options. At the time that Bank of America Corp (BAC) acquired Countrywide Financial Corp in July 2008, Countrywide CEO Angelo Mozilo had picked up $400 million in stock option gains over several years. That money didn't come from Countrywide's cash coffers because the company had negative cash from operations. That money came from middle class Americans who got conned into investing in Countrywide, probably through index funds. Stock option programs facilitated an unconscionable wealth transfer of $400 million to one individual's bank account.

To borrow a phrase from Winston Churchill, never has so much been taken from so many and given to so few. Option programs are insider trading, front running and stock watering exercises. They should be illegal.

So where does this leave the individual investor?

That's why I formed the fund. We back-tested the top 24 stocks in our portfolio and found that they gave you an 18.1 percent per annum return over the past 10 years. It wasn't a lost decade at all.

The companies we own have very few insider sales because there are very few options or no options. These are companies in which you can invest with confidence.

Consider Monsanto (MON) and Syngenta (SYT). Monsanto is a US company in the seed and insecticide business that uses stock options by the truckload.  Syngenta is a Swiss company in the same business. We'll take Syngenta every day; not only has its stock outperformed shares of Monsanto, but we also feel safer about its management and compensation.

That said, we won't buy a company just because it pays peanuts to executives.

How can you identify competent management?

If management can deliver good returns with modest compensation, then you know they have integrity. The Buckle (BKE) is a Nebraska-based retailer that stopped its options program in 2000. The company culture is to promote from within; the CEO worked for the company as a student and stayed on when he graduated. Through the years he's built an ownership interest of 6.6 percent in after-tax earnings.

The Buckle is a good example of honest people at the helm with modest salaries. If you take The Buckle's charts and compare them against Abercrombie & Fitch (ANF) and The Gap (GPS), it's a much better investment over five to 10 years.

Why do you hold so many overseas companies?

We have no preference for foreign or domestic companies. We merely try to find great companies and then weed out those that abuse options to the detriment of shareholders. We've found some really great global companies that fit the bill, but not as many US companies. We hold a number of Canadian companies, which have some of the same characteristics as US companies because they're so tied to our economy. But Canadian firms have a far better perspective on shareholder capital.

You're overweight in industrial materials. Could this be a problem if the global economic recovery falters?

We are a little overweight in industrial materials, but that's misleading. Tenaris (TS) is an Argentine-owned company based in Luxembourg that makes steel pipes for oil and natural gas drillers. It's classified as an industrial materials firm, but it's really a play on the move from onshore drilling to deepwater drilling and the growth of natural gas drilling. It produces highly specialized materials that are in huge demand and controls about 35 percent of the market. The CEO's salary is $660,000 in cash, and the stock has outperformed Google (GOOG) over the long term.

Titanium Metals Corp (TIE) is a play on the growing airline industry in Asia and increased military spending to modernize air forces.

Southern Copper, which I mentioned earlier, will benefit from the expansion of power plants in China and India. Chinese generating capacity increased 19 percent last year. The only way to bring that capacity to the people is through the power grid, which means more power lines.

If you take out those special situations then our weighting in industrial materials is manageable. But obviously if the world goes into a double-dip recession, there'll be no place to hide.

What advice can you offer individual investors?

Look at a mutual fund's top holdings and examine insider sales at these companies. Large amounts of insider sales indicate aggressive stock options programs. Small investors should probably avoid funds with high turnover ratios. Buy and hold is supposed to be out of fashion. But people who don't like buy and hold aren't very good stock pickers. If you're a good stock picker, you want to hold what you bought.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing Stocks
Referenced Stocks: CSCO , JNJ , ORCL , SCCO , XOM

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