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Column

Gary Sutton
‘Sutton’s Laws’ Columnist
Directors & Boards

It’s the Cash Flow, Baby

The solution to excessive CEO comp … as well as the basis of my personal investment strategy.

By Gary Sutton

An angry institutional shareholder voted against my re-election to a board last month. I squeaked back in, but this shows how explosive CEO compensation has become. And there is a solution.

But first, let’s analyze this incident.

In this particular company the growth was slowing. We needed a CEO to broaden the business, adding things beyond our experiences. This is a mid-cap outfit and we successfully recruited the president of a large-cap business, a guy who had precisely the background needed.

We matched his prior salary and options and made good on his lost options in the move. Nothing more. This resulted in a base salary of a half-million dollars. That’s about median for comparable outfits. His option grants were aggressive for us, but he wouldn’t come for less than what he already had, so we anted up.

After he joined, his options for the first full year went underwater as he struggled against the sluggish growth he inherited. He personally went into the open market and bought our shares, investing more than he took home in salary. I liked that, and joined him by investing more than my compensation as a director.

Five quarters later sales are growing faster, earnings are accelerating, and cash flow has bounced way up.

Go Figure
Well, all this is fine and dandy until you issue the 10-K. If you use the Black-Scholes method to value stock options, and if your stock has recently dropped, making it more volatile, that somehow jacks up the imputed value of the grants. Go figure. And so his compensation was reported as something in excess of $20 million. (Well, that would be excessive, if it were real.)

So even professional investors don’t look deep enough.

Okay, now, it’s inarguable that lots of CEO compensation is abusive and threatens the entire idea of a public stock market. But, in this case, we made the best deal we could and had no other candidates interested who were half as qualified. Besides, those who howl about CEOs’ salaries, without regard to the results delivered, should understand that those who flip over into private equity often make multiples of their prior compensation.

And get this. I’m cheap. As a CEO through three decades of businesses in printing, software, aerospace, burglar alarms, and data storage, I never paid myself more than $120,000 (and saved the SEC documents to prove that). Three times I went without salary when embarrassed by results. I never made a nickel on cheap options. My shareholders all had to profit before I saw a farthing.

Solution to All Ills
My personal investment strategies, if adopted by others, would solve all controversy over CEO pay. Really. That works like this:

Once a year I go to my discount broker. They give me their current recommendations. I eliminate the 80 percent with the highest P/E ratios. Next I toss out the “dead cat bounce” stocks. (Throw it down the stairs and even a dead cat will bounce once.) These dead cats are generally the stocks that have low P/Es for good reason, like an airline or domestic auto company. Then I take the rest, which then number about 30, and throw out the 15 where the CEO takes the highest salaries in relation to the cash flow.

If investors would simply pay attention to the relation between CEO salaries and cash flow, and ignore those abstract concepts like “compensation” and “earnings,” the whole problem would self-solve.

How are my results? With only four years of experience, each year my portfolio has done either slightly or noticeably better than the indexes. Not enough for proof, but interesting thus far. And an approach that would help control CEO salaries.

Not Enough Lipstick
I’m sticking with this investment philosophy. It just seems that when a CEO’s salary is excessive, compared with the operating cash flow, there’s not enough lipstick in the world to make that pig pretty. And so far, it seems to pay off.

Three years into this strategy, a study reinforced the thought in a different way. David Yermack of New York University along with Crocker Liu of Arizona State University studied 432 CEOs on the S&P 500 in 2004. They found that 12 percent of these CEOs lived in homes of 10,000 square feet or more or on lots with at least 10 acres of land. Their stocks underperformed the other CEOs by 7 percent.

Warren Buffett would be unsurprised.

Gary Sutton has been a CEO and director of a number of private and public companies in his career as a specialist in startups and turnarounds. He writes the “Sutton’s Laws” column for Directors & Boards. He is the author of two books on business, Corporate Canaries: Avoid Business Disasters with a Coalminer’s Secrets, and Six-Month Fix.

He can be contacted at garysutton@san.rr.com, or visit his website at http://www.sixmonthfix.com.