- Stock option compensation rewards management if the market does well, business performance is almost irrelevant.
- BlackRock and Vanguard are becoming more assertive in the implementation of better governance policies. However, it seems it’s only a rhetoric given that they own 9% of corporate America.
- Two examples show how CEOs can have opposing attitudes toward shareholder value.
Today, we’ll dig deeper into corporate governance as it’s essential for our long-term investment returns.
We’ve already discussed how buybacks mostly negatively affect long term shareholder value. But apart from buybacks, there are other interesting, more subtle issues that can help us lower our risks and increase returns.
We’ll analyze what Larry Fink and William McNabb have to say about corporate governance, and we’ll look at a few examples of how CEOs manage their companies in order to show examples of good and bad practices.
William McNabb & Larry Fink
I imagine many of you don’t know who Larry Fink or William McNabb are as they aren’t investing gurus like Buffett, Dalio, or Klarman. However, it’s extremely important to follow them as how they think and what they do affects our investments. Fink is the CEO of Blackrock, the world’s largest asset manager with $5.1 trillion assets under management, while McNabb is the CEO of Vanguard, the largest holder of U.S. equities with $4 trillion under management. Together, Vanguard and Blackrock own 9% of Apple Inc. (Nasdaq: AAPL) and have similar stakes in most U.S.-listed companies.
The two funds—apart from having a positive effect on general investing returns as they have—lead the low fee movement in finance, also known as the Vanguard effect as it is estimated that Vanguard has saved investors more than $40 billion by lowering fees. They also have a very important role as intermediaries between their clients and the companies that their clients indirectly own. Let’s take a look at how they think corporate America should be governed.
Both Fink and McNabb send annual letters to CEOs to tell them how they expect them to behave with the key ingredient being maximizing shareholder returns over the long term. Vanguard’s key principles include what every shareholder would want to see in his companies:
Figure 1: Vanguard’s key governance principles. Source: Vanguard.
The creation of long term value means, to quote McNabb:
“If you compensate management with stock options, you compensate them for what the stock market does and not for how their company does.”
McNabb is really focused on compensation, and wants boards to do a better job of defining longer term objectives for corporations and link executive pay to those objectives. Vanguard is in favor of more stock grants in place of stock options, with stocks granted only if an objective is reached alongside a very long vesting period. However, McNabb isn’t happy with the long-term thinking in corporate management. According to him, it’s getting better, but it is not where it should be.
Figure 2: Performance based compensation is growing, but stock market related compensation is still high. Source: SAGE Publishing.
In his letter, Larry Fink also focuses on long term value, but goes into more detail by criticizing buybacks. He sees them as a hindrance to growth because the value of dividends and buybacks by S&P 500 companies exceeds their operating profit which is an unsustainable situation.
Criticism On Blackrock & Vanguard
The above all sounds nice, but I question whether it’s only rhetoric or if they are really going to be more assertive in applying these noble principles.
Given the current high level of buybacks and option compensation schemes, it looks like it’s mostly rhetoric as both companies enjoy the higher fees coming from asset prices which are further pumped by buybacks.
Carl Icahn goes a bit further and criticizes the fact that Fink and McNabb push for more acquisitions, or as they call them, “long term investments.” Acquisitions are always done at a premium, so they increase the value of their managed assets and increase fund managers’ fees while it is questionable whether acquisitions really increase value in the long term. Personally, I don’t mind acquisitions, especially if I own the target company, but Icahn is right on the shareholder value creation part.
Two Examples Of Opposing Attentions To Shareholder Value
CEOs of large corporations have an enormous, usually totally overlooked, responsibility. It’s their responsibility to deliver long term value to their shareholders as most of us expect to retire and live better thanks to our investments. However, our retirement isn’t what CEO’s focus on which leads to a discrepancy between shareholder value and CEO vision.
I want to compare two acquisitions that are excellent examples of different approaches to thinking about creating shareholder value. The acquisitions are Berkshires’ acquisition of See’s Candy, and Facebook’s acquisition of Oculus.
In 1972, the asking price for See’s Candy’s was $30 million. However, Buffet thought that was too high an asking price and wouldn’t go higher than $25 million. Fortunately for Berkshire shareholders, the owners settled on the price and sold the business to Buffett. In 2007, See’s Candy’s sales were $383 million and pre-tax profits were $82 million. The funny thing is that Buffet almost turned his back on the acquisition because it seemed too expensive.
On the other hand, a recent lawsuit over some intellectual property issues disclosed an interesting situation with Facebook (NASDAQ: FB) and its acquisition of Oculus in 2014. An attorney asked Zuckerberg if he wanted to begin with due diligence on Friday and sign the deal on Monday. Zuckerberg confirmed with a “yep.” Zuckerberg also said that he didn’t mention to the Facebook board the risk of doing the deal over the weekend. Further, Facebook disclosed a price of $2 billion for Oculus while in the trial, it came out that the real price was $3 billion with the additional billion coming from employee retention packages and goal targets. I have nothing against Facebook, but I do think that a grain of additional thinking about shareholder value creation and due diligence would have been beneficial in this situation especially considering 70% of shares are held by institutions. While many of these institutions are long term oriented like Vanguard, Fidelity and BlackRock, many college tuitions and retirement dreams are entangled in FB’s stock as well.
Another interesting Facebook acquisition was that of WhatsApp where Facebook paid $19 billion for a company with $10 million in revenues, and for a technology that could have been easily developed in-house and freely distributed to Facebook users.
The conclusion is that you have to check whether your CEO walks around thinking about your long-term benefit, or if they are dreaming and spending your money in a virtual world that looks like this:
Figure 3: Mark Zuckerberg with Oculus. Source: Mashable.
Ultimately, I hope both acquisitions work out well for Facebook, but my point is that the same results could have been reached with much less capital for WhatsApp, and that acquisitions shouldn’t be made over the weekend to give more time to focusing a little more on creating long-term shareholder value.