High CEO Pay Means Disappointing Stock Returns
Thursday, July 28, 2016

“Companies that awarded their Chief Executive Officers (CEOs) higher equity incentives had below-median returns.” This is how MSCI started a report on CEO compensation.

The idea of awarding CEOs equity in the companies they oversee was originally pitched as a way to align the interests of corporate executives with those of shareholders. If the stock fared well, shareholders would benefit and CEOs would be rewarded for driving up the stock price. Yet this has not been the case for many companies.

“If the total summary pay figures were effective in incentivizing superior future performance, we would expect to see a strong correlation between higher pay figures and 10-year TSRs (total shareholder returns). However, we found very little statistical evidence to support this; in fact, we found a small but consistently negative relationship, a possible indicator that superior performance may have been linked to lower rather than higher pay awards,” wrote Ric Marshall and Linda-Eling Lee of MSCI’s ESG (environmental, social and governance) research team.

During the period of 2005 through 2014, shareholders of companies with the lowest CEO pay realized 39% greater total returns than shareholders of companies with the highest CEO pay. Put another way, investing $1.00 in the companies whose CEO compensation ranked in the bottom 20% would have grown into $3.67. Investing the same $1.00 in the highest CEO-paying quintile of companies would have only turned your investment into just under $2.65. When Marshall and Lee analyzed companies by their sector allocation, the same inverse relationship appeared: higher CEO pay meant lower shareholder returns.

Given this, it would seem logical that shareholders would use “Say on Pay” votes to express their displeasure. The exact opposite has occurred, with approval rates exceeding 90% for many companies. Setting aside issues about the proportion of shareholders either not voting their shares or simply going along with the board of directors’ recommendations, there is a hurdle to figuring out exactly how much the CEOs are getting paid. An investor looking at a proxy filing (SEC filing DEF 14A) has to combine data from several different tables to calculate the CEO’s compensation.

Even compiling the data mandated to be disclosed isn’t enough to grasp the full picture. Marshall and Lee point to the lack of cumulative realized pay—what the CEOs actual take home from stock and option grants—in SEC filings. They also point out that shareholders don’t know how much compensation CEOs have realized over the course of their tenure or how the cumulative compensation compares to stock performance.

Making matters worse is that the compensation committees often base CEO compensation on what other companies are paying their executives. It’s akin to what’s happened in the world of sports, where salaries have soared as athletes use their peers’ compensation to negotiate better deals. These contracts are often announced by the media with no analysis about how much extra ticket sales, television viewership or merchandise sales the high-priced player will bring. Texas Rangers fans have found this out with Prince Fielder, who is due $96 million through the 2020 season according to CBS Sports. The first baseman is incurring his second injury-shortened season in three years and questions are now being legitimately being raised about how well he’ll play when he returns in 2017.

Ironically, the same day MSCI released its report, The Wall Street Journal published an article discussing how companies are trying to woo individual investors to vote. Railroad operator CSX (CSX) is going as far as to plant a tree for every shareholder who votes. The reason? According to the article, individual investors overwhelmingly side with the company’s management and can be a helpful swing vote in close corporate elections.

Companies should not count on our support. We shareholders are owners. It's up to us to look out for financial interests, which can mean disagreeing with the board of directors’ proxy recommendations as well as voting against Say on Pay proposals.

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Highlights from the AAII Journal

The Week Ahead

Earnings season continues with 119 S&P 500 companies reporting. Included in this group are Dow Jones industrial average components Pfizer Inc. (PFE) and Proctor & Gamble Co. (PG), which will both report on Tuesday.

The week’s first economic reports will be the July purchasing manager’s manufacturing index (PMI), the ISM’s July manufacturing index and June construction spending, all of which will be released on Monday. Tuesday will feature July motor vehicle sales and June personal income and outlays. The July ADP employment report and July ISM non-manufacturing index will be released on Wednesday. Thursday will feature June factory orders. July jobs data—including the change in nonfarm payrolls and the unemployment rate—as well as June international trade data will be released on Friday.

Dallas Federal Reserve bank president Rob Kaplan will make public appearances on Tuesday and Thursday.

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AAII Sentiment Survey

Pessimism among individual investors about the short-term direction of the stock market is at a four-week high, though continuing to remain below average, in the latest AAII Sentiment Survey. Neutral sentiment rose back above 40%, while optimism slipped.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.2 percentage points to 31.3%. The drop keeps optimism below its historical average of 38.5% for a 38th consecutive week and for the 71st out of the past 73 weeks. Bullish sentiment remains within its typical historical range, however.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 2.5 percentage points to 40.3%. The rise puts neutral sentiment back at an unusually high level. This is the 26th consecutive week that neutral sentiment is above its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose by 1.7 percentage points to 28.4%. Pessimism was last higher on June 29, 2016 (33.4%). The historical average is 30.5%.

As noted last week, this is the just the second time this year that optimism has stayed above 30% on consecutive weeks. The comparatively higher level of bullish sentiment comes as the major large-cap indexes trade at or near their record highs, though some (but not all) individual investors have doubts about the ability of stocks to hold their current price levels.

A lack of perceived viable investment alternatives, economic growth and upward momentum in stock prices is encouraging some individual investors about the short-term direction of stock prices. Giving reason for caution or pessimism is global economic uncertainty (including Brexit), the prevailing level of valuations and disappointment with corporate earnings growth. The presidential election and monetary policy are also impacting individual investor sentiment.

This week’s special question asked AAII members what industries or sectors they like right now. Health care topped the list, named by 43% of all respondents. (Included in health care is biotech, which was specifically named by 11% of all respondents.) Technology ranked second, listed by 30% of respondents. About 16% said financial and/or banking stocks. Tied for fourth place were utilities, energy, real estate and consumer staples, each listed by just under 11% of respondents. Several AAII members listed more than one industry or sector.

This week’s Sentiment Survey results:

Bullish: 31.3%, down 4.2 points
Neutral: 40.3%, up 2.5 points
Bearish: 28.4%, up 1.7 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

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