Chapter II – 3 Steps to save capitalism

Wall Street 2By David Nelson, CFA

In Chapter one the first of three steps needed to save capitalism, I focused on taxing capital the same as income. As stated, eliminating the preferential treatment of capital gains isn’t going to solve income inequality and I’m certain that shouldn’t be the goal. There will always be a gap between the successful entrepreneur who is putting capital at risk and the on the line employee, but the playing field should at least be level.

Step 1 is a good start but on its own not enough to bring about real reform.

Step 2 – Eliminate Stock Based Compensation – The Rape of the American Shareholder

Cancel all stock-based compensation and or stock options. Yeah, I know some will give you the song and dance that it puts management and shareholders on the same side yada, yada, yada. I’m here to tell you as a professional shareholder and portfolio manager with over 25 years in the market this argument is total BS.

It’s amazing that most of those giving you that explanation are on the inside receiving stock-based compensation. You pay me $11 million a year the average compensation for a Fortune 500 CEO and I’ll sing the same tune. I call it the Rape of the American Shareholder.

How many CEOs have come on your favorite business news channel touting that they receive little or no salary but willing to receive most of their compensation based on performance in the form of stock.

Since the company is avoiding using actual cash and essentially just printing money, compensation levels have exploded over the last couple of decades. In the end it’s the shareholders who pick up the tab from the ongoing dilution of their own stock ownership.

IBM vs S&P 500 relative performance with Rometty as CEO
ibm vs spx rometty

Let’s take a quick look at how that works out in the real world. IBM was once an American Icon with a proud history that goes back more than a century. As a pioneer to the information-based world that was to follow IBM became the de facto standard in technology. The stock had its share of peaks and valleys and the final all-time high came in early 2013 just about a year after Ginny Rometty became CEO. During her tenure from January 2012 – January 2020 Ms. Rometty received approximately $132 Million. Her 2018 breakdown was as follows: $1.6 million in salary, $10.8 million in stock awards, $4.1 million in non-equity incentive plan compensation and $1.1 million in other compensation.

Stock based compensation is often the largest part of the total compensation package and is usually tied to performance. Given the chart above I’d like to know just what performance metric the board used awarding tens of millions of dollars while their CEO oversaw 22 straight quarters of revenue decline. I don’t mean to pick on Ginny because she’ s only the tip of the iceberg. Bloomberg puts Alphabet (GOOGL) CEO Sundar Pichai’s 2019 compensation package at $281 Million much of which was in stock based compensation. Unfortunately, the above forces companies to go into the open market to buy back shares of their stock.

Stock Buybacks

What’s really going on when a company announces a stock buyback plan, and should it be applauded as a management signal that they believe the company stock is undervalued? Let’s call it like it is, just another part of the elaborate system to jack management pay beyond what traditional compensation models could endure.

Is it possible that management believes their stock is undervalued? Sure, and sometimes even true but more often it’s a signal the CEO is out of ideas on how to organically grow the company. The easiest way to make earnings and those stock-based compensation bonuses is to buy back the stock.

Before I go much further let’s be clear about this. Stock Buybacks do nothing to enhance revenue or net income. It only raises EPS or earnings per share because you’ve reduced the number of shares outstanding.

In addition, stock buybacks are needed to offset the dilution created by the issuing of new shares to the CEO and management making up the bulk of their performance-based compensation. It’s a vicious circle. We shouldn’t be surprised that CEO compensation in some cases reaches 300x that of the average employee.

Wall Street is a willing accomplice rewarding this behavior by focusing on NON-GAAP earnings. In the last couple of decades GAAP or Generally Accepted Accounting Principles have given way to NON-GAAP which doesn’t include stock-based compensation. In some cases, this practice turns Losses into Profits.

Turning Losses into Profits

Let’s look at popular software company:

Twilio (TWLO) GAAP vs NON-GAAP Earnings Per Share estimates –Source FactSet
twlo gaap vs non gaap

For 2020 Twilio is expected to come close to break-even with a loss of (-$0.08) but on a GAAP basis will likely report a loss of ($-2.66). Even as far out as 2022 the company isn’t expected to turn a GAAP profit.

Tomorrow Chapter 3 the last in the series turns to Washington where the real power lies and what it will take to save capitalism, the greatest economic system the world has ever known

*At the time of this article some funds managed by David Nelson were long GOOGL