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It's hard to imagine that Dennis Kozlowski used to be regarded as one of America's most successful and highly respected chief executive officers. Kozlowski was once widely credited for Tyco International's (TYC) tremendous growth spurt in the 1990s. Now, Tyco's ex-CEO is one of the world's best-recognized symbols of corporate greed and the devastating impact it can have on shareholders' investments. He has been sentenced to prison for misappropriating as much as $400 million from Tyco in his ten years at the helm. Among his more flamboyant expenditures: a $1 million birthday party in Sardinia for his wife and a $30 million New York apartment complete with $6,000 shower curtains, all largely paid for by Tyco. The ultimate losers in all of this extravagant spending were Tyco's owners -- the shareholders. Tyco stock plummeted as much as -80% off of its 2002 highs as news of the scandal broke. Fortunately, managers and executives that commit misappropriations on the scale of Dennis Kozlowski are the exception rather than the rule. But just because there's no outright fraud or illegal acts doesn't mean a company's management team is being a proper, responsible steward of shareholder funds. For instance, excessive pay packages aren't necessarily illegal, even for companies that are losing money or missing their profitability targets. The same is true of stock-option grants to managers or company-financed corporate jet use. In most cases, such expensive perks do very little to enhance shareholder value. Take the recent options expensing scandal as an example. For years, companies did not have to legally report the options they issued to managers as an expense on their income statement. However, these options were a form of compensation. If the company's stock did well, managers would exercise the options and be issued shares, thus increasing the company's outstanding share count. That, of course, is the opposite of a share buyback and has the effect of diluting the value of a firm's existing shares. Poor accounting and lack of financial transparency can be devastating for shareholders. Companies that only disclose the bare minimum during quarterly earnings releases tend to see more surprises and volatility in their stock; due to the lack of information, investors and analysts find it difficult to accurately evaluate their corporate prospects. The use of aggressive, misleading accounting tricks to boost returns can also lead to disastrous stock performance. Enron went bankrupt after revealing more than a billion dollars in losses held in off-balance sheet financing vehicles. However, some savvy investors were not at all surprised by Enron's corporate meltdown. In the years leading up to that announcement, many analysts had complained about the poor quality and lack of transparency in the company's releases. And more recently, shares of both Fannie Mae (FNM) and American International (AIG) swooned after those two companies announced accounting irregularities on a smaller scale. Shareholder-Friendly
Policies Lead to Outstanding Results As a smart, well-informed investor, you don't have to fall victim to corporate excesses and accounting blow-ups. There are plenty of warning signs to look for and plenty of specific ways to identify highly-transparent, shareholder-friendly firms. Here are a few of the features we look for in evaluating a company's shareholder friendliness . . . Insider Ownership -- One of the easiest ways to know if management's interests are aligned with common shareholders is to look for management teams that are also major shareholders. For most companies, look for insiders to own at least 5% of the company's stock. For larger companies, we look for senior management to have equity stakes in the companies they manage that are significant relative to their annual salaries. When analyzing insider ownership, we pay particular attention to holdings owned by the CEO, CFO and COO. Typically, if an officer owns stock worth at least double his/her annual compensation, then this is a positive sign. Share Buybacks -- Companies that continually buy back stock are directly boosting shareholders' stake in the firm. The effect is not on total earnings, but instead shows up on a company's earnings per share (EPS) -- total earnings divided by total shares outstanding. As a firm repurchases its shares, its existing shareholders own a larger and larger slice of the firm's earnings pie, thereby boosting EPS. This is one of the most shareholder-friendly policies a company can pursue. Be sure to pay attention not only to a company's announced buyback plans, but also to the actual trend in the share count over time. When companies are buying back shares, the share count should consistently drop over time. Companies with buyback plans that have a stable or rising share count may simply be buying back stock to neutralize the effect of shares issued as compensation for employees. Low Debt -- Bond and debt holders have first claims on a company's assets in the event of bankruptcy -- bondholders must be paid before shareholders get a dime. Therefore, managers of companies with an excessive amount of outstanding debt may be more focused on paying bondholders and meeting interest payments than on generating value for shareholders. Perhaps even more importantly, companies with excessive debt loads carry a higher risk of folding when times get tough. The investment landscape is littered with bankrupt companies that took on piles of debt to fund aggressive expansion, only to flounder at the first sign of an economic slowdown. Typically, we prefer companies with debt-to-equity ratios (total debt divided by shareholder's equity) of less than 40%. Management teams that take on excessive debt are playing a high-risk game with your investment dollars. High Return-on-Equity (ROE) -- Return-on-Equity is one of Warren Buffett's favorite financial ratios. ROE is calculated by dividing net income by shareholder equity. Since shareholder equity is a measure of shareholders' total investment in the firm, ROE is essentially a measure of how much value a company generates for shareholders. Shareholder-friendly firms tend to have higher ROE levels. As a rule of thumb, we prefer to invest in companies with ROEs of close to 20% or higher. We also examine ROE ratios for several years and focus on companies with consistently high ratios. Management Compensation -- The salaries of all company directors and senior managers are disclosed in financial statements. There is no hard and fast rule for what constitutes excessive compensation -- evaluating salary packages is somewhat subjective. Be sure to examine the size of senior managers' salaries relative to the size of the company. In general, managers at a firm with $100 million in annual revenues should be earning less than managers at a multi-billion dollar behemoth. Moreover, evaluate compensation relative to performance. Some managers will actually take significant salary cuts when financial performance is poor. Compensation can even be tied to certain performance metrics. Options Issuance -- Earlier in today's article, we highlighted the potential dilutive effects of options. Issuing options to managers is not as common as it was in the late-1990s. New accounting rules regarding the expensing of options have made it less attractive to issue excessive options packages to employees and top company officers. Nonetheless, some options or share compensation is not necessarily a bad thing, as management ownership aligns management's interests with shareholders. Just as with overall compensation, there's no hard and fast rule here. Options issuance should be examined relative to a company's size and financial performance. Exceptional Accounting Charges -- Exceptional charges are supposed to be one-time charges to account for unusual events such as legal settlements, inventory write-offs, or insurance deductibles. The idea of a one-time charge is that the expense does not reflect the company's normal course of business and should therefore be excluded from its normal operating results. By contrast, if charges are recurring events, then they should be accounted for as normal expenses. But some companies take advantage of this accounting rule by regularly announcing "one-time" charges. By doing this, management can obfuscate expenses and make the business appear more profitable than it really is. While this trick can work for a little while, eventually a company's true fundamentals will become apparent. This sets up shareholders for some major negative surprises. As a general rule, you should avoid companies that post frequent one-time charges or sizeable accounting charges that aren't fully explained in financial statements. Frequent Surprises -- No company meets or exceeds Wall Street expectations in every quarter. But some companies seem to constantly report earnings that are below expectations quarter after quarter. Usually, this results in large downside moves in the stock after each earnings report. A few missteps can be forgiven, but if a company is serially disappointing Wall Street, then this can be a sign that management is misleading analysts. Alternatively, management may simply not be providing transparent information to investors so that they can form accurate expectations. Either way, continued disappointments may be a sign that a company is not as straightforward with the public as it should be. Unusual Share Structure -- Be wary of companies that have multiple classes of shares, or shares that convey exceptional voting rights. Insiders often use these techniques to maintain control even if they only hold a minority position in the stock. Alternatively, such shares may be evidence of what's known as a takeover defense -- a way for management to block hostile takeover attempts from other companies or private investors. Often, hostile takeovers lead to strong share price gains for existing shareholders. As such, takeover defenses generally do not create shareholder value. Instead, they merely provide added job security for top managers. Shareholder-Friendly Firms Editor's Note: Throughout the remainder of this article, StreetAuthority.com founder Paul Tracy and his staff provide an in-depth analysis of several shareholder-friendly companies that could be worthy of your investment dollars. To view the remainder of this article, you'll need to subscribe to our premium Market Advisor newsletter. Please visit one of the following links to continue . . . Good investing!
Paul Tracy founded StreetAuthority and became Chief Investment Strategist in 2001. Prior to that he spent several years as Managing Editor at a multi-million dollar financial publishing firm with over 150,000 subscribers. In addition to his role as managing editor and lead financial writer, he was also responsible for equity research and managing a team of seasoned professional financial writers, researchers and market commentators. Paul's previous experience includes a position at Robert W. Baird & Co.'s full-service brokerage operations as well as economic research work on a Money and Banking project funded by the National Bureau of Economic Research. He has also spent time doing outside consulting and research for the University of Virginia, has appeared as a guest expert on several prominent financial radio shows, and has been a featured speaker at various investment conferences across the U.S. Paul graduated with a B.S.
in Finance and Management from the McIntire School of Commerce at the
University of Virginia.
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