FUNDAMENTALLY FLAWED: Why We Vote Against All Stock Option Plans

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Disciplined Growth Investors

The theory behind stock options is quite sound. That is, options are a form of de facto stock ownership that should provide managers strong incentive to focus on operating the business in a way that would maximize shareholder value. Unfortunately, in practice stock options suffer from four fundamental flaws that subvert this basic premise:

 

1. option holders have limited financial risk,
2. options holders often profit from sub-par performance,
3. short vesting periods encourage a short-term business focus, and
4. options are blunt incentive/retention tools.

Close examination of the impact of these structural flaws combined with a dearth of corroborative evidence tying option use to long-term value creation have led us to the conclusion that stock options as they are structured today simply do not work. Therefore, we have reluctantly decided to vote against all stock option plans.  Over the balance of this paper, we discuss the aforementioned fundamental flaws and detail how each works to prevent stock options from fulfilling the promise of enhancing long-term value creation.

FUNDAMENTAL FLAW #1:

Option Holders Have Limited Financial Risk

Stock option proponents passionately argue that options place senior executives in the same financial camp as long-term shareholders. After all, both option holders and shareholders benefit from stock price appreciation and are penalized by declines in the price of the stock…right?  Well, not exactly. While it is true that both option holders and shareholders benefit from stock price appreciation, they are not equally at risk to declines in the price of the stock.

Remember that an option confers the right to purchase stock at a fixed price, a.k.a. the exercise price. However, corporate employees and directors do not pay for this valuable right. Additionally, if the stock declines in value, option holders are not required to exercise their options, i.e. purchase stock. They simply let them expire. Since option holders put no personal capital at risk upfront and there is no future obligation to invest, option holders have no financial downside.

In contrast, shareholders assume significant financial risk when they purchase a company’s stock. Because shareholders exchange cash for their ownership position, they can actually lose money if the stock declines. Ultimately, shareholders only benefit if the total return from holding the stock exceeds the rate of return required to compensate them for the potential loss of principal plus the opportunity cost of foregoing other investments.

The difference in financial risk assumed by option holders and shareholders is evidenced by the change in behavior that occurs after options are exercised. In our experience, the vast majority of option exercises are followed by the immediate sale of all the exercised stock. This behavior suggests that option holders recognize the difference in financial risk between options and direct stock ownership and typically act swiftly to eliminate that risk by converting their holdings to cash.

Some option proponents contend that the lack of financial risk for the option holder is irrelevant, because the issuing company incurs no cost. There is no cash outlay and therefore no cost to the business, so the argument goes. We beg to differ. The company (and by proxy the existing shareholders) incur a clear economic cost when an option is issued. Focusing on the lack of cash outlay from the option grant obfuscates the value transfer that occurs. The issuance of an option clearly confers a valuable right to purchase stock at a fixed cost. This right represents a real claim on the future cash flows of the business.

One final counter argument we often hear regarding the absence of financial risk to options holders relates to options as part of an overall compensation package.  These option proponents contend that option holders do indeed have financial risk, because they are accepting option grants in lieu of additional cash compensation. In other words, option holders have essentially put a portion of their cash compensation at risk by agreeing to substitute options. We give little credence to this argument given there is scant evidence of corporate executives in the United States being under-compensated on a cash basis (salary plus cash bonus). Continue reading →

Call Me Maybe

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Investment grade credit had a good month – the corporate benchmark was up almost 1.5%, and excess returns were positive by 83 basis points. Interest rates and bond spreads tend to be negatively correlated, so we don’t normally expect a month where both help performance. For October, though, fading expectations for a Fed taper really helped interest rates and riskier assets alike. Financials outperformed on an excess returns basis, as they have all year, and the longer duration the better. Most of the positive performance this month came in the few days after Congress’s debt ceiling deal. Spreads are now more than one standard deviation below their mean for the past 12 months. I can’t say that means they’re overvalued – the range of spreads is getting pretty narrow, and one standard deviation over the past year is just 5 basis points.

What I can say is that we think risk-taking probably ramps up a bit. As mentioned last week, we are entering that phase of the credit cycle. From a credit standpoint, TMT continues to look like the hot spot. (TMT refers to Telecom / Media / Tech. I think that might be a credit-only moniker). Whether it’s a rumor about an AT&T bid for Vodafone or a buyout of Time Warner Cable, the sector continues to come under pressure. Media spreads are wider year-to-date by about 30 basis points, making it one of the few sectors with negative excess returns for the year. Some of the transactions being contemplated actually do seem a little crazy, but it sure feels like there are a few connections just waiting to happen.

Issuers came back to the market this week, bringing about $23 billion in supply. Coca-cola was the biggest, with a $5 billion, 5 tranche deal. KO is one of the few AA-rated issuers left in the market, and their deals are generally well received. Not to be outdone, AA-rated Procter & Gamble brought a $2 billion deal the next day, also well received. On the other end of the spectrum, Altria Group (rated Baa1/BBB) was in the market with $3.2 billion of 10s and 30s.  Next week, we are expecting more of the same, with probably $25-30 billion of supply expected.  It looks like we are setting up for a pretty ordinary month. Maybe.

Thinking Ahead

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One of the challenges of living in the Upper Midwest is that you have to prepare for the Holidays now before it gets too cold. As we say in our household, “Easter is the time of year when can take down the outside Christmas lights you put up after Halloween because the extension cords were frozen solid to the ground since Thanksgiving.” Therefore, we in the Tundra pride ourselves on thinking ahead. We were wondering if we need to think ahead about Affordable Care Act impacts, or if it is too early.

Many health care consumers are having their coverage dropped from their insurance provider (see link below). Much ink has been spilled discussing how that may impact health care companies. We also wonder if this will impact the broader economy, and if so when and do we need to prepare now as investors?

Our gut feel is that it will have less of an impact on the truly affluent in this country as many can pay out of pocket or find alternative sources of care worldwide. We also wonder if little will change with the less affluent. Yes many more will have affordable insurance, but we also do not know what the final deductible and co-payments might be until we get more data on the demographic characteristics of those that signed up. That leaves our large middle class. If premiums, deductibles and co-pays rise for a good percentage of middle-class Americans (e.g. those without existing conditions), what will that mean for disposable income? Will increasing health care costs crowd out consumer spending and will it impact other sectors?

Part of us says that it is too early to make any investment decision, especially since those who work for larger corporations will not feel the impact until 2015 since larger companies received a one year extension under the Affordable Care Act. But still a sizable subsector of the middle class could feel the impact by January, and others who are not affected now may see the impact higher costs have on their neighbors and act accordingly beforehand. What do you think?


 

 

Supporting links:

http://www.kaiserhealthnews.org/Stories/2013/October/21/cancellation-notices-health-insurance.aspx

http://www.bloomberg.com/news/2013-07-02/health-law-employer-mandate-said-to-be-delayed-to-2015.html

A Horse with No Name

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It looks like we will end this week with negative excess returns – just barely, as spreads have moved around in a fairly directionless market. Part of the issue, from our perspective, is that the current credit cycle is getting a little long in the tooth. Credit regularly goes through a boom and bust cycle. Corporate debt levels expand (slowly at first, then rapidly as companies face an earnings shock) and contract, while credit spreads tend to follow this cycle. Right now, revenue growth at most companies is lagging earnings growth, and that is precisely the time management teams turn to higher leverage to boost shareholder returns — which will eventually push credit spreads wider. But spreads can move sideways for quite a while, generating solid excess returns. The challenge for credit investors right now is to figure out which horse they’re riding.

It has continued to be a bit of a desert with respect to new issue. We had another light week, with just about $12 billion in supply. Following earnings releases, a few banks came to market – Wells Fargo brought $3.5 billion of 5s and 30s, Citigroup did $2 billion of a senior unsecured 10 year, while Bank of Nova Scotia and Suntrust were both in the market with 5 year deals. The Wells Fargo 5 year was probably the star of the week – the deal was well oversubscribed, priced at a spread of 85bps to Treasuries, and is trading about 10 tighter. The Citigroup deal is the laggard for the week, trading a few basis points wider. Continue reading →

Climate Change and Investment Analysis

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Tom Brakke, CFA

When readers of the print edition of Bloomberg Markets received the November issue, they were confronted by bold letters on a red background that proclaimed, “The Risks Heat Up.”  A light blue circle provided visual contrast and more context: “Special Report:  Climate Change.”

The four items in the issue included a feature story (the subhead for which began, “As the risks grow on a hotter planet . . .”); a sidebar on how rising seas have affected agriculture in Vietnam; a look at the “laboratory” that is Alaska; and a graphic of the threats and opportunities around the world as a result of climate change.

Bring up climate change and you are sure to get immediate reactions from those on one side of the debate or another, although this is an issue where the political lines aren’t always predictable.  For analysts, however, the question should not be a political one, but a research-based one, dependent upon the facts to date, the scientific possibilities, scenario analyses, and educated estimates of probabilities.

Like it is with other investment endeavors, time horizon is very important here.  As a society, we should be considering the potential long-term impact of climate change and making the appropriate policy changes on that basis.  As investors, that societal horizon might seem too long for our purposes, the impacts too far away to be relevant.  But at some point, our analytical methods may need to be adjusted based upon the range of possible climate outcomes.  (Disclosure:  I wrote a piece on warming up the models of investment analysis in 2008.) Continue reading →