Recently I was reviewing the transcript from General Electric's (NYSE:GE) 2015 annual meeting and happened upon an interesting exchange. A shareholder wasn't particularly pleased with the pay package that General Electric CEO Jeff Immelt received and the individual took some time to detail why. The general gist of the argument could very well be reasonable - in comparison to the work completed and actual influence, CEO compensation could certainly be too high. And not just for GE, you can make this sort of argument for numerous other enterprises.
Yet the way in which the shareholder decided make his argument wasn't particularly compelling. Indeed, it could actually be harmful to your long-term investing psychology. Here's how the shareholder's argument begins:
"It has always been my understanding that a CEO's compensation was based on performance. Let's examine Mr. Immelt's performance during 2014. On January 2, 2014, our stock price was $27.86. And on December 31st, it stood at $25.32, a decline of almost 10%."
Again, the underlying idea that CEO compensation is too high could very well be a reasonable argument to make. Yet this is not how you'd go about making that compelling case. If this is how you view performance - one year's worth of price action - or how you think about the success or failure of your investments, the next few decades of investing are going to much more anxious than they need to be.
Consider what happened in just the very next year. General Electric's share price went from $25.32 up to $31.15 to close 2015; a 23% increase. Surely that same shareholder would not now suggest that the pay package for the CEO is more than fair and ought to now be raised significantly.
Here's the thing: stock prices ebb and flow. Over the very long-term things generally work out, but in the short-term (think months and years) there's nothing preventing a security from exchanging hands at much higher or lower prices. It's just a record of what actually transacted, and is subject to the whims of market forces.
Moreover, a CEO's influence is only so great. Not only is this person's impact on the share price quite remote, the lever that they can pull - business performance - isn't exactly a solo act either. As a business leader you can set the tone and make savvy decisions or blunders, but many more important things are always going to be out of your control. By and large, the industry you're in, the position that your firms happens to be at when you take over, the people that work for you, the reputation of your brand, all of it are going to be just or more important.
It's easy to get caught in this trap: a CEO runs the company, the share price reflects the business, thus the CEO controls the stock price. Yet I think it's important to step back and think about what is really going on before falling into this "speculation trap." The most important realization is that even if a CEO did have full control of the business results (a suggestion that I would adamantly refute) even this aspect would not lead to the short-term stock price link.
I'll give you another example. At the end of 2005 shares of Johnson & Johnson (NYSE:JNJ) closed around $60 per share. By the end of 2010, shares were still exchanging hands around $60 per share.
Now I haven't read all of the shareholder meeting transcripts, but that same shareholder could have popped up there and say, "hey wait a minute, we're paying this guy millions of dollars and the share price has done nothing for five years?" On the surface this may seem logical, but it is anything but helpful.
During that time period Johnson & Johnson's sales went from $50 billion to $62 billion. Total company-wide earnings went from $10.5 billion to $13 billion. Earnings-per-share went from $3.50 to $4.76, and the dividend was increased from $1.28 to $2.11. Clearly the business had improved. Moreover, it wasn't even as if shares started at a sky high valuation. Shares started the period trading around 17 times earnings and by the end of it the number was closer to 12 times earnings. Just because a business does better this doesn't mean that the share price necessarily must reflect this in the short-term.
And this tale is best told by following through with that same investment. From 2010 through 2014 the business performance of Johnson & Johnson was basically what it had been. Yet the share price jumped from around $60 to over $100. That's a classic ebb and flow example for you. No matter how much of the business side you control, you cannot dictate where shares ought to trade. Periods of long share price stagnation can precede significant increases in a short time period or vice versa.
Or 3M (NYSE:MMM) is another example. If you don't have an intimate familiarity with this security's past results, this will be a good puzzle. In both fiscal year 2012 and 2013, 3M the company grew earnings-per-share by about 6% year-over-year. Now which year had the better share price performance?
If you suspect that the share price will reflect business performance in the short-term, you might suppose that both years saw similar share price results. Yet that wasn't even close to what happened. During 2012 the share price went from around $82 up to $93, or an increase of about 14%. Given that this was faster than EPS growth, we also know that the earnings multiple expanded during this time period. Indeed, it went from just under 14 times earnings up to a P/E ratio of about 15.
Now what do you suppose happened in 2013? If you again suspect that the share price must follow business performance in the short-term then the share price would need to reflect that 6% growth or even be a bit lower than that to make up for the 14% rise in the previous year. This supposition wouldn't even be in the same ballpark.
Shares of 3M went from around $93 to start 2013 all the way up to $140 by the end of the year; a 51% increase in just 12 months.
It wasn't that the business was earning that much more (the growth rate was basically the same). And it wasn't that the CEO and the rest of the employees put in 50% more work than they previously had. Instead, it's just the natural ebb and flow of stock prices. In the long-term things more or less work out, but in the short-term this causal relationship that so many want to ascribe is absent quite often.
Even last year this same sort of thing occurred. Earnings for 3M were up 1%, yet the share price declined 8%. That's not on the CEO or any specific employee. Market bids are simply a record of what two people agreed upon. It's the same reason that even when you know the performance of the business, it's still exceptionally difficult to predict the movements of the share price. This short-term relationship that so many want to build up simply does not have to be present.
While the intention of calling into question CEO pay is quite reasonable, the path to do so is not to suggest that their performance ought to be tied to what happens to the share price in a given year. A CEO could do a terrific job, increase earnings, higher payout, more efficient, the works and yet the share price could go down. Or the CEO could take the year off and play golf, and the share price could be higher. (Indeed, some owners would actually prefer this route in lieu of a blundering leader.)
Whether talking about CEO pay or thinking about the success or failure of your portfolio, measuring performance with a year's worth of stock price action is a terribly dangerous way to go about the investing world. You'd be beating yourself up at times when your underlying businesses are improving and the payouts you receive go higher. Alternatively, you'd have to explain away why one year you're 50% better than the next. In my view that's the burden of a speculator - relying on other people's short-term bids to reinforce or tear down your investing psychology. The benefit of being a long-term owner is that you don't have to worry about that sort of tomfoolery.
Disclosure: I am/we are long JNJ, GE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.