News Analysis date published New: 
Friday, September 30, 2011 - 11:00
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Friday, September 30, 2011 - 11:00
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Friday, September 30, 2011 - 11:00

Whatever you do, Stay Away from These Stocks

Friday, September 30, 2011 11:00 AM

Gregg Engles is a very lucky man. The CEO of Dean Foods (NYSE: DF) is surrounded by a very friendly group of board members who want him to make lots of money, no matter how he performs. And frankly, his performance has been dismal. Engles has pursued a "roll-up" strategy, acquiring many dairy-related businesses in hopes of generating higher sales and profits.

The plan hasn't worked: Per-share profits peaked at $2 in 2006 and fell below $0.50 in 2010. The company's staggering $4 billion debt load (thanks to all of its deals) has scared off many investors. Still, Engles has been making an average $20 million annual salary while watching over this destruction of shareholder wealth.

[I recently noted that Dean Foods may finally see some upside, but it's likely to be a long time until the stock moves back up above $20.]

Head they win, tails you lose
A few decades back, a new trend emerged in the field of executive compensation. High-profile CEOs were willing to take smaller salaries in exchange for much larger stock-option grants. It was surely annoying to see some CEOs like Disney's (NYSE: DIS) Michael Eisner take home more than $200 million in 1993 and more than $500 million in 2007, but at least that payday was due to a surging stock price.

These days, executives have it even better -- they still get rich even if the stock price doesn't take off. In many instances, a falling stock price allows them to reprice their options at a much lower price. Michael Eisner's successor at Disney, Robert Iger, is probably unperturbed that his stock has gone nowhere in the past five years. He's still taken home $147 million in the past five years, according to an analysis conducted by Forbes magazine.

It's time for investors to stop rewarding this behavior. Before buying any stock, you need to check out how executives are compensated and you need to see whether they are able to deliver market-beating returns to shareholders. Making a lot of money for doing a bad job is always egregious, but it's especially hard to swallow right now when investors are experiencing deep challenges.

My rule of thumb: never buy a stock that has repriced options for any of its employees. When a company does that, it is tacitly admitting that it has little regard for shareholders.

Although there are myriad examples of this kind of chicanery, I've singled out one company as an example: Comcast (Nasdaq: CMCSA). This cable giant has been making all kinds of bold moves to dominate the cable- and Internet-access industry. Trouble is, those bold moves haven't really paid off. For all of its muscle, Comcast earns just a 3% return on its assets (ROA) and an 8% return on equity (ROE). In light of Comcast's $38 billion debt load, ROE should be twice as high.

The weak returns help explain why shares of Comcast have actually fallen 15% in the past five years. The growth strategy adapted by CEO Brian Roberts simply hasn't worked as had hoped. Still, Roberts has taken home almost $150 million during this time. All while presiding over a $10 billion loss in shareholder value. It's exactly these kinds of stocks that you should avoid like the plague.

Risks to Consider: The risks you run here is that you narrow the universe of potential winning stock ideas. After all, who's to say that Comcast still can't turn it around and end up being a great investment? If history is any guide, then that's not likely to happen, but it's still possible.

Action to Take--> If you've spent a great deal of time analyzing a stock, then you need to take the final step of looking at executive compensation. Focus on the base salary (which realistically should never exceed a few million dollars) and the structure of stock option grants. Options should be priced far above the price it had been trading when the grant was issued, and those options should never, ever be swapped out for lower-priced options.

The issue is especially important for smaller companies. Comcast's Roberts is at least capable of tacking on billions in shareholder value if his strategy ever pays off. Smaller companies, which are typically poised for much smaller potential appreciation, can see all of the gains wiped out by a greedy pay package.

If you want to read up on the issue, I suggest starting with Graef Crystal's website, who publishes The Crystal Report on Executive Compensation. He has been focusing on this issue for several decades, and many institutional investors check in with his compensation analysis before making their final investment decisions.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.