Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
Annual meeting season is in full swing and your mailbox is probably stuffed with proxy voting instructions. In Canada, you may be asked to vote on the directors’ recommendation regarding executive compensation – the “say on pay” resolution. The management information circular will contain lots of detail on the paycheques of senior management and a discussion on the rationale for those eye-popping numbers.
After browsing through this material, you may still not be comfortable. Much of the discussion will involve comparisons with the previous year and with companies of comparable size and complexity. How can you decide if management has done a good job? Share price can be one indicator, but many factors that affect a stock’s price are outside management’s control.
My benchmark for evidence of effective management is an above average and consistent return on equity, defined as net income divided by common shareholders’ equity. The drivers of return on equity are asset turnover (sales divided by total assets), balance sheet leverage, pretax margins and the tax rate. Management doesn’t have complete control over each of these items every year, but it is surely responsible for the trend.
What represents an above average return on equity? Over the past ten years, the companies that make up the S&P/TSX Composite have earned an average of 13 per cent return on equity. I would be hard-pressed to justify a generous compensation package for an executive team that did no better than the corporate Canada average.
There is, however, one problem with an exclusive focus on the recent track record of return on equity: today’s profitability is to some extent a result of the decisions, good or bad, made in the past by the same or previous management teams. Wildly successful products coming to the end of their natural lifespan may be flattering today’s return on equity because the plant and machinery is fully depreciated. More recent product introductions by the new management team may be complete lemons, but the current accounting impact is negligible.
To address this issue, I find it helpful to calculate the marginal return on equity – a measure of how much incremental profit is being generated by the incremental equity retained within the firm by management. Marginal return on equity addresses quite neatly the question about compensating management for doing a good job during their term in office.
Calculating marginal or incremental return on equity sounds complicated, but it can easily be approximated from the earnings per share (EPS) and book value per share (BVPS) statistics reported in most annual reports. After all, EPS and BVPS are the same as net income and common equity, but simply on a per share basis.
So, you simply go back several years, make a note of the EPS and BVPS at that time, do the same for the current period and subtract what you hope is an increment from each one. The increment in EPS divided by the increment in book value is the marginal return on equity. You may be surprised to discover that this number is dramatically below the average return on equity reported for the past few years. If it is negative, then either earnings or equity has been destroyed – not a good argument for a pay raise for management.
A new company in an emerging industry may argue that investments made over the past few years have yet to achieve takeoff velocity, but that should not be the case for a large company with an established track record. For example, 3M Co., a well-established global manufacturer of specialty tapes and adhesives reports an impressive return on equity in the range of 27 to 38 per cent over the period 2006 to 2011.
According to the Globe Investor website, book value per share in 2006 was $13.52 while EPS was $5.15. Five years later, book value had grown to $22.63 while EPS was reported at $6.05. So EPS grew by $0.90 while book value was up by $9.11 for a marginal return on equity of 9.9 per cent – well below the recent 27 to 38 per cent range. This doesn’t mean that 3M is in imminent danger of collapse, but the trajectory is reminiscent of Xerox in the eighties and General Electric in the nineties. It took a while, but both became fallen angels.
At this point, you may be wondering if a marginal return on equity analysis casts any light on the recent CP Rail controversy, or investor discontent at Rona Inc. as a result of the board’s reluctance to even consider an approach from Lowe’s Companies Inc.
In the case of CP Rail, the marginal return on equity from December 2002 to December 2011 was 4.9 per cent. No wonder shareholders were upset enough to change the board. At RONA, the situation is even more clear cut. Over the past five years, book value has grown by $2.54 per share, while earnings per share has reversed course from $1.61 to a loss of $0.66 – a negative marginal return on equity. Unless management can change this trajectory, it is likely that investors will continue to agitate.