Buybacks, CEO pay add up to big costs for shareholders

David Winters says passive investors are rubber-stamping compensation packages

Dec 13, 2017 @ 5:21 pm

By John Waggoner

David Winters, manager of the Wintergreen Fund, says that buyback programs and CEO compensation are adding an enormous drag to investor returns, and that index funds are making the problem worse.

Before you dismiss Mr. Winters as yet another disgruntled active manager in a period when passive investing is ascendant, you should know that he has some excellent bona fides. Mr. Winters is a value manager who cut his teeth on the Franklin Mutual Shares funds, whose talent for finding genuinely undervalued stocks goes back decades to legendary investor Michael Price.

This has not been a happy year for value investors: Momentum has been the favored strategy on Wall Street this year, and Wintergreen (WGRNX) has gained 13.03% this year, vs. 21.61% for the average world stock fund, according to Morningstar. "Our hope is that it's a cycle," Mr. Winters said. Ten stocks — Alphabet, Amazon, Apple, eBay, Facebook, Microsoft, Netflix, Priceline, Salesforce and Starbucks — have gained an average 28.82% this year. Take out those stocks and the rest of the Standard & Poor's 500 index has gained 8.71%.


Mr. Winters' worries aren't with the so-called "FANG and friends" stocks. (FANG stands for Facebook, Apple, Netflix and Google). It's with the enormous voting power of index funds — and the fact that they vote for management nearly 97% of the time. That's based on proxy voting by Vanguard, State Street and BlackRock for the year ended June 30, 2016.

What's wrong with that? Many companies' buyback programs are simply a way to finance top-level compensation. Companies often issue shares to fund executive compensation, then use buyback programs to offset stock options dilution. All that money comes from shareholders, and creates a drag on corporate earnings — and, ultimately, stock returns.

Consider this example: Goldman Sachs (GS) disclosed in its 2016 annual report that it had 108.8 million shares available for issuance for executive compensation. The average annual dilution rate was 9.1% the past three years. The company's proxy revealed average annual share buyback of 7.6%. Adding the average dilution to the average buybacks is an average 16.7% — what he calls the total look-through expense.

Goldman Sachs has the highest lookthrough expenses, Mr. Winters said, followed by Citrix Systems, Cintas, HP and Ameriprise Financial. The three largest passive investors — BlackRock, State Street and Vanguard — all voted for those companies' proxy proposals, according to Mr. Winters' research.

Interestingly, the FANG & Friends stocks aren't the worst offenders. They have an average 3.8% of look-through expenses, as opposed to 11.6% for the highest cost stocks in the S&P 500. Facebook's look-through expenses are just 1.2%.


All told, the "look-through expenses" in the S&P 500 cost investors about 4.3% a year, Mr. Winters said. That was about $908 billion last year. And much of those costs are thanks to index funds and actively managed funds that mirror the indexes and rarely challenge management. The top investors in most stocks in the S&P 500 are index funds and ETFs. All told, passive funds have seen $607.2 billion in net new cash this year, according to Morningstar.

Mr. Winters argues that funds have a fiduciary responsibility to look after the best interests of their investors, and that responsibility includes making sure that executive compensation plans and buyback plans do, in fact, work towards investors' benefit.

He has some experience in standing up to large companies' pay plans. In 2014, Wintergreen challenged Coca-Cola's equity pay plan. The company slashed compensation for CEO Muhtar Kent by 42% in 2016. Led by Mr. Winters, 17% of Coca-Cola's shareholders didn't support the company's proposed plan.

Is this a bubble? Passive investment is a rational, low-cost way to invest. But if Mr. Winters' research is correct, funds need to understand that they need to take a harder look at how top-tier employees are compensated — and how much it costs shareholders.


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