The Advisors' Blog

A manifesto is defined as “a written statement declaring publicly the intentions, motives or views of its issuers.” While most of my experience with the term is related to the Unabomber and his manifesto, it was nonetheless the word that came to mind as I read the draft white paper – “Explorations in Executive Compensation” – by RiskMetrics Group (formerly known as ISS). RiskMetrics is seeking comments on this draft.

The paper focuses on a number of subjects, and takes turns being educational, informational and editorial in content. Specific subjects covered include:

– Evaluating Executive Pay Components;
– Key Considerations in Executive Pay;
– Equity Compensation Plans;
– Peer Group Benchmarking; and
– Executive Compensation Risk Modeling.

It is the last two areas that I found the most interesting. I will dive a bit deeper into the peer group modeling piece in this post, and potentially take up the risk profiles piece later—unless someone beats me to it. [Note: The entire paper is worth reading by anyone who wants to get up to speed on executive compensation, as well as those who want to know where RiskMetrics is headed.]

Number of Peer Companies

The ISS research suggested that most S&P 500 companies have between 11 (20th percentile) and 23 (80th percentile) companies in their peer group, and goes on to suggest that any company with a group smaller than 11 or larger than 23 should raise red flags. I guess I agree with half of that statement. If a group is too small, then the practices of one or two companies can have a dramatic effect on the median or average, which may or may not reflect a valid change in the marketplace. On the other hand, companies that do not have a clear set of peers may be well served by using a broader sample—perhaps well beyond 23 companies.

Ways to Define Similar and Dissimilar Companies

In defining similarity, RiskMetrics focused on three measures—revenues, market capitalization, and industry (2 digit GICS code), though they did acknowledge that financial companies might want to use assts instead of revenues. They then went on to scrutinize the peer group used by Ford Motor Company. It turns out that virtually all of the companies are from a different industry, and/or outside the revenue or market capitalization boundaries—they defined 0.5-2.0 as an acceptable boundary, though they also acknowledged that companies may need to stray outside in some cases.

I am not here to defend the Ford peer group—after all, the group includes both Exxon Mobil (market cap of $463 billion) and General Electric (market cap of $305 billion), while Ford’s market capitalization as of today is about $14 billion. According to RiskMetrics, 22 of the 22 peer companies have a higher market capitalization.

However, I was interested in seeing what companies might fit the RiskMetrics definition of “similar” defined above. I ran a screen using industry (2 digit GICs code), sales (0.5-2.0x Ford) and market capitalization (0.5-2.0x Ford). I only found one U.S. public company that met all three criteria–General Motors. While no one would argue that GM is a good peer company for Ford to use, it also illustrates that finding 11 companies that fit like a glove can sometimes be challenging.

So, Who Could Ford Use as Peer Companies?

We used our proprietary Peer Group Analyzer to try to answer the above question (the Peer Group Analyzer uses more than 20 factors across the dimensions of industry, size, valuation, and performance in an attempt to address the question of similarity). The model suggested that the best fit was companies such as Archer Daniels Midland, Johnson Controls, and Dell, as well a number of retailers and wholesalers—mostly companies with a sales to market capitalization ratio of greater than one, and almost all companies with sales below Ford’s $172 billion.

Are these companies perfect?—clearly not. Are they better than Exxon Mobil and General Electric?—that is a distinct possibility. If Exxon Mobil gave away 1% of the company to executives ($4.63 billion of $463 billion), Ford would have to give away about one-third of the company ($4.63 billion of $14 billion) in order to be competitive in terms of dollar value delivered.

In any event, I had better stop writing before someone accuses me of creating my own manifesto.

– Jim Woodrum, EC Analysis