The Advisors' Blog

– Broc Romanek, CompensationStandards.com

Somewhat related to Mike Kesner’s blog about “Coke’s Cautionary Tale: Fungible Share Requests,” yesterday’s WSJ contained this interesting op-ed by Holman Jenkins:

Gilda Radner is dead and Emily Litella lives, and it’s too bad it’s not the reverse.

Emily Litella was the hard-of-hearing “Saturday Night Live” character who would launch an outraged monologue based on a simple misunderstanding and, when corrected, conclude sweetly, “Never mind.” Never mind is also the right response to the media-generated controversy over pay practices at Coca-Cola Co. KO +0.86% David Winters, a fund manager whose clients own 2.5 million shares, is cast as the hero of the piece for loudly dissenting from Coke’s 2014 management compensation plan. Warren Buffett, whose company owns 9% of Coke, is the goat for dissenting not loudly enough, or something like that.

In fact, both men are waving wet noodles at a matter where their chastisements aren’t useful.

Mr. Buffett believes only a CEO should get stock because only a CEO realistically can influence the share price, yet the Coke plan would extend stock incentives to 6,400 managers. His tastes in this regard must be respected, but nothing in logic says stock-based compensation can’t be a cost-effective way to compensate even employees unable to influence the share price.

Both men dislike dilution, but Mr. Winters’s damning critique holds that Coke’s plan potentially would result in a “transfer of wealth” of $28 billion, or 16.6% of the company, from shareholders to employees. This is a whopping number but it’s also nonsense, the equivalent of saying a company that sells stock to the public is transferring wealth to the public—forgetting that the company is getting something in return.

Even if Coke were to issue all the authorized stock as stock options (which it wouldn’t) and every option were exercised (unlikely), Coke would get the strike price plus the services of 6,400 managers in return. Even then, given Coke’s notoriously flat growth prospects and reliance on the dividend to support its share price, the cost realistically would be a small fraction of Mr. Winters’s estimate.

That is, unless a miraculous takeoff occurs in Coke’s shares, which should delight Mr. Winters and other shareholders, and which, importantly, would occur only after the market had discounted the dilution implied by Coke’s widely advertised compensation commitments.

Since we’re using our brains, Mr. Winters also worries Coke will spend money on share buybacks to offset dilution that would be better spent elsewhere. This is nonsensical too, because offsetting dilution is a nonsensical reason to engage in share buybacks (not that companies don’t state this rationale), but also because Coke has no shortage of other ways to finance promising corporate opportunities.

But now we come to the larger point. If Mr. Winters doesn’t trust Coke management not to squander shareholder wealth on misconceived compensation schemes or dumb buybacks or any of the infinite ways management can squander shareholder wealth, he would be smart to sell the stock or lobby loudly for a change in management.

This is not to say Coke management or any management should be trusted. But it goes to the great rolling experiment of American corporate capitalism—the reliance on pre-emptively large carrots to reinforce behaviors that outsiders can’t observe or control directly. Coke explains in great detail its compensation plan. It throws out lots of numbers. But the devil isn’t in the details—it’s in the implementation.

Mr. Buffett, when explaining why he complained privately to Coke management but didn’t join Mr. Winters in voting against the compensation plan, said he trusts Coke management. This got him beat up in a typically formulaic New York Times piece, but he’s right in the sense that the answer to untrusted management is always going to be “get rid of management” and not “cast a meaningless vote against its compensation plan.”

Mr. Winters, for his part, demurred when asked exactly how Coke should redraft its compensation strategy. And he’s right too, because any compensation plan in the hands of untrusted management is a formula for wasting shareholder resources.

Executive pay is obviously an incendiary topic for American liberals, but there is a simpler reason why Coke has become a compensation cause célèbre: Mr. Winters produced a colorful PowerPoint with large type, claiming Coke’s plan is “bad for Coke” and a “bad example for corporate America.”

Now that’s an easy one for pundits straining for opportunities to position themselves to bask in the admiration of their readers. Pundits are always bravely in favor of good things and against bad things, and they don’t care who knows it. Plus, journalists need not hurt their brains actually trying to evaluate Coke’s compensation plan, which would mean confronting the basic problem of corporate governance.

Perhaps one day a computer will take in all relevant information and tell us how to optimize corporate decisions about where to invest, where to cut, how to market products, and we can do away with invidiously large incentives for management. Until then, large incentives appear to be the solution our restlessly pragmatic capital markets have settled on for influencing what goes on behind the corporate veil.