The Razor’s Edge
Commentary by Julie Fox Gorte, Senior Vice President, Sustainable Investing
It’s annual meeting season, when corporate management and boards meet with shareholders. That means it’s also the season to focus on executive compensation, with pay-watchers looking for the most outrageous stories like birdwatchers awaiting the arrival of the swallows at San Juan Capistrano. Sadly, it doesn’t take powerful optics to see that executive compensation has yet to be tamed.
Tamed, in this context, does not necessarily mean “slashed.” Taming executive compensation simply means tethering executive pay — more particularly CEO pay — to performance. Few of us are CEOs of large corporations, which means that for most of us, the size of the paycheck and the number of perks is usually tied to some measure of achievement. Reams of research support links between productivity and workers’ pay. Moreover, the direct relationship between rewards (pay, perks, recognition, what have you) and accomplishment is also ingrained in our culture and our values, and maybe even our DNA. It should therefore be no surprise to find that breaking that link generates anguish, or worse.
Consider, for instance, the case of Circuit City (not currently held in any Pax World fund). In late March, the company announced a layoff plan targeting its better-paid workers, or in the company’s own words,
“The company has completed a wage management initiative that will result in the separation of approximately 3,400 store Associates. The separations, which are occurring today, focused on Associates who were paid well above the market-based salary range for their role. New Associates will be hired for these positions and compensated at the current market range for the job.”1
According to one of the many stories written about this event, affected employees were also allowed to reapply for their former jobs at lower pay, following a ten-week hiatus.2 It is entirely possible that some of those laid-off workers did reapply for their old jobs at the new pay scale — people will often do things like that when they compare a smaller paycheck with no paycheck. But how productive would they be? Moreover, how productive can we expect all those new associates to be, surrounded by the other 92% of Circuit City workers who survived the “restructuring”? Analysts commented that Circuit City’s experiment could easily backfire, as a result of sinking morale among employees and customer aversion. In fact, the company’s stock price since the announcement seems to reflect that view — the stock closed just over $19 on March 28, and was trading at under $16 on May 25.
Meanwhile, total compensation for Circuit City’s CEO exceeds the median for a comparably-sized company by over 20%, according to the Corporate Library. (While there are doubtless many determinants of CEO compensation, the size of the corporation turns out to be the most reliable and robust indicator of CEO pay — CEO’s of big companies
simply get paid more, regardless of how good of a job they are doing or how well their company is doing.)
It is tempting to wonder whether Circuit City’s management and board thought the layoffs — as well as the other restructuring measures — would bring a favorable reaction on the stock market. One suspects that they did, in which case they must be worried by their stock’s decline. Mass layoffs can actually be a signal that the CEO is on the glide path. According to a recent academic study, mass layoffs “significantly increase CEO turnover in the following year,” and layoff announcements that are greeted by stock price declines are “much more likely to lead to CEO turnover.”3
This does not mean that Circuit City’s CEO has a pink slip in his near future. No matter how strong the relationship between two observations in a statistical study, any individual occurrence can easily turn out the opposite way. But it should be a signal to corporate management that Wall Street isn’t necessarily convinced that the company can shrink its way to success, or that layoffs are always good news. I asked one of the smartest portfolio managers I know — our very own Chris Brown, Chief Investment Strategist at Pax — what kind of signal is sent by the announcement of a mass termination. Brown’s opinion is that while it may signal appropriate managerial reaction to performance problems in the short term, it’s often a sign of poorer prospects in the long term. This is Occam’s Razor in action: the simplest explanation is often the best explanation. Firms that are downsizing may well have reasons to be smaller, which in the world of finance often means that a downward adjustment in valuation is in order.
In short, if a company is laying off people, the best thing to look at when assessing the value of its stock is its long-term growth potential. If it’s not very encouraging, then we might reasonably expect CEO pay to reflect the same dimmer prospects. But that’s where the world turns upside down. According to one academic study, CEOs of firms that announce layoffs receive nearly 23% more in total compensation, and nearly 45% more in stock-based compensation, the year following the announcement than their counterparts at firms that kept their workforces more or less intact.4 Two years after the layoff announcement, CEOs of the firms making those announcements received over 77% more stock-based compensation than their peers at non-layoff firms.
The same study also reports that layoff announcements coincide with shareholder value increases between $40 million and $95 million. Big numbers, but in perspective, that’s between half a percent and one percent of the average market cap of a Russell 1000 company as of April 30, 2007. It is also noteworthy that the shareholder value increases were measured only for a six-day window following the announcement. It is not clear whether shareholder value increased by 23%, as CEO compensation did, over the succeeding year (or 77% after two), but if it didn’t, it would be shocking to anyone who really thinks that CEO pay is related to performance. But it’s also possible that the CEO won’t be around to find out. The people with bandages over their downsizing wounds aren’t always just the workers: Occam’s Razor can cut the CEO, too.
1Circuit City Press Release dated March 28, 2007. Posted at http://newsroom.circuitcity.com/releasedetail.cfm?ReleaseID=235835.
2Mae Anderson and Ellen Simon, “Circuit City to Cut More Than 3,500 Jobs,” Associated Press, March 28, 2007.
3Sherrilyn M. Billger and Kevin F. Hallock, “Mass Layoffs and CEO Turnover,” Industrial Relations, Vol. 44, No. 3 (July 2005).
4Jeffrey T. Brookman, Saeyoung Chang, and Craig G. Rennie, “CEO Cash and Stock-Based Compensation Changes, Layoff Decisions, and Shareholder Value,” forthcoming in The Financial Review.