Despot Of Home Depot

Soon to be former CEO of Home Depot (HD) Robert Nardelli has been heavily criticized for his excessive compensation. My voice has certainly been in the chorus of critics. However, as much as I believed the shareholders needed to reign in his compensation, I wish that we had not triggered his resignation.

Today, HD announced that Nardelli would be leaving and taking his $210 million package with him. That number, while sounding high, may in fact be low when his other benefits including corporate jet use and gross-ups are included. Such is the sad state of CEO compensation.

But, as my parents repeated, "two wrongs don't make a right" and the loss of Nardelli is, to me, a greater wrong than his excessive compensation. Nardelli has reengineered HD from a simple "big box" retailer to a complex building solutions company. However, the result has been mixed. While HD has posted much higher earnings, the lower P/E assigned to a more complex company has netted out for flat stock performance for the past six years. If Nardelli had not come along, I believe that HD's results would be much inferior to those posted.

But this is where "activist" shareholders err when they focus exclusively on the price of the stock. I believe that shareholders serve their interests most intelligently when they focus on long-term corporate operating performance, rather than stock performance. Excessive focus on the price of the stock only tends to create short-term gimmicks, while focus on operating issues builds a strong company with a sound culture and quality employment.

But now that HD's board has lost Nardelli, what's their answer? Surprisingly, Frank Blake. He has no retail experience and has never run a company. He is a lawyer who's worked in legal at GE and been deputy secretary to the Department of Energy. These are strange credentials for running the third largest retailer in the world. If the price of HD weren't so low, I'd be tempted to watch rather than participate in this saga.

Our "public duty"

Today's WSJ summarizes the history of executive compensation through stock options. The story is partially disturbing because it highlights what my Humanities teacher taught: "power corrupts, and absolute power corrupts absolutely." But it's even more disturbing because it points to our own lack of responsibility.

These CEOs were absolutely corrupt, in the sense of lacking a fiduciary responsibility to their public shareholders. In a wide range of companies from UnitedHealth Group to Citigroup to Disney, the behaviors of the CEOs have been unwarranted. As fiduciaries, these CEOs should be held to a "prudent man" level of compensation.

Yet, my high school lessons indicate that the real responsibilities lie more fully with the board of directors and major shareholders. The board is responsible for the oversight of the CEO and the shareholders for the board. All too often, though, shareholders, and thus boards, are more focused on simply getting the price of the stock to go up. When shareholders, such as myself, invest more time and energy on good governance then we are less likely to see such egregious behaviors. Analogous to voting, it's our "public duty."

Real Employee Benefits

Pirkei Avos 1:3 says "be not like servants who serve the master on the condition of receiving a reward; rather, be like servants who serve the master without the condition of receiving a reward." This statement may seem like an unreasonably high standard, but it guides us to a better life.

If I say I love someone who makes me feel good, I may be telling the truth, but I'm misusing the term "love." What I really mean is that I love the benefits being provided. Such love might be pleasurable, but not ultimately fulfilling.

Similarly, when I say that I love chocolate, I am misusing the term "love." If I loved chocolate, then I would cherish it in my refrigerator. I certainly would not destroy it for my eating benefit!

So if I truly love a person, then I love that person regardless of the benefit for me. For example, I "loved" Warren Buffett long before I owned shares in his company. It wasn't for my direct benefit that I loved him. It was because of his humility, honesty and integrity.

Yet this example shows the powerful indirect benefits of following this exhortation from Pirkei Avos. By reflecting on Buffett, I imbibe some of those characteristics and experience some of those benefits personally.

So this verse challenges me to identify those "masters" whose merits stand beyond my personal benefit. Then by "serving" them without concentrating on their direct benefits, I can find my best life.

The Best Defense at ProAssurance?

Since its IPO in 1991, ProAssurance (PRA) has identified itself as a "reputation defender" for doctors, trying lawsuits where other medical malpractice companies would typically settle. In 2005, PRA settled about 10% of its cases, whereas the industry norm had been around 20%. This approach has been rewarding. In 2005, PRA delivered a loss ratio of 81.5% in an industry that rarely breaks a ratio of 100%. (For the insurance illiterate, less than 100% is profitable while more than 100% is money-losing.) More telling, PRA spends 70% of its expenses on legal fees and only 30% on loss payments whereas the industry standard is exactly the opposite - about 30% on legal fees and 70% on loss payments. But all that may start changing.

On October 4, 2006, a Florida jury tagged a group of physicians insured by a subsidiary of PRA for $217 million. ($100 million is punitive.) This monster verdict came as a result of poor care that may have allowed a stroke to become severely debilitating. Rather than having doctors attend to the patient, the doctor group allowed an unlicensed physician assistant (PA) to diagnose and treat sinusitus. This PA was unlicensed because he had failed the exam four times. That's the case against the doctors.

In theory, PRA should only be liable to the policy limits of $1 million. However, the plaintiff's attorney claimed that they tried to settle with the insurance company for the policy limits, but were rebuffed by a settlement offer of $300 - $100 for the disabled man, $100 for his wife and $100 for the 10 year-old son. If that is true, PRA may be liable for the entire amount for negotiating in "bad faith." In such a situation, PRA would also be sued by the doctors it had defended. It appears that PRA will have a chance to defend a new reputation - its own.

The General at Mercury General (MCY)

Mercury General Corporation (MCY) is a wonderful example of "making a stepping stone out of a stumbling block." Rather than view the independent agent as excess cost in the Internet age, MCY puts the independent agents to work as part of the underwriting team. The result: lower total cost ratios (MCY 58% vs. ALL 70%) with higher independent agent commissions (16% MCY vs. 8% PGR).

The founder and long term leader (since 1961) of the company is George Joseph. He and his former wife control 52% of the company's stock. During the same period it took for my parents to get me to age 45, George and his former wife built a net worth well over $1.5 billion. (I guess I should be mindful of how much I might have cost my parents!)

But, now, at age 85, Mr. Joseph is passing the CEO job to Gabriel Tirador. When he was asked about his retirement on the third quarter earnings call, he emphatically stated, "I am not retiring! I am only passing part of my responsibilities on to Gabriel." It is encouraging when I think about already being 45 to realize that my last two posts focus on businessmen who are active in their late eighties.

MCY continues to face the challenge of expanding its model successfully outside California. Premiums had accelerated outside of California as planned. However, expense and loss ratios were higher than expected. As a result, MCY has been more restrictive about its underwriting outside of California, leading to a drop off in premium growth. Clearly, these are appropriate steps to take - few mistakes are more painful than creating a book of mispriced insurance. Mr. Buffett compared its creation to Hell - easy to enter, hard to exit. It appears that Mr. Joseph's leadership continues to keep shareholders from going to Hell, so to speak.

Kerkorian and GM (Greedy Management)

Today's WSJ announced that Kirk Kerkorian had sold the rest of his shares, completely closing out his 9.9% position of 56 million shares with a value of about $1.6 billion.

In an earlier post (1/25/06), I described Kerkorian's long history of successful, but unusual investments. I also described how difficult it was to replicate his decisions because they were made, in part, by his ability to directly affect the outcome.

True to form, Kerkorian studied the situation, purchased shares, got Jerome York to propose solutions and set about accomplishing them. Management seemed to listen, for a brief period. But when it really came to making changes, like cutting inefficient projects, such as Saab or Hummer, management balked. The more dramatic proposal of creating a global alliance with Nissan-Renault was rejected under the reasoning that GM was not getting enough. I believe that the real likelihood was that the management getting enough.

Rather than fight it out, Kerkorian was slightly above breakeven and simply sold his shares. I think GM has lost its best asset. When Wagoner was asked about the move, he replied that management was focused on eventually posting positive cash flow and earnings, saying "that's what shareholders, all of them, really care about." It makes me wonder who bought Kerkorian's shares so as to become one of those caring shareholders?

Marshing Onward

Marsh McLennan (MMC) has endured two long ordeals and appears to be surviving both of them. First, an after-hours trading scandal and inferior investment performance combined to cause MMC's investment arm, Putnam Investments, to decline more than $200 billion in assets, starting 2000 with more than $390 billion under management and finishing 2005 with less than $190 billion. Second, Eliot Spitzer accused MMC of unethical practices, forcing new commission structures in its insurance brokerage division. As a result, MMC saw its brokerage margins move from 30% to less than 10%.

With these ordeals basically behind MMC, what lies ahead? Putnam Investments is still sizeable with $190 billion under management, arguably valued at nearly $6 billion by applying the multiples accorded other public traded mutual funds. This translates to about $11 per share, assuming the bleeding continues to be stanched.

The brokerage division is still powerful, sharing the title of largest in the world with AON. With the loss of contingent commissions, MMC's brokerage appears to be at reduced 14% operating margins, still giving an operating income of about $800 million. By applying a multiple of 10 times operating income, the brokerage area is arguably worth about $8 billion or $15 per share.

The two remaining divisions have been unhampered by controversy. The Mercer consulting division has been growing and should contribute about $500 million of operating income. Again, by applying a multiple of 10 times operating income, Mercer may be worth about $9 per share. The Kroll risk management division has done well and is probably worth another $4 per share, bring the entire value of MMC to about $39 per share, significantly higher than the current $31 per share. However, the long term debt level has risen and when subtracted, the intrinsic value seems close to current market levels.