THE INTELLIGENT INVESTOR   |   MAY 2, 2009

CEOs Need to Bring Investors Along for the Ride

By JASON ZWEIG

From 2006 through 2008, the 10 largest financial companies in the U.S. awarded their chief executives a cumulative total of more than $560 million in cash, stock and options. Those firms -- some of which are no longer among the 10 biggest -- have lost a total of nearly $1 trillion in market value since the end of 2006.

Is it any wonder that investors are angry at CEOs like Bank of America's Kenneth Lewis?

Of course, CEOs earned a lot of that swag as options and restricted shares that have lost most of their value. But it's hard to argue they deserved it all; something is dangerously wrong with a system that showers riches upon good and bad leaders alike.

Now consider Alleghany Corp. The small, New York-based insurance holding company hasn't awarded stock options to managers in decades, doesn't measure its performance against a peer group when calculating incentive pay and reserves the right to claw back bonuses if results are later revised downward.

Alleghany's proxy statement reports that the CEO, Weston Hicks, has earned (although not necessarily received) $28 million since 2005. That hardly puts him in the poorhouse. But his shareholders are unlikely to complain. From 2005 through 2008, Alleghany gained an annual average of 1.7%, while the Dow Jones U.S. Property & Casualty index lost 2.7% per year. So far in 2009, Alleghany is down 8.3%, but the index has fallen 13.8%. Over the longer term, under both Mr. Hicks and his predecessor, John Burns, Alleghany has outpaced the overall stock market by a wide margin.

What Alleghany and a few other exemplars in the world of corporate compensation do right says a lot about what the rest of corporate America does wrong.

First, too many bosses get unconditional cash bonuses even when they push their firms to the brink of disaster. In 2006, Merrill Lynch's then-CEO, Stanley O'Neal, earned an $18.5 million cash bonus, and Charles Prince, then the CEO of Citigroup, got $13.2 million in cash.

Second, companies measure performance inconsistently, with a grab-bag of metrics that change over time. Lately, two measures have been popular: the stock's total return and the growth in earnings per share. Unfortunately, earnings in the hands of clever managers are like Silly Putty in the hands of an energetic second-grader. Earnings per share can be stretched upward by stock buybacks, accounting changes, unrepeatable gains and a host of other ephemeral factors.

And instead of patiently measuring results, companies have ants in their pants. According to a survey by the National Association of Stock Plan Professionals and Deloitte Consulting LLP, 81% of companies tracked results over three years or less when granting stock incentives; 21% gave out "performance shares" based on a single good year.

Alleghany, by contrast, looks at the long term, using measures that are hard to game. The firm bases incentive pay for its managers on the four-year average growth rate in per-share book value -- simply put, the surplus of what the company owns over what it owes. Book value, as Warren Buffett once wrote, is a "conservative but reasonably accurate proxy for growth in intrinsic business value -- the measurement that really counts."

Stock options? Forget it. "We don't want to be in the position of betting against the shareholders," says Mr. Hicks, Alleghany's chief. (Many CEOs who exercise options promptly sell.) Alleghany pays its long-term incentive awards as "performance shares" that go up or down with the market. Last year, when the stock fell 28%, "the value of my total compensation was negative," Mr. Hicks says, "as it should have been, since the shareholders didn't make anything."

Markel Corp., another small insurer, also bases incentive compensation on long-term growth in book value -- and, likewise, has delivered outstanding returns to its outside investors.

The compensation plans at both companies seem to have been designed not to maximize the short-term pay of management, but to reward long-term thinking that will benefit insiders and outside shareholders alike.

In the 1949 first edition of his book "The Intelligent Investor," after which this column is named, Benjamin Graham said "there are just two basic questions" that investors should care about: "Is the management reasonably efficient?" and "Are the interests of the average outside shareholder receiving proper recognition?" Unless investors pressure more companies to adopt smarter incentive plans, the answer will remain "Probably not."

■  Email: intelligentinvestor@wsj.com

Printed in The Wall Street Journal, page B1