Why CEO Pay Matters to Stock Performance

Money isn’t everything.

It may strike you as an odd thing to say since the point of investing is to make money.

However, it turns out that when there’s an obsession with money on a multitude of levels, things can backfire, including in terms of corporate performance.

Widening Wage Gap

It’s no secret that the gap between the very rich and everyone else has widened sharply, with corporate bigwigs commanding ever bigger pay packages. In 1970, U.S. CEOs, depending on whose figures you use, on average were paid around 10 times more than the median earned by their employees. Today, the ratio has soared to more than 250:1, and some estimates put it as high as 500:1. Whichever figure you use, it’s many times higher here than anywhere else. In Germany, Great Britain, France, and Japan, for instance, the average ratio is less than 20:1.

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Whether this bothers you or not on moral grounds, the data indicates that companies with the highest-paid executives tend to underperform in the stock market. That corresponds with other areas where more money spent doesn’t produce better outcomes. For instance, the U.S. spends far more per capita on health care than any other country. Yet life expectancy here recently tumbled to levels not seen since 1996. It’s now at about 76 years – around four years below Chile, a country we outspend by more than 4:1.

It’s a similar story for education. Every three years, around 80 countries participate in giving tests to 15-year-olds. In today’s world, the most important skill tested is in math. In the early 1970s and before, our high schools were known for graduating highly trained math students. Today – although only tiny Luxembourg outspends us on a per-capita basis on education – we’re 37th in the world in math scores.

Higher CEO Pay Correlated With Stock Under-Performance

And mattering the most to investors, the principle that money isn’t the key to better outcomes shows up in corporate performance. In their proxy statements, companies must include salaries of officers along with the median salary of employees. We looked at the latest list for S&P 500 companies and compared the stock market performance of the 15 companies with the lowest ratios to that of the 15 with the highest ratios.

It turns out that over the past five years, the low-ratio companies outperformed the high-ratio companies. What makes this striking is that this is true despite incentives paid to executives who boost stock performance. It seems that a focus on high executive compensation can partially backfire by failing to motivate the company as a whole. A smaller pay gap seems to boost the entire company. On this count, a nod goes to a group of London-based social psychologists who have shown that the more a person cares about money, the more likely that person is to treat other people as mere objects.

These results are meant to be only suggestive. Companies may have high pay gaps for various reasons, such as employing a lot of part-time workers. Still, given the higher performance of the lower-ratio 15, the suggestion is that too large a pay gap may create a work environment in which employees don’t feel valued and so don’t do their best. Pay gaps are intrinsic to capitalism, and we’re all for them. But if they become too great, and the big boss regards employees as tools, not as valued team members, the overall results may be negative for the company.

Pay gaps aren’t the only metric we could have looked at. For instance, comparing total CEO compensation yields similar results, is strongly correlated with pay gaps, and is possibly less dependent on the type of business involved. Whatever metric you use, the message is that while money is good, there can be too much of a good thing.

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As chief investment strategist of The Complete Investor, Dr. Leeb has produced a special report on how to survive the tectonic shifts facing the financial world. Click here for details.