Our CEO of the Year Finalists

Corporate governance has been in vogue over the past couple of years, but for our four CEO of the Year finalists, it never went out of style. For many years, all four have treated shareholders' capital as if it were their own.

Of course, exemplary corporate stewardship is just one of the qualities we look for. Nice guys don't always finish first, and so we also look for CEOs with a proven track record of allocating capital efficiently and generating shareholder value. We look for consistent, above-average financial performance to ensure that the firm's leadership has increased intrinsic value, and not just pumped up the share price. Finally, we like to see CEOs who are independent thinkers, and who focus on long-term value creation despite the market's many incentives to focus on short-term issues.

This year's finalists are a strong group--much like the finalists for Domestic-Stock Fund Manager of the Year and International-Stock Fund Manager of the Year--and I don't expect the decision to be an easy one. We'll announce the winner in early January.

John Mackey
 Whole Foods Market 
The grocery industry has experienced a death by a thousand cuts since  Wal-Mart (WMT) entered the fray in earnest in the mid-1990s. While other grocers were getting bigger and fighting a losing low-cost battle against Wal-Mart, Mackey chose to do something completely different--create an entirely new kind of grocery store for customers who care more about what they're buying than what they're paying.

For a grocer, Whole Foods is quite profitable, with returns on invested capital of 14% and operating margins of about 6%. (Most grocery stores have struggled to hit 4% operating margins in recent years, with returns on capital in the high single digits.) In fact, Whole Foods is generating so much cash that it's paying a small dividend while continuing to fund 15%-20% annual growth.

Finally, the firm has solid, if not spectacular, corporate governance. Although it does grant more options than we'd like, and Mackey is both CEO and chairman of the board, Mackey is very reasonably compensated--he earns an annual base salary of just $342,000, and his total compensation is limited to 14 times the average salary of all full-time employees. Moreover, Whole Foods has excellent financial disclosure.

Herb and Marion Sandler
 Golden West 
The Sandlers, who are husband and wife, have run this California thrift since 1963 as co-CEOs, and still own 11.1% of the shares. Returns on equity regularly top 20%, earnings per share have increased at almost 20% per year over the past decade, and Golden West shares have compounded at about 28% per year over the past decade--about three times higher than the S&P 500.

Compared to many of its mortgage-banking peers, Golden West does things very differently. It emphasizes adjustable-rate mortgages--which comprise almost all of the loans it makes-- allowing it to keep those same loans on its balance sheet. As a result, the company’s earnings are simply the spread between the interest it earns on its mortgages and the interest it pays on deposits like checking, savings, and CDs. The result is a cleaner, less-volatile income stream compared with most mortgage banks, which sell off their loans and have to make tons of assumptions about what their earnings ultimately will be. With Golden West, what you see is what you get--a rarity in its industry.

Without putting too fine a point on it, Golden West is a paragon of corporate governance. Compensation is reasonable, option issuance is very mild, seven of the nine board members are outsiders, and financial disclosure is superb. (Side note: Golden West is just one of two Fortune 500 companies with more women than men on its board.) The Sandlers' approach to running the firm is summed up by this quote from Herb Sandler, in response to a question about the firm's lack of diversification, and the fact that the stock can be volatile when the mortgage cycle turns: "So what? We're not here for the moment or the quarter. We're here for the long term. We think the path to hell, with all due respect, is worrying about a quarter or a year."

James Sinegal
 Costco Wholesale (COST)
Sinegal co-founded Costco and has been president and CEO since 1993. He pioneered the warehouse-club retailing concept, while at the same time creating one of the few companies to successfully compete head-to-head with Wal-Mart, which owns Sam's Club. Although it certainly has low costs, Costco has competed effectively with Wal-Mart by differentiating itself from Sam's Club through vastly superior customer service. One way Costco has done this is by treating its employees much better--the firm has relatively high pay and benefits for a retailer--leading to lower employee turnover and a more motivated workforce.

Although it's not spectacularly profitable, Costco consistently generates returns on invested capital in the 11% range--higher than its low cost of capital--and has been growing well over the past year, with same-store sales rising 10%. The firm also recently began paying a small dividend, and in spite of Costco's enviable track record of performance and shareholder value creation, Sinegal's pay is extremely low. He's been paid a $350,000 salary and has been granted 150,000 stock options a year the past three years, and has refused to be paid a bonus each year.

Richard Kinder
 Kinder Morgan Energy Partners ,
 Kinder Morgan (KMI)
For the third year in a row Richard Kinder has made our list of finalists. You can read more about him in last year's column about the nominees, but I'll recap the highlights.

Since creating Kinder Morgan in 1997 out of pipeline assets that Kinder's former employer--the ill-fated Enron--was short-sightedly selling off, Kinder has delivered great returns for shareholders, with KMP shares delivering a 34% annualized return. As the largest individual shareholder, Kinder makes more money only by increasing partnership distributions. (He receives only $1 in cash compensation from Kinder Morgan.) However, as a general partner, he is entitled to a sizable share of each incremental dollar of cash flow that the firm generates, which you can view either as a reasonable performance incentive or as dipping too much into the well. In any case, it's certainly commendable that he takes such a low cash salary, given that his income is already tied to the company's performance.

Etc.
While we're on the subject of corporate governance, I thought I'd pass this story along. One of our analysts was recently visiting a large tech company at which the brother-in-law of the founder is head of the audit committee. When our analyst asked the firm's investor relations representative whether he thought this was a conflict of interest, the IR rep said he'd never been asked that question.

And you wonder how so many firms have been able to get away with conflicted arrangements for so many years--it's because until recently, no one cared.