Tuesday, December 13, 2011

Buffett on "Truly Extraordinary" CEOs: Berkshire Shareholder Letter Highlights

Warren Buffett, in the 2005 Berkshire Hathaway (BRKashareholder letter, used the arrival of Jim Kilts at Gillette in 2001 as an example of "the truly extraordinary CEO".

According to Buffett, Kilts transformed a company that was struggling from capital-allocation blunders and made moves that "dramatically increased the intrinsic value of the company".

In Buffett's view, as a result of "his accomplishments, Jim was paid very well – but he earned every penny."

So the rare but an extraordinary CEO can be worth every penny he or she is paid.*

Unfortunately, executive compensation systems seem designed to encourage anything but the extraordinary.

From the 2005 Berkshire letter:

Executive Pay Versus Performance
Indeed, it's difficult to overpay the truly extraordinary CEO of a giant enterprise. But this species is rare.

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won't change, moreover, because the deck is stacked against investors when it comes to the CEO's pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

Take, for instance, ten year, fixed-price options (and who wouldn't?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let's say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company's earnings to repurchase stock.

Let's assume that under Fred's leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.

The problem doesn't end there.

Low Return Projects & Acquisitions in Lieu of Dividends
Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred's option will deliver him $63 million. 

Finally...

Adjusted Strike Price Stock Options
It doesn't have to be this way: It's child's play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation "experts," who are nevertheless encyclopedic about every management-friendly plan that exists. ("Whose bread I eat, his song I sing.")

The worst part of all is that getting fired can be especially bountiful for CEOs:

Today, in the executive suite, the all-too-prevalent rule is that nothing succeeds like failure.

Buffett points out that having served as a director on the board of twenty public companies, only CEO has put him on an executive comp committee.

I wonder why.

Adam

Long position in BRKb

Related posts:
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager

* Of course, beyond the $ 100k/year Buffett is paid, his wealth has come primarily from the compounded value of Berkshire shares he bought using his existing wealth a number of decades ago. An exceptional CEO with less than exceptional compensation. Imagine if all those years ago Buffett had demanded the "2 and 20" fee arrangement that is the norm among hedge funds. I took a hypothetical look at it in a previous post and this follow up.
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