Friday, June 20, 2014

Buffett & Munger on Compensation - Part I

From Warren Buffett's 1985 Berkshire Hathaway (BRKa) letter:

"...retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign - with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest."

He then adds...

"Many corporate compensation plans reward managers handsomely for earnings increases produced solely, or in large part, by retained earnings - i.e., earnings withheld from owners."

When it comes to stock options, according to Buffett, two important factors are too often ignored:

"It would be particularly unthinkable for managers to grant a long-term option on a business that was regularly adding to its capital. Any outsider wanting to secure such an option would be required to pay fully for capital added during the option period.

The unwillingness of managers to do-unto-outsiders, however, is not matched by an unwillingness to do-unto-themselves. (Negotiating with one's self seldom produces a barroom brawl.) Managers regularly engineer ten-year, fixed-price options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value and, second, ignore the carrying cost of capital."

Unfortunately, when the economic rewards of stock options do end up being reasonable and fair, it usually is by accident:

"Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. (Indeed, managers who are really exceptional almost always get far less than they should.) But when the result is equitable, it is accidental."

He adds that the "managerial Rip Van Winkle, ready to doze for ten years, could not wish for a better 'incentive' system."

Stock options are often described as aligning managers and owners but, in reality, that's just not the case:

"Ironically, the rhetoric about options frequently describes them as desirable because they put managers and owners in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk; an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I'll be happy to accept a lottery ticket as a gift - but I'll never buy one.)"

The holder of a stock option actually benefits from a no-dividend policy. Funds paid out as dividends reduce retained earnings and should, all else equal, lower option value (whatever the difference is, if anything, between market price and exercise price). So maybe no dividend is paid -- or less of a dividend -- because incentives aren't better aligned. Creative justifications for the policy no doubt likely will follow.

"...most people either seem to have difficulty recognizing what lies in plain sight, right before their eyes, or, perhaps even more pervasively, refuse to recognize the reality because it flies in the face of their deep-seated beliefs, their biases, and their own self-interest. Paraphrasing Upton Sinclair: 'it's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it.'" - From John Bogle's remarks at NYU in 2007

The misalignment can lead to behavior often far from ideal for the owners.

Options can work out okay in some circumstances but Buffett's criticism is of "their indiscriminate use". Some managers Buffett admires ("whose operating records are far better than mine") disagree with him on the use of stock options and he mentions this in the letter. Buffett says that certain business leaders have developed the right kind of (but rare) corporate culture where employees mostly think and act like owners. So, in those cases, options end up being an effective incentive despite their flaws and shortcomings.

"'If it ain't broke, don't fix it' is preferable to 'purity at any price'."

The tough part for the investor is judging which company has the right kind of corporate culture.

In contrast, Berkshire's compensation system "rewards key managers for meeting targets in their own bailiwicks. If See's does well, that does not produce incentive compensation at the News - nor vice versa. Neither do we look at the price of Berkshire stock when we write bonus checks. We believe good unit performance should be rewarded whether Berkshire stock rises, falls, or stays even. Similarly, we think average performance should earn no special rewards even if our stock should soar. 'Performance', furthermore, is defined in different ways depending upon the underlying economics of the business: in some our managers enjoy tailwinds not of their own making, in others they fight unavoidable headwinds.

The rewards that go with this system can be large."

The preference is for Berkshire's stock to be purchased by the managers with their own funds:

"Obviously, all Berkshire managers can use their bonus money (or other funds, including borrowed money) to buy our stock in the market. Many have done just that - and some now have large holdings. By accepting both the risks and the carrying costs that go with outright purchases, these managers truly walk in the shoes of owners."

I think it's fair to say that the pay controversy at Coca-Cola (KO) might have gone somewhat differently if they had taken more of this thinking into account.

In this CNBC interview, Warren Buffett commented on Coca-Cola's equity compensation plan (among other things).

Comments that, at least initially, were also somewhat controversial.

Some related articles:
Buffett Punts on Pay
Warren Buffett: We took a stand on Coke's pay package
Buffett Bites Back
Warren Buffett Defends Coca-Cola Abstention
Coke's Pay Hurts the Media's Brain

In any case, it's a plan that Buffett didn't like very much and ended up letting it be known in his own way.

Well, it turns out Coca-Cola's equity compensation plan is now likely to be altered due, at least in part, to some of the pressure.

Here was Munger's take on the way Buffett handled the Coca-Cola compensation controversy during this separate CNBC interview:

"I thought he did it just right. He complained a little, but not too vociferously. I think that was just the right tone, and with compliments which were deserved to the management of Coca-Cola. I thought he handled it perfectly."

More in a follow up.

Adam

Long position in BRKb and KO established at much lower than recent market prices

Related post:
The Illusion of Consensus
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