Wednesday, March 9, 2016

Buffett on Stock-Based Compensation

From Warren Buffett's recently released 2015 Berkshire Hathaway (BRKashareholder letter:

"...it has become common for managers to tell their owners to ignore certain expense items that are all too real. 'Stock-based compensation' is the most egregious example. The very name says it all: 'compensation.' If compensation isn't an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?

Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring 'earnings' figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing 'access' to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors."

I've covered this subject to an extent in prior posts. Ignoring these very real costs -- especially when it comes to evaluating those businesses that happen to be highly dependent on stock-based compensation -- can lead to vastly different estimates of per share intrinsic value. It's possible that the tendency to ignore such expenses is at least in part related to what Jeremy Grantham has called "career risk" and Warren Buffett has described as "the institutional imperative".

The risk of permanent capital loss can to an extent be mitigated by using conservative assumptions about future business prospects. That way, if the least optimistic scenario -- or, worse yet, the supposed worst case turns out to be too optimistic -- is what plays out, the investor is at least somewhat protected.
(There'll obviously be no complaints if prospects prove to be surprisingly good.)

So estimate value conservatively then purchase shares when market price represents a nice discount to that estimate.

Ignoring a whole category of expenses such as stock-based compensation is hardly consistent with such a recipe.

Why there'd be a willingness to overlook -- by those who should be some of the most informed and knowledgeable no less -- what is, especially for certain tech stocks, too often a rather large expense is well worth understanding (for reasons that include but extend far beyond investing).

Estimating what'll end up being the true cost of stock-based compensation beforehand is not easy to do in a precise manner. Yet that reality doesn't justify pretending the costs don't exist at all. For investors, difficult to measure factors are often important to consider with stock-based compensation being just one of many. The correct response to this necessary imprecision is to make -- or at least attempt to make -- a rough but meaningful estimate. Existing accounting standards will always have their limitations, but at least can provide a useful starting point for the investor.

This ultimately gets back to the broader subject of risk. Investing competently starts with staying away from what's not well understood by the investor. No margin of safety should be considered large enough when outside one's comfort zone.

Sometimes it's necessary to avoid an investment with otherwise lots of potential upside because the worst case is intolerable. In other words, a known, if improbable, yet totally unacceptable outcome exists so no margin of safety seems large enough. Howard Marks has has said "I have no interest in being a skydiver who's successful 95% of the time."

That's a useful way to think about it. The outcome 5% of the time is just unacceptable no matter how good things go the other 95% of the time.

Some choose to treat volatility as a proxy for risk.

If risk analysis were only that straightforward.

It's just not and never will be.

Since, for investors, much of what matters can't be precisely quantified, it's the qualitative factors that end up deserving at least as much if not a whole lot more attention. As Charlie Munger once said:

"...practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."

Just because something is tough to quantify doesn't necessarily reduce its significance.

Adam

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

Related posts:
Earnings Inflation
Howard Marks on Risk
Stock-based Compensation: Impact On Tech Stock P/E Ratios
Big Cap Tech: 10-Year Changes to Share Count
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Technology Stocks
Time for Dividends in Techland
Munger on Accounting

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