There are Amazing Lessons in Warren Buffett’s Shareholder Letters Part Four

When I finished Warren Buffet’s authorized biography The Snowball: Warren Buffett and the Business of Life last month I knew I wasn’t done understanding all that is Buffett.  I immediately downloaded all of his shareholder letters.  If you are new to Buffett (beyond reading what other’s think he is thinking on investment sites) I would recommend reading the two books in this order as it gives you an idea as to what is going on in his life.  For example, if you read his biography first there is an entire chapter dedicated to his relationship and eventual purchase of the Nebraska Furniture Mart, so when he mentions the purchase in his annual shareholder letter there is a deeper meaning to you.

So far I have discussed:

Warren Buffett’s View on Stock Options and Incentive Compensation Plans

With Warren Buffett quoted on a daily basis his views are pretty well known, however, I am not sure how true that was whenn he released his 1985 Annual Letter.  Like most of the topics I have been highlighting and will continue to highlight, the message I am attempting to pull out is intertwined with BRK business happenings.  In recent years Buffett hasn’t been shy about his dislike of stock options as a way to compensate key employees, however, this was written nearly 30 years ago!  Wayyy before companies gave out stock options like toliet paper in the late 90s.

First Buffett provides an example why options based on retained earnings provides for inequities to shareholders.  ,

Let’s suppose that you had a $100,000 savings account earning 8% interest and “managed” by a trustee who could decide each year what portion of the interest you were to be paid in cash. Interest not paid out would be “retained earnings” added to the savings account to compound. And let’s suppose that your trustee, in his superior wisdom, set the “pay-out ratio” at one-quarter of the annual earnings.

Under these assumptions, your account would be worth $179,084 at the end of ten years. Additionally, your annual earnings would have increased about 70% from $8,000 to $13,515 under this inspired management. And, finally, your “dividends” would have increased commensurately, rising regularly from $2,000 in the first year to $3,378 in the tenth year. Each year, when your manager’s public relations firm prepared his annual report to you, all of the charts would have had lines marching skyward.

Now, just for fun, let’s push our scenario one notch further and give your trustee-manager a ten-year fixed-price option on part of your “business” (i.e., your savings account) based on its fair value in the first year. With such an option, your manager would reap a substantial profit at your expense – just from having held on to most of your earnings. If he were both Machiavellian and a bit of a mathematician, your manager might also have cut the pay-out ratio once he was firmly entrenched.

This scenario is not as farfetched as you might think. Many stock options in the corporate world have worked in exactly that fashion: they have gained in value simply because management retained earnings, not because it did well with the capital in its hands.

Building upon that example,

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.)

In dividend policy also, the option holders’ interests are best served by a policy that may ill serve the owner. Think back to the savings account example. The trustee, holding his option, would benefit from a no-dividend policy. Conversely, the owner of the account should lean to a total payout so that he can prevent the option-holding manager from sharing in the account’s retained earnings.

Working with high net worth individuals I am always shocked to see how much compensation is actually provided to an individual through stock option programs.  Until reading this Annual Shareholder letter I never really thought how these types of compensation arrangements affect shareholders (although I did express frustration with buyback programs not actually reducing outstanding shares probably due to options).

Buffett’s Preferred Compensation Method

Cash.  Said more eloquently,

At Berkshire, however, we use an incentive compensation system that 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. At our various business units, top managers sometimes receive incentive bonuses of five times their base salary, or more, and it would appear possible that one manager’s bonus could top $2 million in 1986. (I hope so.) We do not put a cap on bonuses, and the potential for rewards is not hierarchical. The manager of a relatively small unit can earn far more than the manager of a larger unit if results indicate he should. We believe, further, that such factors as seniority and age should not affect incentive compensation (though they sometimes influence basic compensation). A 20-year-old who can hit .300 is as valuable to us as a 40-year-old performing as well.

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.

While I don’t foresee being in a position where I would be able to affect a stock option culture I still find it interesting to learn how Warren Buffett may feel about a certain business topic (especially ones that are in the financial news almost weekly).

 

One Response to There are Amazing Lessons in Warren Buffett’s Shareholder Letters Part Four

  1. Interesting post…too bad stock options aren’t provided in the public sector. You might get more public employees to actually want to do well. In my opinion, public sector jobs, which I’m a part of, do such a terrible job offering incentives to excel. Just food for thought.

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