Interestingly, this isn’t the first time our comments have made their way into SEC filings.
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Interestingly, this isn’t the first time our comments have made their way into SEC filings.
]]>During the second quarter of fiscal 2011, the Company bought shares of common stock of two foreign manufacturing companies.
Meanwhile, the stock price of BYD, the Chinese manufacturer of which Berkshire owns 10% and Munger has spoken enthusiastically, is down 2/3 from its highs.
Which leads us to wonder…is Charlie buying BYD at these prices?
]]>Credit arrangements have been made.
And this nugget from the Sears Proxy:
]]>ESL provides consulting services to the Company pursuant to an agreement entered into as of January 30, 2011. The consulting services involve, among other things, strategic planning, financings and other financial matters, legal risk analysis and management, personnel, mergers, acquisitions and divestitures, new business and business development and general corporate, operational, and organizational matters. The consulting agreement provides for a monthly fee of $41,666.67 plus reasonable out of pocket expenses. The Company has granted rights to indemnification and advancement of defense expenses to ESL and its directors, officers, controlling persons, agents, representatives and employees in connection with legal proceedings to which the indemnified person is made a party or is threatened to be made a party by reason of the services provided under the consulting agreement.
Analyzing Analysis
One of our favorite authors is the ecologist/economist Garrett Hardin, author of works such as Living Within Limits and Filters Against Folly, as well as the famous essay on the “Tragedy of the Commons.” In Filters Against Folly, Hardin outlines his approach to rational thinking through three major filters: literacy, numeracy, and “ecolacy.”
Literacy is easy to define: What do the words mean? Language, as Hardin points out, can be used to inhibit or enhance clear thinking. (Think about how politicians use certain words and phrases to frame issues.)
Numeracy is straight-forward as well: What are the quantities involved? As Hardin saw it, the failure to invoke quantities is a major weak-point in critical analysis. Any competent analyst (not just in business, but in all human endeavor) must be in tune with quantities, numbers, and scale.
As for his “ecolate” filter, Hardin focuses on the first law of ecology: You can never merely do one thing. Even the most numerate and literate analyses usually forget to ask the crucial question: “And then what?” It’s a messy question; asking it leads you to a lot of dead ends. But that doesn’t mean it should be ignored. The second order of effects can often dwarf the first.
Hardin’s filters are useful in analyzing complex systems like the global economy. An economy is like an ecosystem: complex, interconnected, adaptive to change, and consequently, highly unpredictable. As an example, let’s take the problem of Federal Reserve “Quantitative Easing” and put it through our filters.
Literacy: What do the words mean?
What does “quantitative easing” actually mean? In essence, it’s the creation of money by the Federal Reserve in order to purchase debt obligations. The effect is to inject dollars into the banking system (which may or may not be subsequently lent out) and “monetize” the outstanding debt – mostly mortgage bonds and US Treasury bonds. By being a huge source of “demand” for bonds, the Fed is trying to use this tool to keep long-term interest rates lower, stimulating economic activity and raising asset prices. We believe the jargon “quantitative easing” seeks to inhibit thought, rather than promote it.
Numeracy: What are the quantities involved?
The Fed has spent over a trillion dollars and has hundreds of billions more planned. The Fed is expanding its balance sheet by multiples, not small fractions. (Before the first round of QE, its balance sheet was in the $1 trillion range.)
But while the quantities themselves are known, some questions remain: What are the appropriate quantities to take into account? What should we compare the amount of QE against to judge its size? We’ve heard arguments that it’s way too large (potentially causing hyperinflation) or, alternatively, that it’s just a drop in the bucket, a useless distraction. Which you agree with depends on the quantities you consider relevant and the historical examples you choose to cite.
Ecolacy: And then what?
Here’s the major question that neither we nor the Fed can answer (although, at least we admit we can’t answer it): What are the domino effects of the government buying bonds in scale and attempting to dampen interest rates? From the vantage point of Mr. Bernanke, the effects have been mixed so far: asset prices have increased across the board and animal spirits have been raised, but long-term interest rates have actually increased. Would they have been even higher otherwise? How does increased speculation in financial assets support long-term growth? What if it’s actually a net negative? How much QE is too much?
Getting back to our numerate analysis, there are few truly objective measures of the success or failure of Fed action. We get the feeling that there is a statistic to support any position, and even with hindsight, it will be difficult to pinpoint what the effects of QE were. All we know is that artificially distorting the monetary system is a dangerous game; although we can make models and informed guesses, we don’t know the long term effects. When you combine the actions of the Fed with the actions of foreign countries in response, the complexity becomes mind-boggling. You can never merely do one thing.
Conclusion
The foregoing is not an attempt to show our prowess in macroeconomic analysis. In fact, it’s the opposite: we hope to show the near impossibility of the task. Clear thinking only allows us to understand the severe limits to how much we can know. In light of this, our approach is basic: We try to be prepared for a wide range of outcomes.
In our opinion, more reliable conclusions can be made in determining microeconomic outcomes (competition between individual businesses), so those are the ones we focus on. Instead of dealing in large-scale trends and trying to “get exposure” to them, we build the portfolio one by one, evaluating each opportunity on its merits.
]]>You can read the transcription here.
]]>Gold – 10 Year Chart
10-Year Treasury Yield – 10 Year Chart
S&P 500 Index – 10 Year Chart
To be clear, we do not purport to be predictors of future returns, especially in the near term. However, we believe investors should be careful with their assumptions.
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]]>Q: You call yourselves value investors. You — and, of course, the rest of the world — are looking to buy the proverbial dollar’s worth of assets for 50 cents. But you’re also looking for good businesses.
Greenberg: That’s correct. I would emphasize that we are looking for good businesses where the fortunes of those businesses don’t turn on slight changes in GNP statistics, where there is substantial free cash generated and put into the hands of extremely capable managements which will not go out and spend that money foolishly by overexpanding plant capacity, or paying too much for an acquisition to get into somebody else’s difficult business…we look for people who have a vision of building something, building their company into a great business.
May 5, 2010
To the Board of Directors:
In light of the company’s recent decision to implement a new incentive bonus agreement for its CEO and Chairman, Sardar Biglari, we are writing to express our concern.
The current system, as proposed, is ridiculous by itself and, additionally, runs contrary to the ethos Mr. Biglari claimed to have when nominating himself for election to the Board of Steak ‘n Shake.
The decision by the Board of Biglari Holdings to accept such a generous and easily manipulated compensation system, demonstrates they either fail to understand the nuances of the proposal or they are simply unwilling to take a stand against Mr. Biglari, ignoring their obligations to shareholders.
* * *
Let us remind the board, of what Mr. Biglari, then attempting to gain a Board seat on Steak ‘n Shake, said with respect to how executives should be compensated.
In our assessment, the variable element of the compensation package should be tied to the executives’ ability to generate free cash flow and to earn a high return on invested capital.
Mr. Biglari continued:
The current compensation arrangement is askew, so that even if the company performs below its competitors, management and directors will stand to gain.
The current compensation arrangement, if applied retroactively to prior Steak ‘n Shake management, would increase the very rewards Mr. Biglari claimed were already excessive in light of their poor performance.
We suspect Mr. Biglari’s thinking towards compensation has changed now that he’s in charge. How else could he desire a pay package that violates his own, purported, tenets?
To be perfectly clear, the currently proposed package, without modification, destroys shareholder value.*
We think we can all agree that paying for performance is both necessary and desirable. We believe the current framework the board has put in place can, if modified, work to the benefit of both management and shareholders.
Luckily, Mr. Biglari has already provided a better template for the board to consider that employs both invested capital and a higher hurdle rate.
As Chairman and CEO of Western Sizzlin Corporation, Mr. Biglari designed the following performance bonus structure for Robert Moore, CEO of Western Sizzlin Franchise Corporation:
Such bonus shall be equal to twenty percent (20%) of Cash Flows in excess of $ 2.3 million annually as adjusted by a charge of 20% of any incremental reinvestment of capital during each year (“Bonus Compensation”).
We welcome the opportunity to help the board determine a more equitable compensation arrangement before the next shareholder meeting. We would appreciate a response at your earliest convenience.
Sincerely yours,
NFI
Sources:
http://www.sec.gov/Archives/edgar/data/93859/000009385910000008/form10q_1q2010.htm
http://www.sec.gov/Archives/edgar/data/930686/000110465909030087/a09-11139_1ex10d1d4.htm
* The language was modified from the original letter in an effort to be suitable for a wider audience.
At, NFI, we’re firm believers in paying for (actual) performance. Ideally, all CEO’s would receive a living wage and generate the rest of their compensation from bonuses based on performance.
Performance, however, is an illusive concept and corporate Boards are often left with the task of determining CEO compensation. Unfortunately, rather than thinking, many boards delegate this critical task to outside consultants who, for a fee, legitimize an ever increasing number which boards can easily rationalize to shareholders as correct. CEO’s, of course, rarely complain about the payday.
Given that the CEO typically chooses the board members and the board members pick the consultant and determine compensation, you can see how this incestuous relationship can quickly become one that benefits everyone but the shareholders. It would be better if Boards spent more time thinking about and creating the right incentives than outsourcing such a crucial task.
However, this undertaking is not as easy as it sounds. Something as simple as rewarding a CEO for increases in shareholder equity can be very dangerous. If the long-term historical return on equity is 10% how much should a CEO be paid for average performance? How do you account for inflation? Risk free interest rates? The incentive to leverage the company? Shareholder equity, after all, is not the same as invested capital. What about the fact that you can lag the S&P 500 and still collect massive compensation?
Pay is such a hot topic that activist shareholders often mention it as one of the things they want to change. That is, until they are in charge. And so it goes.
After determining performance objectives, Boards often have to adjust reported numbers as these can be materially misleading. An undertaking, I fear, which makes a lot of them uncomfortable.
Let’s look at some examples of how, not adjusting things, can quickly lead to paying CEO’s well above their actual performance.
Consider the Dr Pepper Snapple Group’s focus on Earnings Per Share. This company considers earnings per share increases as one of the key components to the CEO’s incentive compensation. Next year the board will face a tough question: should we include the gains resulting from Coke and Pepsi taking the bottlers private or should we make adjustments? These gains are non-operating, non-recurring, and outside the control of anyone inside the company. So will the company exclude them when making compensation decisions? We’ll have to wait and see.
What about a CEO, who, because of a spike in oil prices increases earnings or shareholders equity? Should they be rewarded simply for the price of oil?
Another example would be companies placing an emphasis on “return on invested capital.” While this sounds good, again, the success of this system lies buried in the details. Unfortunately for shareholders, a lot of executives find it pretty easy to hide poor capital allocation skills. They manipulate the system. If, for example, a company marks down goodwill they also reduce invested capital. In the process they lower invested capital because they’ve lowered the denominator. Assuming the return part is constant, the company, increases return on invested capital with the stroke of a pen.
I’ve read more than a few proxies this year which place an emphasis on “return on invested capital” (calculated without adjustments) for companies which, over the last two years, were all too eager to rid themselves of goodwill. You can be sure those executives will be handsomely rewarded this year.
Some companies do understand pay for performance and those are companies we eagerly keep a close eye on. Companies with a large shareholder on the board seem, generally, to better understand pay for performance.
Not all companies need a large shareholder to ensure thoughtful compensation. A great leader can sometimes rise above the folly. JPMorgan Chase & Co.’s proxy generally stands out and this year was no exception. Thanks in large part to Jamie Dimon, JPMorgan is clearly a cut above the rest of Wall Street when it comes to compensation philosophy.
Let’s take a look at some of JPMorgan Chase &Co.’s discussion on compensation in their most recent proxy statement:
Highlights of some changes introduced in 2009 and 2010 include the following:
In addition to our long standing recoupment policy which enables the Firm to recover cash and equity incentives in the event of material restatement of the Firm’s financial results or a termination for cause, we also implemented terms and conditions in January 2009 for all employees that enable the Firm to clawback or recover these incentives in the event they were based on materially inaccurate performance metrics or on misrepresentations by employees.
In January 2010, we implemented enhancements to our provisions in equity awards to enable recovery: 1) for conduct detrimental to the Firm, insofar as it causes material financial or reputational harm to the Firm or its business activities, and 2) for members of the Operating Committee, members of LOB Management Committees and certain other employees, failure to properly identify, raise or assess, in a timely manner and as reasonably expected, risks and/or concerns with respect to risks material to the Firm or its business activities.
For Operating Committee members (i.e. the Firm’s most senior officers), we introduced terms and conditions in January 2009 that enable the CEO, with ratification by the Compensation Committee, to determine that awards may be reduced, forfeited or delayed if the executive’s priorities or those of the Firm are not achieved at a level deemed appropriate.
For incentives awarded in 2010, the Firm increased the portion deferred into equity based on incentive compensation level to further align deferral rates with global regulatory principles like those of the Financial Stability Board and endorsed by the G-20, specifically to provide longer term incentives for those earning greater compensation and engaged in more material risk-taking activities. Members of the Operating Committee received on average at least 75% of their incentive compensation in equity.
Beginning in 2010, approximately 15,000 employees across multiple businesses had the mix of their total compensation adjusted to provide more fixed compensation (i.e., salary) and less variable compensation (i.e., incentives) going forward.
Management has engaged the Compensation Committee in more discussions and reviews of the relationship between risk and compensation and the Compensation Committee will now meet at least annually with one or more members of the Risk Policy Committee of the Board of Directors.
JPMorgan Chase has policies that would permit recovery of incentive compensation awards in appropriate circumstances.
Stock-based awards vest over multiple years, and such awards granted in 2010 are subject to the Firm’s right to cancel an unvested or unexercised award, and to require repayment of the value of certain shares distributed under awards already vested if:
- the employee is terminated for cause or the Firm determines after termination that the employee could have been terminated for cause,
- the employee engages in conduct that causes material financial or reputational harm to the Firm or its business activities,
- the Firm determines that the award was based on materially inaccurate performance metrics, whether or not the employee was responsible for the inaccuracy,
- the award was based on a material misrepresentation by the employee,
- and for members of the Operating Committee – the Firm’s 16 most senior executives – and certain other employees, there is a failure to properly identify, raise, or assess, in a timely manner and as reasonably expected, risks and/or concerns with respect to risks material to the Firm or its business activities.
Under our recoupment policy adopted in 2006, the Firm may seek repayment of incentive compensation (cash and equity) in the event of a material restatement of the Firm’s financial results for the relevant period.
Appendix D
JPMorgan Chase Compensation practices and principles
We believe that JPMorgan Chase has consistently been at the forefront of sensible compensation practices. We have a rigorous performance and compensation management system that incorporates the following practices and principles:
- A focus on multi-year, long-term, risk-adjusted performance and rewarding behavior that generates sustained value for the Firm through business cycles
- An emphasis on teamwork and a “shared success” culture
- A significant stock component (with deferred vesting) for shareholder alignment and retention of top talent
- Recoupment and clawback provisions in addition to disciplined risk management to deter excessive risk taking
- A recognition that competitive and reasonable compensation helps attract and retain the best talent necessary to grow and sustain our business
- Strict limits or prohibitions on executive perquisites, special executive retirement or severance plans
- Independent Board oversight of the Firm’s compensation practices and principles and their implementation
These practices and principles are supported by additional beliefs that guide how we operate.
Compensation should not be overly rigid, formulaic or short-term oriented
- Compensation programs should be designed as much as possible to allow for the Firm to exercise discretion and retain flexibility in compensation decisions. Multi-year guarantees should be kept to an absolute minimum. More generally, the assessment of performance should not be overly formulaic and should not overemphasize any single financial measure or single year, as that can result in unhealthy incentives and lead to unintended, undesirable results.
- Performance should be considered using a broad-based evaluation of people and their contributions to ensure that the right results are being encouraged. Factors such as integrity, compliance, institutionalizing customer relationships, recruiting and training a diverse, outstanding workforce, building better systems, innovation and other outcomes should be included. Performance feedback should be obtained from multiple sources across the Firm to ensure it is both balanced and comprehensive.
- Commission-based incentives generally should be limited to sales or production oriented employees who do not control credit or investment decisions. The different risk profiles such as liquidity risk, time horizons for realized gains or losses, and reputational and operational risk all should be appropriately taken into account.
In a fiduciary business, certain roles are evaluated solely on individual and business unit results. In addition, some of these roles are paid long-term compensation with incentives linked directly to their investment strategies in order to more fully align their interests with those of the clients.
In the end, Boards need to understand the key business drivers, human nature, and incentives. Even then, they need to make adjustments to ensure the company doesn’t pay someone for something they didn’t actually do. Too often CEO’s are rewarded for the wrong reasons. Let’s start paying them for the right reasons.
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