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The Importance of Proper Incentives

During a recent appearance on the Invest Like the Best podcast (link), Chris Bloomstran, the president and chief investment officer of Semper Augustus Investments Group, made some compelling points on how he uses proxy statements to assess whether management has the proper incentives to align their interests with shareholders:

"One thing we've started doing recently is we're spending a lot more time in the proxy statement... We've gone back and we've started looking at businesses and taking a series of 15 years' worth of proxy statements. What that does is give you a sense of where changes have been made. So, to the extent the board of directors wants to make sure their CEO's and their CFO's and their managers get paid, they're always moving around these hurdles for incentive compensation. If straight salary compensation is 10% or 15% or 20% of comp, the majority of how these people get paid is bonuses. And the vesting of their incentive stock options and the bonuses all have caveats to them...

[Look] what has happened at a company like General Mills (GIS). Think about the nature of branded consumer goods businesses and the threats they have from private label, for example. If we go back 10 - 12 years ago, these guys had in their proxy statement for bonus comp a hurdle of maybe 3% organic sales growth. And in the successive period, through this last year, that number had declined from 3.0% to 2.0%, 2.0% to 1.5%... the number today, the hurdle today, is a negative 1.4% organic growth rate. Now that is stunning. We're going to pay you performance comp to slowly shrink the business.

The other overlay to the current comp, and this has evolved in the case of General Mills as well, is we're going to pay you on free cash flow... So, I guarantee you these people lay awake at night thinking about what they have to do to the business for the five years they're on watch to how they're going to earn their incentive comp. If one of the two metrics is free cash flow, you can cut advertising spending, you can cut capital expenditures. You can kill the brand of the business that you're running, but you can drive the free cash.

So, with one of their hurdles, there's a 50% mix between the organic sales - which they did not hit for a rolling three-year period so they got 0% - but then they hit 132% of their free cash metric. They paid that pro rata, so they split the 132%. They paid 66%. They didn't get 0% and then 100% [for a total payout of 50%], they got 66%, which is crazy...

Too many businesses don't have a return on capital; they don't have an asset-based return metric, they don't have an equity-based return metric, they don't have a capital-based return metric. They are paid for all kind of nonsense like top-line growth.

So, what does a General Mills do in the wake of all that? Well, they're not hitting the portion of comp that's tied to organic growth, so you buy Blue Buffalo. You pay something like $8 billion for $1.2 billion in revenues. It might be a good deal, it might not... but you have a business that's clearly going to drive top-line growth.

Is it profitable? I don't know. Is that too big of a premium for that brand to be accretive on a return on capital basis? It doesn't matter, because that's not part of the metric on how they pay themselves. And I think that's insane."

I have less of an issue with Mr. Bloomstran's first point (changing targets to reflect the current reality of a business or industry). For example, that is what has happened at Markel (MKL) over the past few years: they've lowered their five-year book value per share CAGR to account for the realities of operating in the current interest rate environment. Some people have an issue with the lowered hurdle rate. It is admittedly unimpressive relative to prior expectations (and prior results). But I personally view it as a reasonable change given the facts at hand. It does not make sense to stick with a compensation plan that does not reflect the realities of the world that you're currently living in. Management should not be held to unreasonable expectations .

On the other hand, I think Mr. Bloomstran's point on the importance of logical objectives in executive compensation plans is spot on. And the example he discussed (the General Mills acquisition of Blue Buffalo) is emblematic of the problem. The idea that a CEO should be encouraged through the design of a compensation plan to seek out high growth businesses to acquire - regardless of the economic rationale for doing so - is patently absurd.

Misguided objectives lead to irrational behavior (in the eyes of the shareholders). Whether the funds are being intelligently allocated is never considered. And in the end, shareholders are left holding the bag. But by the construction of the plan, that "doesn't matter, because that's not part of the metric on how they pay themselves". The plan leads to a clear conflict between what investors care about (or should care about) and what the management team is focused on.

In that scenario, I don't think you can blame the people operating within the system for questionable decision-making (again, in the eyes of the shareholders). Improper incentives are the culprit - or more directly, the individuals responsible for those incentives.


I'll close with some comments Warren Buffett (Trades, Portfolio) made at the 1995 Berkshire Hathaway (BRK.A, BRK.B) shareholder meeting that I think highlights the key component of a rational compensation plan:

"We want our managers to understand just how highly we value capital. And we feel there's nothing that creates a better understanding than to charge them for it. So, we have different arrangements. Sometimes it's based a little on the history of the company. It may be based a little bit on the industry. It may be based on interest rates at the time that we drew it up. We have arrangements depending on those variables... that range between 14% and 20%, in terms of capital advanced... We believe in managers knowing that money costs money. Generally, my experience in business is that most managers, when using their own money, understand that money costs money. But sometimes managers, when using other people's money, start thinking of it a little bit like free money. And that's a habit we don't want to encourage at Berkshire."

Disclosure: Long BRK.B
This article first appeared on GuruFocus.