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Warren Buffett: The Deck Is Stacked Against Shareholders When It Comes to Executive Pay

In recent months, I have written about a number of market phenomena that present investors with problems. One of these things concerns the use of stock-based options as a means of compensating executives. In one of his letters, Warren Buffett (Trades, Portfolio) criticized the practice, arguing they represent an unfair transfer of wealth from shareholders to managers.

I have also argued that the practice of stock buybacks as currently implemented has caused a number of problems, incentivizing managers to pursue strategies that prioritize short-term increases in share price above all else. Today, I want to look at another Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) letter of Buffett's, this time from 2005, that takes a similar point of view.

When managers take from shareholders

In the letter, Buffett argued that executive compensation in corporate America is significantly out of line with performance. This is due to the fact that the CEO and senior executives often have a tremendous amount of influence over their own compensation packages. For instance, Jamie Dimon, who has amassed a net worth of $1.6 billion by being the top manager at JPMorgan (NYSE:JPM), is both CEO and chairman of the board of his company. As chairman, he has the power to set his own compensation (and to appoint "independent" compensation boards).

Buffett uses the fictional example of "Fred Futile," the CEO of "Stagnant Inc." who receives a bundle of fixed-price options that give him a 1% stake in his company:

"Let's assume that under Fred's leadership, Stagnant lives up to its name. In each of the 10 years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at 10 times earnings per share, it will have appreciated 158% by the end of the option period. That's because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant's earnings had declined by 20% during the 10-year period".

"Fred" benefits disproportionately by choosing to retain earnings to repurchase shares, rather than paying them out as dividends. The standard textbook explanation for buybacks is that they should only be undertaken if there is no better way to deploy capital internally, and only if the company's share price is below intrinsic value. Obviously, if you are a manager with stock options, your incentive is to repurchase shares regardless of the long-term consequences to the company. This is an example where sterilized financial theory does not align at all with the reality of corporate finance, and is one that I think will become increasingly important going forward.

Disclosure: The author owns no stocks mentioned.

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This article first appeared on GuruFocus.