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Mental Model Application - Reward and Punishment Super-Response Tendency (Incentives)

April 15, 2014 | About:
Grahamites

Grahamites

124 followers

“I think I’ve been in the top 5 percent of my age cohort almost all my adult life in understanding the power of incentives and all my life I have always underestimated that power.”

Charlie Munger (Trades, Portfolio)

In one of my previous articles, I tried to analyze how Charlie Munger (Trades, Portfolio) applied mental models to the Coca Cola case study. It is encouraging to have received many insightful comments. A few readers were kind enough to provide links to lists of mental models compiled by very intelligent individuals. While a list of mental models is a good way to start, we must heed the advice from Leonardo Da Vinci: “Knowing is not enough; we must apply. Being willing is not enough; we must do.”

It is tempting to write an article that covers all mental models, but that goal seems unrealistic. In choosing the mental model for this specific article, I decided to narrow the list down to the ones that are enormously important to investing but are at the same time, remarkably under-discussed. And from this list, the Reward and Punishment Super-Response Tendency jumps out. If even the great Charlie Munger (Trades, Portfolio) has estimated the power of incentives, it is scary to think about the degree to which a normal investor underestimate incentives. In a world where valuation is what most people focus on, I think the Reward and Punishment Super-Response Tendency for those in charge of the companies we invest in needs to be checked.

While incentive is multifaceted and argubly contains more intangibles than observable tangibles, it is safe to say that most executives are mainly driven by the incentive of financial wealth. Let me be clear that I think the pursue of financial wealth is perfectly legitimate. But we have to distinguish the paths that one can take to achieve that. Executives can get super rich slowly, or they can get super rich quickly. As investors, we want to make sure that the financial incentives that are in place for the executives we want to partner up with are in line with those of ourselves.

Now naturally one may wonder: Well it all sounds good but how can we achieve that goal?

Fortunately, the Proxy Statement, which is a required SEC filing, contains great information that if read carefully and with a purpose, will serve us well.

Granted, the Proxy Statement could be lengthy, and it is one of the most boring documents to read. This is probably why very few people go through it in detail. But if you follow Charlie Munger (Trades, Portfolio)’s advice and you want to add a powerful weapon to your investment process, I think reading the Proxy Statement is a must.

Let me illustrate my point with two contrasting examples: LinkedIn Corp (LNKD) and Markel Corporation (MKL).

Readers can find the Proxy Statements of both companies online easily. The key to reading them is to be selective. I would simplify the process by skipping the introduction and jumping directly to where the meat is at — executive compensation discussion. This section is usually less than 10 pages long. You can simplify the process further by focusing on these points:

1. How does the Compensation Committee work (does the company use compensation consultant, who uses peer analysis)? Do they have incentives to stay blind to exorbitant CEO pay?

2. What metrics are used in evaluating executives' performance? Do they focus on profitability and free cash flow, or revenue growth and other non-profit-related areas?

3. How are the non-cash awards structured? For option grants, what is the strike price and expiration date? For restricted units, what are the vesting requirements?

Let’s take a closer look at LinkedIn’s Compensation Committee. One thing that stands out is that out of the three members, two of them (A. George “Skip” Battle and Leslie Kilgore) serve on the board of Netflix, a similar company. The power of herding and social proof is present here. If Netflix has a culture of high executive pay, that culture will be effortlessly and shamelessly transferred to LinkedIn without raising any eyebrows. And vice versa.

LinkedIn's Compensation Committee uses a compensation consultant, who uses peer analysis. Again, combining social proof, herding and inadequate incentives, we have a lollapalooza effect that will almost guarantee exorbitant and regrettable executive pay. Why not mimic the peers if it serves everyone’s interest?

In sharp contrast, here is how Markel’s Compensation Committee works:

The committee annually reviews and resets the compensation of the company’s executive officers taking into account, among other factors, years of service; level of experience; individual areas of responsibility; the annual rate of inflation; the company’s operating performance; and total compensation opportunities relative to compensation opportunities of other members of management of the Company and its subsidiaries. The committee considers recommendations from senior management in the course of its review.

The committee has authority to retain, appoint, compensate and oversee the work of compensation advisers and require the company to provide reasonable compensation to such advisers as determined by the committee. Neither the committee nor the board has retained compensation consultants to assist it in determining the amount or form of compensation for executive officers or directors.

Now let’s turn to the metrics used to evaluate management’s performance and non-cash awards:

LinkedIn:

No mention of profitability or cash flows. EBITDA can be adjusted to show whatever numbers they want to show. Management can be paid exceptionally well if they can grow membership and revenue. What about options grant? Here is the option awards information for LinkedIn's senior managers:

Any reasonable investor will conclude that there is a massive misalignment of interest here. The exercise price of these option grants are laughable. If management claims that their interests are aligned with investors, ask the management if they can grant those options to investors. And when they exercise those options, LinkedIn has to go to the open market, and purchase them at a much higher price. The shareholders get a double whammy here. Not only are their shares diluted but they also suffer from a lower profitability due to higher share-based expense. Boy, is it no wonder that profitability is not a consideration in determining executive fees and share-based expense is added back for adjusted EBITDA?

Markel: Although there are a variety of both cash and non-cash awards, book value growth over a period of time is often the dominant factor. The Company's compensation plan has the following information: Growth in book value over a period of several years has been used as the primary performance goal under the plans based on a belief that consistent increases in book value will enhance the value of the Company and will, over time, benefit shareholders through higher stock prices. The five-year measurement period provides balance between line of sight for actions currently being taken and a long-term perspective in managing the Company’s operations. In addition, using a longer-term measurement period does not encourage the taking of excessive or unnecessary risks in order to earn incentive compensation.”

Here is an example of how long-term book value growth is used in one of Markel's incentive awards:

Is it obvious that Markel’s incentive compensation structure is much more likely to reward long term value creation than that of LinkedIn? If you are a long-term shareholder, why wouldn’t you want to be associated with Markel’s ethos?

Incentives are enormously important. Now that we have analyzed two public companies' executive compensation by applying one of Charlie Munger (Trades, Portfolio)’s recommended mental models, we can see why reading and analyzing Proxy Statements should be a crucial part of your multi-disciplinary investment analysis process. It won’t take hours and all it requires is to ask the three key questions and find the answers. Anyone with a normal IQ can do that, but not many people will.

“The best thing a human being can do is to help another human being know more,” says Charlie Munger (Trades, Portfolio). I couldn’t agree more.


Rating: 4.7/5 (21 votes)

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Comments

venkatmvr
Venkatmvr premium member - 5 months ago

Any chance you could provide a few links of the mental models to start on, especially those focused on investing. I am imagining models in visual sense if you have anything like that.

Thanks

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