“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)
“Knowing is not enough; we must apply. Being willing is not enough; we must do.”
- Leonardo Da Vinci
In his talk at Harvard about human misjudgment, Charlie Munger (Trades, Portfolio) has admitted that all his life he has under-estimated the power of incentives. If that’s the case, it is scary to think about the degree to which the less wise investors underestimate incentives. The underestimation, in my opinion, comes from three forms: the complete ignorance of executive compensation in the investment analysis itself; incorrectly assessing the structure of the executive compensation system; or failing to understand the degree to which executive compensation align to those of the shareholders.
Sometimes non-financial motives can be the main driver as often is the case for family-owned businesses, but most executives are mainly driven by the incentive of financial wealth, such is the nature of human beings. There is absolutely nothing wrong with this, but whether the long-term financial interests of both management and shareholders are aligned are of key concern. As investors, we want to make sure that the financial incentives that are in place for the executives are in line with those of ourselves. This is extremely important.
Let me walk through Markel’s executive compensation as an example. I’ve heard a lot of good things about Markel (MKL, Financial), most of the argument centers around Markel’s ability to grow book value at double digits over a long period of time. However, I rarely hear anyone talk about Markel’s executive compensation system, which can be easily found in the Proxy.
The proxy statement can be rather lengthy, but I usually go directly to the part regarding executive compensation part. Here is what I found about how Markel’s management team is compensated, which is extremely rare among public companies:
“Growth in book value over a period of several yearshas 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.”
Then I go to the executive compensation committee part and check out how that committee works. Most executive compensation committees basically apply the social proof and herding principle, meaning they find some peer group and come up with a benchmark pay structure then apply that to the company. I find it is remarkable that most companies pay those consultants to do the job. Here is what a compensation committee is supposed to do, again, taken directly from Markel’s proxy statement:
“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.”
You may say that’s great, but where is the numeracy part? How do we know exactly how Markel’s management team is compensated? What hurdle rate do they use?
These two charts say it all. Although management gets something below 10% BV growth, there’s little incentive to go from 6% to 9% but the tremendous incentive to strive for over 10%. I would imagine Tom Gayner and Steve Markel to work extremely hard to clear that 10% hurdle as opposed to the 6% hurdle.
I’ll end with an exercise for the readers who are interested in this topic. Read the Proxy Statement for Transdigm (TDG, Financial). You may get a feel of why it is mentioned in the great book “Outsiders.”
