One of the most important measures in deciding which companies do or don’t make it into one’s portfolio is the test of managerial integrity. An investor will always look more favourably on businesses where large portion of the stock is held directly by its management.

The principle is simple enough – if the managers do believe in their company and their own ability to run it successfully, they should not be afraid assigning a large portion of their own net worth to the company stock. Warren Buffett calls this “aligning the managers’ interests with the interests of the company owners” (i.e. shareholders).

However the interests of the owner are ill served if the company chooses to use stock options as a tool in management compensation structure. The main reasons are following:

1. Options reward for profits on retained earning
   No extra managerial skills are necessary to keep the retained earnings in the bank and make profits from interest. However the option will reward such managerial technique by increasing in value since also these “lazy profits” will appear on the annual report and increase the bottom line.
   The difference in interests could not be more obvious. While the option holder wishes for no dividend payout to earn the biggest amounts of interest possible, shareholders are best served by the profits being paid out in full.
2. Shifting the management’s focus
   Instead of fully commit and monitor the performance of the business, managers will will most likely work with one eye on the the stock performance. Many times decisions cheered on by the share market may lead to future disasters within the company or the other way around.
3. Fixed option has no downside
   While the owner of the company (i.e. shareholder) needs to bear all the capital costs, the fixed option holder bears no cost. The fixed option in its reality does only have upside and has no downside being sometimes compared to a “free lottery ticket”.

So can the option be ever used in the compensation scheme appropriately? Probably yes however some stringent rules would need to apply:

• Options should be priced realistically
  Too often the management puts in an extra effort to find out how low it can go with the price of options they are about to grant themselves. Obviously no owner is served well if a part of his business is sold for a bargain price either to an insider or to an outsider.

• Options only to managers with overall responsibility
  As options are tied to the overall performance of the business it does not make much sense to use them while rewarding a manager only responsible for one part of the business. Even if some departments and their managers perform poorly, the options reward them equally with all the other executives.
• Pricing structure needs to reflect retained capital
  As per above, the credit for profits made on retained earnings should not be automatically awarded to the option holders. Instead, as the interest earnings on retained funds grow, the options should allow for repricing to reflect that fact.

As can be seen, using the stock options in executives compensation schemes is less than ideal and more often than not it goes directly against the interest of the very owners of a company – the shareholders.

From an investor’s point of view, it is much more satisfactory to see a company using cash bonuses which are tied up to the performance of a particular manager in his area of responsibility, not the share price. Only if such manager than uses his bonus to purchase the company stock at market levels, are his interests truly aligned to those of the company owners.

For more information regarding this topic read Berkshire Hathaway Letter to Shareholders 1985.

This entry was posted on Wednesday, January 17th, 2007 at 3:32 pm and is filed under My View, Warren Buffett. You can follow any responses to this entry through the RSS feed. You can leave a response, or trackback from your own site.