Leithner & Co Pty Ltd - ...And Brickbats for Share Options

This episode illuminates Mr Buffett’s principles about the motivation of managers and his practice with respect to their remuneration. He has often expressed disdain for options and has never granted them to the managers of Berkshire’s subsidiaries. Moreover, the salaries received by these managers, relative to those prevailing in their respective industries, are not excessive. (Moreover, practising what he preaches, Mr Buffett has never received options and has long been among the lowest-paid executives of a Fortune-500 company).

He does, however, write bonus cheques – sometimes for very large amounts – to managers who achieve operational results which meet or exceed pre-agreed standards. As a result of these and other practices, Berkshire’s subsidiaries are run by some of the most capable executives in American industry. And arguably more than any other corporation, Berkshire is dedicated to the financial well-being of its shareholders. These characteristics make Mr Buffett and Berkshire Hathaway unique. And as recent events attest, they also put several of Australia’s largest and most prominent companies to shame.

The prominence of exchange-traded options, launched in Australia in 1976, has grown enormously during the past quarter-century. Although their importance here and elsewhere owes much to the financial market deregulation of the 1980s and 1990s, their origins and existence are by no means recent. As noted by Edna Carew in her readable book Derivatives Decoded, option contracts date from at least the Middle Ages, and in the seventeenth century options over tulips were traded in England and Holland. (Why tulips? The answer is quite relevant to today’s market participants, but is another story for another day.)

An equity call option (also known as a call option over the shares of a company) is a contract between a buyer (or recipient) and a seller (or provider) which grants the buyer the right – - but not the obligation – to buy a stipulated number of shares from the seller at a set price (the “strike“ or “exercise“ price) on or before a pre-determined date.

One call option gives its owner the right to buy 1,000 shares. If you buy a BHP September 2000 call $21.50 option, you have the right to buy 1,000 shares of Broken Hill Proprietary Co. Ltd at a price of $21.50 on or before 30 September. Clearly, the more the price of BHP shares increases between now and the option’s expiry, the more valuable an option over those shares becomes. Suppose you bought the option for $0.58 on 15 February. This means that the exercise of the option will cost $580 (since an option contract is based upon 1,000 shares). If the price of BHP climbs to $23.00 on or before 30 September, then the option can be exercised at a total cost of $22,080 (i.e., $21,500 for the shares plus $580 for the option) and the shares immediately sold for $23,000. This operation yields a net profit of $920 and a return of 158% (i.e. $920/$580); and if the option was granted to you at no cost, then you gain the full $23,000 and “earn“ an infinite return on your outlay of $0.00.

Clearly, then, the recipient of a call option thus incurs a limited and specific risk. Indeed, a call option is arguably the least-risky of the large and growing number of derivative instruments. When purchasing an option, the premium paid represents the maximum loss which the buyer can incur – irrespective of subsequent trends and movements in the price of the underlying asset. Depending upon the increase (if it eventuates) in the price of the underlying asset, however, the buyer’s potential for gain is great. And if the option is granted and the recipient pays nothing for it, then the recipient gains if the price of the underlying asset increases but loses nothing if it decreases.

Indeed, under these conditions the only risk faced by the recipient is the risk that the seller will not be able to fulfil the obligations of the options contract when the recipient exercises it. Conversely, the seller of a call option incurs a much less clearly defined and potentially much greater risk. The seller’s maximum gain is the amount (if any) received through the sale of the option. The greater the increase (if it eventuates) in the price of the underlying asset, however, the greater the seller’s loss.

The conventional wisdom about options over shares asserts that they align the interests of managers and shareholders. An article published in The Australian on 24 February, for example, stated that “options are the most powerful tool capitalism has so far found to align the incentives of workers with employers. This approach is good for everyone, given the tax-advantaged, off-income-statement status of this form of compensation.”

The reality, however, is completely different. Just as they cannot evade the risk which attaches to the ownership of capital, shareholders cannot evade the risk which is created when they sell or grant options to executives. As the owner of an option, on the other hand, an executive bears no such risk. In Mr Buffett’s words, “alignment [between shareholders and managers should mean] being a partner in both directions, not just on the upside. Many ‘alignment’ [option] plans flunk this basic test, being artful forms of “heads I win, tails you lose.”

The option plans granted to Australian executives seldom increase the strike price of the option in order to compensate for the accumulation of retained earnings within the company. Nor, as a rule, do they specify a return on equity or similar threshold. Indeed, on the editorial page of The Australian Financial Review in August 1999, Fairfax Ltd CEO Prof Fred Hilmer argued that executives’ remuneration packages should not contain performance hurdles. Accordingly, more often than not option arrangements in this country simply specify the future share price which places the options “in the money.” As a result, the combination of a five-year option, average dividend payout ratio and average rates of simple compound interest can provide considerable gains to an executive who does nothing but simply mark time.

To see this, consider a simple set of examples inspired by a passage in Berkshire’s 1985 Letter to Shareholders. Suppose that you are the sole shareholder in a company which has $1m of equity and earns 7% on that equity. Suppose further that at the end of each year for five years you receive a dividend equal to one-half of that year’s earnings, and that management retains the remainder within the company.

Note that this example is identical in its fundamentals to a savings account with an initial balance of $1m earning interest at the rate of 7% per annum. (It is also identical to a bond with a 7% coupon. For extended periods during the 1990s, it was possible to buy a risk-free 5-year Commonwealth bond with a 7% yield; indeed, it was possible to do so in January of this year). At the end of each year, you withdraw an amount equal to one-half of the interest earned in that year and retain the remainder in the account to compound.

	7% Interest-ROE	11% Interest-ROE	16% Interest-ROE
Beginning Balance-Equity	$1,000,000	$1,000,000	$1,000,000
Final Balance-Equity	$1,187,690	$1,306,970	$1,469,330

First Year’s Earnings-Interest	$70,000	$110,000	$160,000
Final Year’s Earnings-Interest	$80,330	$136,270	$217,680
Total Earnings-Interest	$375,380	$613,920	$938,650

First Year’s Dividend-Amount Withdrawn	$35,000	$55,000	$80,000
Final Year’s Dividend-Amount Withdrawn	$40,160	$68,140	$108,840
Total Dividends-Amounts Withdrawn	$187,690	$306,970	$469,330

Under these assumptions, and as shown in the second column of the table, at the end of 5 years the equity in your company/balance in your account has grown from $1m to $1.19m. The company’s annual earnings/interest earned by the account have increased by 15%, from $70,000 to $80,330; and your annual dividend/amount withdrawn has also increased by 15%, from $35,000 to $40,160.

It is in this respect that the logical equivalence – and the identical returns – of the company, the bank account and the risk-free bond become critical. As long as the interest rate/return on equity is positive, managers need hardly lift a finger in order to report annual increases in earnings and dividends: they need do no more than simply retain and re-invest a portion of their annual earnings. And they can do this simply by stuffing those retained earnings into a bank or buying risk-free government bonds. If for an extended period of time they return no more than 7% on capital – if, in other words, their return is no better than a bank deposit or government security – then they have done nothing whatever to provide a real return on capital and thereby deserve no reward for their effort.

Yet Australian companies regularly praise and reward executives who increase earnings. They often do so, however, without examining whether this increase can be attributed simply to the retention of earnings at average rates of compound interest and the passage of time. As a result, according to Buffett many companies issue stock options whose value increases simply because earnings have been retained – not because the retained capital has earned superior or even good returns. Shareholders, as we have seen, bear all of the risk implied by the issue of options over shares. Option holders, in contrast, bear none of this risk. Moreover, stock options are often irrevocable, unconditional and benefit managers without regard to their individual performance. Many companies, in other words, use a system of remuneration which has a multitude of carrots but no sticks (and almost invariably considers the opportunity cost of retained earnings and equity capital to be zero). Mr Buffett concludes that “a managerial Rip Van Winkle, who wants nothing more than to doze for five years, could not devise a better ‘incentive’ system.”

It is also worth noting that, from the standpoint of shareholders, share buybacks and options sit at opposite ends of the value-for-money spectrum. As demonstrated in the circular dated 1 April, properly-structured buybacks promote returns to shareholders and improperly structured ones (such as those undertaken at high prices and financed with debt) retard them. So too – and for similar reasons – does the exercise of options over shares. They expand the company’s number of shares without expanding its capital, thereby diluting shareholders’ stake in the company. Accordingly – and unless accompanied by compensating increases in earnings – they depress earnings per share, book value per share and return on shareholder equity.

If, on the other hand, the company is able consistently to earn a superior return on capital (including retained earnings) throughout a (say) 5-year period, and if those superior returns can be plausibly attributed to superior management (as opposed, for example, to favourable economic tailwinds), then plaudits and commensurate remuneration are in order. Column 4 of the table shows the results which obtain if the company’s return on equity increases to 15% for 5 years. At the end of this period, shareholders’ equity has grown from $1m to $1.47m. The company’s annual earnings have increased by 36%, from $160,000 to $217,680; and the annual dividend has also increased by 36%, from $80,000 to $108,840. Under these circumstances, returns in excess of those available from bank deposits or government securities have been created for shareholders. It is to a portion of those returns in excess of “risk free“ returns – and not to the total return without reference to this or other performance standard – that management may have some moral claim.

Elementary logic and simple mathematics such as those set out in this circular are virtually always ignored when companies set their managers’ remuneration. This oversight can and does harm shareholders. It cannot be overemphasised that shareholders are the owners of a business’s capital. Its managers, in turn, are the custodians of that capital. The best managers should and do make decisions (i.e., allocate shareholders’ capital) as if they were shareholders. Ideally, then, managers will own a substantial number of the company’s shares – and will have bought them on-market, using their own cash derived from salary and cash bonuses earned by achieving operational results which meet or exceed pre-agreed standards. It is noteworthy that Warren Buffett built his fortune in Buffett Partnership Ltd and Berkshire Hathaway in exactly this way.

Mr Buffett stresses that performance should be the basis for executive remuneration. Executive performance, in turn, should be measured by profitability (i.e., return on equity); and for this purpose profitability should reflect a charge for the capital employed in the business, the earnings retained by it or both. Options over shares fail on these and other counts. Notwithstanding their ubiquity, they should therefore not be a part of an executive’s compensation.

Yet few Australian companies, it seems to me, truly understand and practice the principle of executive-reward-in-exchange-for-excellent- performance. The comments of one prominent and newly-installed executive speaks volumes about this point. As reported in The Australian Financial Review on 18 February, in response to a question at the presentation of the company’s half-yearly results the executive said “I certainly think it is very important the executive [sic] compensation should relate very strongly to the performance of the corporation and be performance-based.” So far (by Australian standards) so good. And by what criterion should corporate performance be judged? The executive responded that this must entail more than merely growth in earnings per share: “it has to do with intelligence and guts, with ethical standards, with the management of human capital. Usually the stock price will reflect that, but not always.” Oh, my goodness me. (the AFR reported that last year this criterion-challenged executive earned $A386,736 in director’s fees).

Manitou Investment Capital Limited, a Canadian investment firm based at Toronto, has written a provocative article about stock options. Its macro perspective nicely complements this circular’s micro orientation. The Amazing Stock Option Bubble documents the distortions and damage to the broader economy which options may cause.