The power of incentives. Book#75
In a world moving towards index funds, it is important to remember that institutional ownership passivity has disempowered shareholders and that’s terrible. Why ? Because if the owners of businesses don’t behave as such, who is in charge? The managers? Is that always sensible? Ever heard about the principal-agent problem? If not check this on wikipedia.
The principal–agent problem, in political science and economics, (also known as agency dilemma or the agency problem) occurs when one person or entity (the “agent”) is able to make decisions on behalf of, or that impact, another person or entity: the “principal”.[1] This dilemma exists in circumstances where agents are motivated to act in their own best interests, which are contrary to those of their principals, and is an example of moral hazard.
Why is that important? Because governance is the foundation of everything. It’s hard, and a business can flourish only if the incentives are aligned between management and shareholders.
Last year I came across this book “Dear Chairman” by Jefferson Gramm, recommended by Warren Buffett in his 2016 shareholder letter. The critics seemed very good too so that got me curious.
“A sharp and illuminating history of shareholder activism in the United States, Dear Chairman has been praised as ‘a terrific read’ by Andrew Ross Sorkin in the New York Times, ‘a revelation’ by the Financial Times, ‘a grand story’ by the Wall Street Journal, and ‘an engaging and informative book’ by the New Yorker. It was named one of best books of 2016 by the Financial Times.
The basis of each chapter lies in a letter, written by mainly by fund managers and stockholders to boards of public companies and/or other stockholders. All in all, it tells 8 detailed cases of shareholder activism. They include, Benjamin Graham, Warren Buffett, Dan Loeb, and Carl Icahn among others.
I personally found one story interesting. It’s one about a fight between the major shareholder of a company and its CEO, except that here they are husband and wife. She owned the company but her husband enjoyed the prestige of the CEO role and wanted to get things done his way. A good reminder of how ugly things can turn when people are not looking in the same direction.
Here are a couple of examples from Charlie Munger, not in the above mentionned book, but that I found on the web to illustrate the importance of incentives. FedEx — couldn’t get the planes to shift packages from plane to plane in a timely manner. The problem was that the workers were being paid per hour. When FedEx changed to paying the workers per shift, the workers were able to shift packages faster. Xerox — Joe Wilson had to return to Xerox to help figure out why their sales of older, inferior copy machines were outperforming those of newer, better machines. Wilson found the explanation in a perverse commission structure that incentivised selling the older machines more than the new machines. In the article Standard Causes of Human Misjudgment, Charlie Munger himself said:
“Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”
You can also listen to the speech here below.
Overall activism is by and large a good thing. Management needs to know that shareholders are watching over their shoulders and are able to react in case they don’t like what they see. But it’s not obvious that shareholders should always be active, sometimes the managers know best, for instance when to pay dividends and when to invest. Capital allocation is really an art.
On a side note, I found it funny that the author mentions his involvement in Tandy Leather Factory, since I happened to look at it by chance last year. It is a rather interesting and well-run niche business.
My purpose in life is independence, fulfilment and a better understanding of how the world works. Like Charlie Munger, I believe in the discipline of mastering the best that other people have ever figured out. And like Sir Isaac Newton, I believe in our ability to see further than any others before us by acknowledging that we are standing on the shoulders of giants. With this blog I hope to keep track of my learning about investing, business, decision making, entrepreneurship and self development while inspiring others to do the same. For the moment the format of this blog will be one post for each book that has influenced me, but I expect it to evolve over time. Join my Journey. John.
