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Trite Munger quotes that hit me, H1'23: Incentives rule all
A few weeks ago, one of my friends took a “bad beat” on a college football bet. Given my friend’s track record of betting on sports, I would argue this beat was less a bad beat and more inline with the rest of his track record, but enough other gamblers took the bad beat that it got its own story on a few national sites, so I guess we can chalk that one up to bad luck and not his personal inability to analyze football games.
Anyway, at the time my friend took the bad beat, I was wrapping up my Trite Buffett quotes that hit me (23H1 edition) piece. The bad beat made me think of a quote from Charlie Munger (Buffett’s partner), so I couldn’t help writing a “Trite Munger quote” piece to go with my Buffett piece.
The Munger quote (which I believe is from Poor Charlie’s Alamanac?) I want to focus on today is on the power of incentives:
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.
So why does a football bad beat make me think of a Munger quote?
In the “bad beat” game, Iowa had been favored by 28.5 points heading into the game, and they were up 24 with the ball and thirty seconds left. In other words, the game was completely over; Iowa could just kneel, the game would end…. and betters who had Iowa’s opponent +28.5 would cover the spread and cash their checks (note I’m slightly simplifying here; it was actually fourth down, but they could have kneeled on the prior plays to end the game so what I’m saying holds).
Instead, Iowa rushed the ball and scored a touchdown, bringing their lead to 31 points. Those meaningless points resulted in Iowa “covering” the spread, so if you had bet against Iowa your bet lost.
Why would Iowa go for such meaningless points? Again, the game was completely over; most coaches would chose to kneel the ball and run out the clock for both sportsmanship purposes and to avoid the risk of a player getting injured on a throwaway play (football is a violent game; it’s absolutely not unheard of for players to get injured on meaningless plays. Cooper Kupp has ruined my fantasy football season this year, and a lot of his injuries date back to this hit on a meaningless play last year. The Chargers lost multiple key players before a playoff game when they played them in a meaningless regular season game last year).
It turns out that Iowa’s offensive coordinator has an unusual incentive clause in his contract that says the team must average 25 points per game (and win 7 games) or else his contract will terminate. That clause has proven somewhat controversial, but it’s yet another reminder: incentives drive outcomes, and poorly structured incentives can lead to a lot of suboptimal decision making.
The clause in question was clearly designed to say “hey, we want the team to be good and have a strong offense; if they’re not, then you’re fired.”
But the measurement designed in the contract is just suboptimal, and it could have disastrous consequences. Stranger things have happened than a football player blowing out their knee and ending their career on a single play. Imagine a world where a college student blows out their knee and ends their career on that meaningless run play. How much heat would Iowa be taking right now for trying to run up the score to hit the incentives?
Moving to my day job and the focus of this blog…. suboptimal contracts and incentives are a huge issue for investors; many investors consider the proxy statement the most important financial statement because it so clearly lays out what management is incentivized to do, and suboptimal incentivizes can encourage management to torch shareholder value or just do weird things. For example, few weeks ago, AHT’s bonus structure (from their 2022 proxy) went semi-viral because one of the key metrics was “investor/analyst interactions.” It’s one of the silliest objectives I’ve ever seen; meeting with hundreds investors and analyst adds no real value to a company. Yes, companies probably need to do some investor relations / discussions with analysts and investors to get feedback on their strategy and understand investors’ concerns, but encouraging management to average roughly 2 investor calls / interactions per business day feels like telling the management team to spend more time pumping the stock than actually focusing on the business. You get what you incentivize, and AHT’s management blew away that target by doing more that 700 interactions during the year.
So AHT went a little viral for that bit of malarkey…. but I think people were missing the forest for the trees by focusing on their investor/analyst bonus.
Take another look at that incentive structure; it’s one of the worst designed comp structures I’ve ever seen. Every single one of those metrics can be easily hit by any management team. There is not a single mention of what investors ultimately care about: per share value. AHT’s incentive structure is designed for management to just light money on fire; by aggressively issuing stock and doing overpriced deals, the management team can easily hit or significantly exceed every single target presented to them even though shareholders will be much, much poorer for it. Consider an extreme example: AHT gets paid for hitting $131m in EBITDA no matter how they get there. Say there’s an office building on the market that generates $131m/year in EBITDA; AHT would be incentivized to buy it at any price because they would hit their target. And I do mean any price, AHT could bid $100 trillion dollars (roughly the value of global GDP) for that single office building, which would clearly be a terrible idea and result in AHT incinerating roughly $100 trillion of value….. But it would not matter: AHT would hit their EBITDA target, and management would be up for a huge bonus.
Sure enough, with a bunch of easily achievable metrics, AHT’s management significantly exceeded every single goal laid out for them…. but that didn’t exactly translate into shareholder value. You could probably forgive shareholders for feeling like the target hitting was a bit of a pyrrhic victory, as AHT’s stock was more than cut in half through the year.
To turn this post back to Munger, Charlie is famous for…. well, a lot of things, but aside from being Buffett’s partner he’s probably most famous for his thoughts on incentives. On top of the quote I started out this post with, he had this gem:
“Never, ever, think about something else when you should be thinking about the power of incentives.”
Munger would likely describe Iowa’s and AHT’s incentive systems as “perverse”; here’s his thoughts on “perverse” incentives:
You do not want to be in a perverse incentive system that’s causing you to behave more and more foolishly or worse and worse — incentives are too powerful a control over human cognition or human behavior. If you’re in one [of these systems], I don’t have a solution for you. You’ll have to figure it out for yourself, but it’s a significant problem.
I’ve always been a big “show me the incentives” person, but the more I learn about investing the more I realize how right / powerful Munger’s quote is. Incentives are the most powerful driving force in investing.
And, the more I do this (I’ll leave that “this” dangling and let you decide if “this” refers to investing full time or writing a very thinly trafficked finance blog!), the more I realize that most company incentive systems are like AHT’s. Ok, maybe they’re not quite as bad, but just about any incentive can be gamed and hit if that’s all a management team cares about. Often hitting the targets will come at the expense of shareholders in some way, shape, or form, but the targets can get hit.
So the longer I do this, the more important it becomes to me that management teams have real “skin in the game.” The only way you can really ensure skin in the game / management alignment is if management will only get paid if and when shareholders do, and the only real way to ensure that alignment is to have an ethical management team that owns a lot of stock. Of course, having a management team own a huge amount of stock isn’t always possible for a variety of reasons (it’d be kind of crazy if Bezos retired from AMZN and one of the requirements for his successor was they needed to own a huge piece of the company, as they’d need to be a multi-billionaire already before they even took the CEO job!), so failing that set up the best option is generally to reward management teams with long term stock options or RSUs that only vest when the stock does well (something like Charter does). Those payoffs create a “management only wins when our shareholders win” dynamic, which is generally good….. but even those can be prone to gaming! For example, a management team could intentionally tank the stock price right before their options get struck in order to strike the options at artificially low prices (this is not terribly hard; just go on an earnings call and say “the environment is getting more competitive” or “our outlook is getting murkier” and the stock will drop ~10%!), or if a management team realizes that they probably won’t hit a price target they might be encouraged to lever up or gamble on a highly risky deal. If those bets work out, management will save their payouts; if they don’t, then shareholders will do dramatically worse but management’s “zero” payout won’t change.
There are no easy answers here. But incentives drive all, and one of the most powerful things for investors today is understanding the incentive system for the company they’re looking at. A good incentive system will encourage management to create shareholder value, but they’re few and far between. Most incentive systems are more like Iowa’s: the intention behind them is good, but they can ultimately be gamed to maximize payoff regardless of how much value is created for shareholders or the company.
And some incentive systems, of course, are like AHT’s: just flat silly.
Try to find the good ones, avoid the bad ones, and laugh at (and also avoid) the AHT ones.