Lunch Money Indicators

A lot of money managers, stocks analysts, and CEO's emerged from our recent tech bubble looking pretty foolish. Looking back on it now, it is hard to understand how so many reasonably intelligent people could have made so many dumb mistakes. At the peak of the bubble in the fall of 1999 a lot of these smart people had written off Warren Buffett. He was too old to get it, or that he just did not understand tech.

Yet now, with three years of perspective it is pretty clear that Buffett got it a lot better than anyone else. It is equally clear that Buffett's ability to judge the character of a company's management is nearly flawless. None of 40 some-odd wholly-owned subsidiaries has made the headlines; not one of the managers from any of these companies has been involved in any investigation into accounting artifice or financial scandal of any flavor. While some of the public companies in which Berkshire owns stock have seen their prices decline since the death of the bubble, it is largely because their stock price had been inflated by the bubble. These stocks are now just in the process of returning to what can be considered a reasonable valuation. It is remarkable that Berkshire, as large as it is, has been able to emerge totally untouched by the scandals that now seem almost ubiquitous.

Mr. Buffett has been quoted as saying that he looks for three things in his manager: intelligence, honesty and integrity. If they do not possess the last two characteristics, the first one will kill you. Now, because there is evidence everywhere you look, we can begin to understand the really profound nature of this simple statement.

At the 1997 Berkshire Hathaway Annual Meeting Buffett was discussing this criteria for judging managers at businesses that he was considering for acquisition or investment. He said that the integrity of the individuals running company was an absolute prerequisite to any business relationship with Berkshire Hathaway. Someone from the audience asked, "How do you know if a prospect has the proper attitude?" Warren smiled his wry smile and said something to the effect of "Well you can always leave your lunch money on the desk and leave the office." The line got a big laugh from the shareholders, as they contemplated this picture of a man worth 30 billion or so putting ten dollars at risk in order to save his investors hundreds of millions. Maybe he was serious, maybe he was not.

Personally, I got the impression that he was speaking metaphorically. Perhaps, he leaves a little money lying around or maybe he has system of tests that he applies to conduct of managers. And he uses these to judge how well an executive will use his shareholders money. This is Buffett's version of due diligence, one that does not require that he spend millions of dollars feeding lawyers and accountants.

So what are the best "Lunch Money Indicators?"

I can only guess about Buffett's ideas, but it is not too difficult to think of corporate behavior that tells you something important about the character of the people running the business. I would like to suggest a few simple tests that we can use that will help us judge the integrity of the managers. This is about watching what the managers do, not what they say. It is about identifying behavior that gives us clues to the character of a companies management, and about how they treat shareholders. Enron and the other bubble disasters have done the market a favor by bringing into focus the importance of assessing the integrity of management before making an investment. But even better we are left with a huge database of the type of behaviors that shareholders want to avoid.

Lunch Money Indicators

Lunch Money Indicators - a Check List for Character of Management. The list of Lunch Money Indicators below is tentative, and will change as we have further opportunity to observe management behavior. These Lunch Money Indicators are based on information that is generally availably to the public, and do not require a personal visit to corporate headquarters.

1. Ownership

We want are managers to act like owners. Perhaps the best indicator for this behavior is when the CEO owns a big piece (10% or better) of the company. Warren Buffett owns 39.1% of Berkshire Hathaway, the Arison Family owns 39% of Carnival Corp, and Russell Gerdin owns 40.4% of Heartland Express ...

2. Options

Ownership of options is not the same thing as owning the stock. If the CEO owns a lot of the company's stock he has a lot to lose if the price goes down, or if the company files for Chapter 11. If he own options he benefit's only if the price goes up, and has much less to loose if the price goes down. These are very different incentives and they can and will result in very different behavior. Lunch Money Indicators - Options Recently there has been a movement among some the better managed companies to expense options voluntarily, and to convert option programs to outright stock ownership. This kind of behavior is a strong positive indicator of management character. The voluntary expensing of options is a good indication that management is friendly to shareholders.

3. Executive Compensation

Whether options or cash, executive compensation is an expense that the shareholders pay. Obscene compensation is an indication that the managers love theirs paychecks more than they do the business. In his 2001 Chairman's Letter, Buffett promised Berkshire stockholders his personal economic results would continue to parallel theirs. Buffett said, "We will not take cash compensation, restricted stock or option grants that would make our results superior to yours," He continued, "Additionally, I will keep well over 99 percent of my net worth in Berkshire. My wife and I have never sold a share, nor do we intend to."

If the company's CEO compensation package makes you want to hold your nose, it is time to move on to the next idea.

4. Earnings Projections

Time and again the disasters of the last three years were the result of management trying to meet growth targets that were absurd, unrealistic, and totally unsupported by economic reality. Smooth earnings growth looks pretty, and it makes Wall Street happy, but it is a profoundly unnatural condition. Businesses is cyclical. The economy is cyclical. Pretty earnings are generally a sign that there is an artist at work in the accounting department.

"... Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers). Charlie and I not only don't know today what our businesses will earn next year - we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future - and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to "make the numbers" will at some point be tempted to make up the numbers." – Warren Buffett 2002 Chairman's Letter.

5. Capital Allocation

You can tell a lot about the integrity (and intelligence) of a company's management by studying how they spend the shareholder's money. Money that comes from stock offerings and retained earnings is shareholder money. But most CEO's think that since they can sign a check, the money is theirs to spend as they like. We do not want managers who engage in mergers for ego gratification or who buy back stock to keep their options "in the money." In either case they are using shareholder money to promote their personal goals. Other People's Money

Cheap money is usually bad for a stock because corporate CEOs think that if they are smart enough to get their hands on large piles of cash they must be smart enough to spend it. Build It and Money Will Come.

6. EBITDA

At a Berkshire Annual meeting, Charlie Munger said that if some officer connected with a prospective investee starts talking about EBITDA, it "is time to zip up the purse." The officer is trying to be too optimistic about his company's prospects. The problem is not so much that he is trying to kid the investor, but far worse, that he may well be successful in kidding himself.

In the 2002 Chairman's Letter, Buffett had the following advice for investors: "Beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen. Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a "non-cash" charge. That's nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business."

In an article written for the Washington Post in April 2002, Charlie said accountants have no business being optimistic. Accounting rules need to be changed because people will stay the same.

"Fools and knaves, like those at Enron, will always be with us and will be particularly active where big money can be made - for instance, in reporting ever-higher earnings." (Optimistic Accounting Is a Public Menace. Washingtonpost.com).

New money managers feel that pumping the stock is part of their job. But when a stock gets overpriced it means that new shareholders are entering with a lot of risk. In contrast to this, think of Berkshire's famous prospectus for the sale of the B Shares, where Berkshire offered stock for sale but Warren said that neither he nor Charlie would buy the stock at current prices.

7. Annual Reports

What would you rather see in a company's annual report, an accurate presentation of the financial records, or lots of pretty pictures? Lunch Money Indicators - Annual Report At the SEC Roundtable on Financial Disclosure and Auditor Oversight on March 4, 2002, Buffett indicated that the real problem was not so much a matter of more disclosure as was a matter of the quality of the disclosures to be made. He went on to list exactly what it was he would to like see in all annual reports:

"And, the CEO should write that letter as if he had one partner, and that partner has been away for a year. The partner is intelligent. He's somewhat versed in accounting terminology and finance 8 terminology, but he's no expert. He's interested because he has a large section of his net worth in the company. He's ready to be an indefinite shareholder – a shareholder for an indefinite period, if he's treated well. And, the CEO, if he has that mental picture of that partner, and just writes to that partner what's happened that year, I think that's going to be better than all the information that can be required by any rules. Because, the CEO has a definite desire to communicate to that partner."

"And, I say, the CEO's attitude should be what would I want, if our positions were reversed? It's that simple. I mean, what do I need to know?"

Footnotes

In the 2002 Chairman's Letter, Warren Buffett said this about financial statement footnotes, "Unintelligible footnotes usually indicate untrustworthy management. If you can't understand a footnote or other managerial explanation, it's usually because the CEO doesn't want you to. Enron's descriptions of certain transactions still baffle me."

8. Director Compensation

Charlie Munger says that the solution to the executive compensation is easy, do not pay directors: "I mean you've got the crazy booms and the crooked promotions - all you have to do is read the paper in the last six months. I mean there's enough vice to make us all choke. And by the way, everybody's mad about compensation at the top of American corporations, and they should be. Yet all these crazy nostrums invented by lawyers, and a solution is just so obvious they won't do it: If directors got a pay of zero, you'd be amazed what would happen to the compensation of corporate executives."

One of the easy ways for a corrupt CEO to control the board of directors is to provide directors with lavish perks, consulting fees, contracts with the a business owned by the director, directors fees, and expense accounts.

The conflicts of interest here are obvious and odious. Directors are supposed to represent the interests of shareholder. However, if the CEO is using shareholders money to pass around very nice cookies to directors, it is likely that the directors will end up more interested in the CEO's welfare than they are in protecting the shareholders' interest. We know that Munger's "modest proposal" has no chance of acceptance, but he certainly has done a good job at identifying at huge problem.

Does Losch Management Company expect to find a lot of companies where the management displays all of the above behavior? Not really - many good potential investments are weak in one or two of the above items. We are not looking for absolutes here, just a general "leaning toward the light."

Strongest Indicators

The strongest positive indicator is stock ownership by management and the strongest negative indicators are large stock option programs, and egregious CEO compensation, either one of which will immediately remove a company from my consideration as an investment.

Keep in mind that a good portfolio does not need 300 stocks. Buffett says that all new money managers should be given a ticket with twenty punches, and told that was the limit of stock selections for their career. This is an exaggeration, but the point he is trying to make, is that you do not need to own lots of stocks, all you need is a few good ones. In every investment the investor has to have faith in the people that are handing his money, so if the management fails the integrity test, the investor needs to find a new home for the money.

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