Client Letter August 2000
Anyone who has read a Berkshire Annual Report Knows how Warren feels about stock options. "... they (stock options) are more often wildly capricious in their distribution of rewards, inefficient as motivators, and inordinately expensive for shareholders."
His objections to the accounting fiction evolved are well known, "If stock options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"
Damaging as this fiction is, I am not sure this will be the only source of grief generated by the stock option mania. It is bad enough that shareholder must watch as his interest in the company is diluted in order to enrich employees, but how do these "capricious" rewards influence the behavior of the management that is supposed to be running the company for the benefit of their shareholder partners.
Superficially it would appear that the options offered, as an incentive to the employee manager would work to encourage the manager to pursue the interests of the shareholder. The employee can only benefit if the price of the stock goes up. But in practice this is not always the way things work out. It is also possible for the options to encourage behavior deleterious to the interest of the long-term investor.
For example consider the case of A CFO who receives a large part of his compensation from stocks options. He may have little direct operational responsibility for what happens to the bottom line but by practicing his art in creative fashion can influence the bottom line (and therefore hopefully the stock price) though artifice. It seems logical that this incentive while it might serve the shareholders interest in the short run can lead eventual to accounting games and therefore, occasionally to disaster. The owner with all of his net worth tied to his business is in very different position than the young manager who exercises his options and sells the stock as soon as it goes up.
A couple of months ago I did a study of four small retail stocks: American Eagle, Pacific Sun, Buckle, and Abercrombie and Fitch. At the time I wondered about the store growth rate, (the number of new stores that the respective chains planned to open during 2000.
This store growth ranged from conservative (10%), at Buckle to very aggressive (36%) at Abercombie. All these chains were quite profitable and had plenty of cash available to fund an aggressive growth policy. So why was Buckle was willing to commit only to only 15.4% of its available cash for new stores while Abercrombie was planning to spend 50.4% percent of available cash on new stores plus fund a 70 Million buy back of common stock at the same time?
Recently I decided to look at ownership of the Companies by the top managers to see if this might have had some influence on the company's growth policies. I quick review to the proxy statements for these companies revealed the following facts:
- Abercrombie's CEO Michael Jeffries owns only 1,331,357 shares outright (about 1 ½%), but has options on 8,600,000 more shares
- American Eagle's Chairman Jay Schottenstein and his family control 67% of the Company's stock by outright ownership.
- Buckle's Chairman Daniel Hirschfeld owns 64.6% of the stock outright.
- Greg Weaver at Pacific Sun owns 421,600 share out right (1.1/2%) and has options on another 979,000 shares.
This in no way is a comprehensive survey. But if it was what would it tell us about management behavior? It would appear obvious that outright ownership of a large stock position leads to entirely different behavior than Ownership of stock options. The two companies with the most conservative management philosophy where companies where top management had large Ownership positions. It does not take a genius to figure this out, the owner already has considerable wealth and is more concerned with the long-term viability of the business that with the price of the stock. He has less to gain from taking risks and a lot more to lose. As a stockholder (other things being equal) you want a partner that has real money invested in the business.
The Company were top management has a large number of stock options relative to the size of his out right holdings had the most aggressive growth policy, and is ready to spend a significant portion of its cash reserve on the repurchasing the companies stock. Again it does not take a genius to figure what is going on. The manager has less to lose and more to gain from taking risks. If the Stock does not go up his option either will not vest or will become worthless. If his ownership position is small but he has many options his maximum reward may come from rolling the dice.
Perhaps it is a stretch to generalize this sort of behavior over a broad segment of American business, but let's look at one more fact. Friday's Wall Street Journal contained a story about the credit quality of US Corporations. It seems that Corporate debt as a percent of equity has been increasing rapidly since it hit a low of 70% in 1997. During a time when corporate profits are at the highest level in history, corporations are borrowing like crazy. Do these businesses really need to spend all that money or are they just funding unreasonable growth programs and borrowing to buy back stock because they want to push the price of the stock past the strike price and cash in on their option programs?
The distortions caused by stock options are not limited to accounting fictions and cash flow windfalls, and the eventual economic damage may not be limited to the shareholders of tech stocks.
Those of you that have read your statements may have noticed that Zindart has disappeared. This was a stock that was purchased because it was cheap (PE of 6) and because it had no debt. Sometime after our purchase the company announced an acquisition and borrowed money to finance the purchase. I could have exited with the announcement because of my aversion to debt and my usual skepticism of a CEO's motives for acquisitions, but I decided to wait a few months and observe.
In many cases it is the investment management's ego that is the diving motivation behind the merger process and they become blind to potential financial problems. Unfortunately now it appears that this was indeed an ego based acquisition (the debt level is still high and earnings are trending down) and thus the disappearance of Zindart.