I   confess that I might not have noticed the stir caused by Warren Buffett’s remarks in the 2005 Berkshire-Hathaway annual report in which he attacked buyback-option schemes if it were not for an unusual event.

That ‘event’ was a reporter from USA Today calling me to ask my opinion on what Mr. Buffet had said.

Really, a journalist from a newspaper that is known mainly for reporting the weather, sporting events, and the doings of television personalities called me showing interest in Federal Reserve flow of funds accounts and Capital Flow Analysis, discussing these arcane matters for almost half an hour — I was very surprised indeed!

Ben Graham Also Attacked Stock Buybacks

Now I’m not surprised that Warren Buffett does not favor stock buyback-option schemes.

His famous mentor, Benjamin Graham, three generations earlier, drew a very sharp ethical line against stock buybacks in any form, for any reason, even when a company’s stock traded below intrinsic value.

But Warren Buffett himself had waffled about stock buybacks over the years, not adopting the hard line of Benjamin Graham.

A Signal of Shifting Opinion?

The fact that Warren Buffett choose to come out against buybacks in the much-read Berkshire-Hathaway annual report, in a year when stock buybacks-option schemes had soared to absurd levels, may signal the beginning of a shift in the sociology of the U.S. stock market.

If stock-option buyback schemes fall into disfavor, one of the two pillars that support stock prices will collapse.

The other pillar, the Common Stock Legend, is already being questioned by none other than Professor Jeremy Siegel, one of its most famous proponents. (See earlier article.)

Warren Buffet Argues Against Buybacks

Because of the significance of stock buybacks to an understanding of capital flows, I am quoting from the Berkshire-Hathaway 2005 annual report at length:

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay.

The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock.

Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares.

If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80.

Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.

Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle.

Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was supposed to occur when Fred was issued options.

A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces less extreme results but still can provide lush rewards for managers who achieve nothing.

CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan.

Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.

It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists. (“Whose bread I eat, his song I sing.”)

Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets.

Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all-too-prevalent rule is that nothing succeeds like failure.

Now, I don’t want to quibble with this fine attack on buybacks-option schemes, because I agree with the idea that buybacks linked to options are unethical.

However, Mr. Buffett doesn’t make it clear that prices do not rise because of increased earnings-per-share, but rather because of the buying pressure of the buybacks themselves. In other words, motivated buyers (executives wanting to give value to their options) using all corporate money at their disposal, can force stock prices upwards.

But then, Warren Buffett probably never has heard of Capital Flow Analysis.

For more on this subject, see “Essays on Buybacks and Options“

This entry was posted on Friday, June 16th, 2006 at 11:26 am and is filed under Equities, Corporate Managers. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.

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