Warren Buffett and Charlie Munger on Stock Options and Executive Compensation

Warren Buffett and Charlie Munger have voiced their opinions on executive compensation many times in the past. Munger and Buffett have consistently spoken about the power of incentives and how executive compensation can play a role in management performance. In this article, I’ll discuss the wisdom the pair have shared over the years and some examples of businesses that have compensation structures aligned with the interests of shareholders.

Here are some quotes from Buffett and Munger on the subject:

We believe in tying incentive compensation to performance for which you have responsibility

Any option should have a step up in price that reflects the fact that money is reinvested by the shareholders annually

It’s perfectly appropriate to compensate them by options that in some way reflect the performance of that entire business. The trouble is that stock prices reflect factors other than the performance of the business.

If you have a dumb incentive system you get dumb outcomes

They (managers who own stock) face the downside of decisions as well as the upside. They incur a cost of capital and they can’t ‘reprice’ their stakes: What they paid is what they live with

As Buffett explained, managers holding stock options do not face the downside that shareholders face, so they are less incentivised to manage the downside risk of the business. As Munger explains below, managers owning stock would be the ideal way to align them with shareholders.

I am not totally wild about the extreme prevalence of the stock option modality in American corporate life. Personally I would vastly prefer different modalities which would probably involve stock instead of stock options

Some examples of compensation plans that don’t use excessive stock options and align management incentives with those of the shareholders are ARB and Costco.

ARB is a 4×4 vehicle accessories manufacturer and retailer from Australia. They do not grant options or even stock to key management personnel, as insiders own significant amounts of stock. Here is a quote from their 2022 annual report:

“The Company provides a remuneration package to all KMP which may incorporate both cash-based and non cash-based remuneration. The contracts for service between the Company and specified KMP are on a continuing basis, the terms of which are not expected to change in the immediate future. The remuneration policy is based on providing a fair and competitive annual remuneration package to KMP based on market related data. KMP do not participate in any short-term or long-term incentive arrangements. The Board does not believe that incentives based on the Company’s short term returns are appropriate to long term wealth creation for shareholders. The Board believes that the Managing Director and the Board as a whole are appropriately incentivised in the long term by their shareholdings in the Company.”

Costco differs from ARB in that they do offer Restricted Stock Units (“RSUs”), but still do not offer any stock options. They explain the details in their 2022 proxy statement:

  • “There were no options, warrants, or rights outstanding at August 28, 2022.”
  • Their RSUs are used to incentivise both short-term and long-term goals: “The Committee believes that emphasizing this form of compensation helps align the interests of employee-grantees with those of shareholders, both in the shorter term (with one-year performance conditions) and in the longer term (with share ownership requirements and time-based vesting of up to five years, subject to earlier vesting for long service, as described below).”
  • Costco also have stock ownership requirements: “Executive officers are required by the end of each calendar year to own and retain shares of Company common stock representing in value at least three times (seven times for the Chief Executive Officer) the base salary of the officer in effect at the beginning of the fiscal year”

Overall, since Costco awards executives with stock that vests over a 5 year period, management face the downside risk that shareholders face. 

These are two examples of companies that I believe have compensation structures aligned with the comments of Buffett and Munger.

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