Warren Buffett and Charlie Munger on Options, Black-Scholes, and Executive Compensation

Understanding Options and Their Value

Warren Buffett and Charlie Munger have spent their lives thinking about options. Buffett emphasizes that while one doesn't need to understand complex models like Black-Scholes, it's crucial to grasp the general utility and value of options, as well as the cost of issuing them.

The Inherent Value of Options

Buffett illustrates this concept with a personal anecdote:

"I bought a house in 1958 for $31,500. Let's assume the seller had said, 'I'd like an option on it, good in perpetuity, at $200,000.' That wouldn't have seemed like it cost me much if I'd given it to him, but an option has value. Any option has value."

This fundamental principle explains why some savvy businesspeople sometimes acquire options for very little or even nothing. The key is recognizing that options, regardless of the underlying asset, always carry inherent value.

The Black-Scholes Model: A Critical Perspective

The Black-Scholes model is an attempt to measure the market value of options. It incorporates various variables, with past volatility being a crucial factor. However, Buffett and Munger argue that this approach has significant limitations.

Limitations of Black-Scholes

1. Past Volatility: The model relies heavily on historical volatility, which may not be the best predictor of future value.
2. Mispricing: For longer-term options, Black-Scholes can produce nonsensical results.
3. Mechanical Nature: As a formulaic system, it fails to account for nuanced understanding of businesses and markets.

Charlie Munger describes Black-Scholes as a "know-nothing value system," suggesting it's only useful when price is the only available information. For short-term options (e.g., 90 days), it may provide reasonable estimates. However, for longer-term options, its utility diminishes significantly.

Exploiting Model Weaknesses

Buffett reveals how Berkshire Hathaway has profited from the model's limitations:

"We made one large commitment that basically had somebody on the other side using Black-Scholes and using market prices. We made $120 million last year, and we love the idea of other people using mechanistic formulas to price things."

This anecdote underscores the potential for savvy investors to capitalize on the model's shortcomings when they have a deeper understanding of value.

Executive Compensation: Aligning Interests

The discussion shifts to the critical issue of aligning employee compensation with shareholder interests. Buffett and Munger offer a scathing critique of prevalent compensation practices in corporate America.

Berkshire's Approach to Compensation

Berkshire Hathaway's compensation system differs significantly from most large corporations. Key aspects include:

1. Performance-Based: They believe in paying for performance that is under the reasonable control of the individual.
2. Avoiding Lottery Tickets: They reject the idea of giving options that act as lottery tickets on overall company performance.
3. Tailored Incentives: Berkshire uses various incentive programs that are similar to properly designed option systems, including cost of capital and other relevant factors.

Munger emphasizes that their system is "less capricious" than traditional stock option systems, which can result in extraordinarily liberal awards to some and nothing to others, regardless of individual contributions.

Critique of Widespread Compensation Practices

Buffett and Munger are highly critical of prevailing executive compensation systems:

1. Wealth Transfer: Buffett notes an unprecedented wealth transfer in corporate America over the past five years.
2. Misaligned Interests: Traditional options can create conflicts between executives and shareholders, particularly regarding dividends and retained earnings.
3. Repricing: They criticize the practice of repricing options when stock prices fall, effectively giving executives a "free ride."

Munger goes so far as to say that "more than 99 percent of corporate compensation systems are more than a little crazy in America."

The Compensation Negotiation Problem

Buffett delves into the fundamental issues with how executive compensation is determined in many large corporations.

Lack of True Negotiation

Unlike other business negotiations, executive compensation often lacks a true adversarial process:

1. Imbalanced Interests: The executive has an enormous interest in the compensation amount, while the board members often deal with what Buffett's friend Tom Murphy called "play money."
2. Comp Committees: These are often not selected for their toughness in negotiations.
3. Consultants: Compensation consultants are incentivized to recommend higher pay and rarely suggest salary reductions or executive removals.

Buffett states, "I have never seen a comp consultant come in and say we ought to reduce this guy's salary. I've also never seen a comp consultant come in and say, 'Why don't you get rid of this bozo?'"

The Need for Reform

Buffett sees executive compensation as the "acid test of corporate reform." He argues that significant shareholders must provide a countervailing force to prevent:

1. Continued disparity between top executive pay and worker compensation
2. Disconnect between executive compensation and shareholder returns

Berkshire's Philosophy on Wealth Creation

Despite their criticisms, Buffett and Munger emphasize that Berkshire is not against rewarding exceptional performance:

"We're not against rewards for people who make vast contributions, but a system that's basically capricious and which doesn't tailor the results per person and per activity very well, we just think it's crazy."

They express enthusiasm for seeing Berkshire-associated individuals prosper, provided they're simultaneously creating value for shareholders.

Implications for Investors and Corporate Governance

The insights shared by Buffett and Munger have significant implications for investors and those involved in corporate governance:

1. Scrutinize Compensation Systems: Investors should closely examine how companies structure their executive compensation and whether it truly aligns with shareholder interests.
2. Value of Fundamental Analysis: The discussion on Black-Scholes highlights the importance of understanding a business's intrinsic value rather than relying solely on mathematical models.
3. Long-Term Perspective: Berkshire's approach emphasizes long-term value creation over short-term gains or manipulating metrics.
4. Shareholder Activism: There's a call for more active engagement from shareholders, particularly large institutional investors, in shaping compensation policies.

The Broader Economic Impact

The issues raised by Buffett and Munger extend beyond individual companies and investors, touching on broader economic and social concerns:

1. Income Inequality: The growing disparity between executive and worker compensation contributes to wider societal income inequality.
2. Market Efficiency: Misaligned incentives and flawed valuation models can lead to market inefficiencies and misallocation of capital.
3. Corporate Culture: Compensation systems significantly influence corporate culture and decision-making at all levels.

Lessons for Business Leaders

For current and aspiring business leaders, the discussion offers several key takeaways:

1. Align Incentives: Design compensation systems that truly align with long-term value creation for all stakeholders.
2. Understand Value: Develop a deep understanding of value that goes beyond simplistic models or market prices.
3. Ethical Leadership: Recognize the ethical implications of compensation decisions and their impact on organizational culture.
4. Critical Thinking: Question prevailing wisdom and popular models, especially when they conflict with fundamental business principles.

The Future of Corporate Compensation

As investors and regulators increasingly scrutinize executive compensation, companies may need to evolve their practices. Potential changes could include:

1. Greater Transparency: More detailed disclosure of compensation rationales and metrics.
2. Longer-Term Incentives: Increased use of long-term performance measures and holding periods for equity awards.
3. Broader Stakeholder Consideration: Incorporating metrics related to employee satisfaction, customer loyalty, and environmental impact.
4. Simplified Structures: Moving away from complex option schemes towards more straightforward and understandable compensation packages.

Conclusion

Warren Buffett and Charlie Munger's discussion on options, the Black-Scholes model, and executive compensation offers a wealth of insights for investors, business leaders, and policymakers. Their critique of prevailing practices challenges us to rethink fundamental aspects of corporate finance and governance.

By emphasizing the importance of understanding intrinsic value, aligning incentives, and maintaining a long-term perspective, they provide a framework for more sustainable and equitable business practices. As the corporate world continues to evolve, the principles espoused by these legendary investors remain as relevant as ever.

Their call for reform in executive compensation serves as a reminder of the ongoing need for vigilance and active engagement from shareholders and board members. Only through such efforts can we hope to create a corporate environment that truly serves the interests of all stakeholders while driving long-term value creation.

Ultimately, the wisdom shared by Buffett and Munger transcends the specific topics discussed, offering broader lessons on critical thinking, ethical leadership, and the enduring principles of sound business management and investment.

Article created from: https://www.youtube.com/watch?v=H4X-4e7fPgI