In my previous wire, I highlighted a vital reality that hardly anybody has noticed (or, perhaps, wants to mention): remarkably few financial advisers, analysts, brokers, journalists, strategists and the like are financially independent. Few own sufficient investments to generate the stream of dividends, payments of interest or other income sources to finance their living expenses. Instead, they rely as heavily as the average adult does – that is, almost completely – upon their jobs and salaries. Morally, it’s concerning that many providers of financial services can’t practice what they preach. Empirically, it creates and worsens conflicts of interest that the 2018 banking Royal Commission didn’t even touch on.
In this wire, I show that if you’re determined to become financially independent, are nearing it or have achieved it, and you don’t wish to manage your own portfolio, then it’s logical to invest with a firm that charges no fees, pays no salaries or bonuses and no more than token directors’ fees.
Specifically, it’s sensible to seek an investment company whose directors, executives and managers receive remuneration in the form of dividends derived from the firm’s actual profits rather than salaries extracted from various fees. Such a firm will probably be owned and run by its major investors; moreover, their equity stakes in the company will likely comprise significant percentages of their total net worth. Accordingly, they – unlike employees – have plenty of balance sheet in the game. Their incentive is to act as stewards of capital rather than croupiers of fees and salaries. This firm’s manager-investors don’t need fees and salaries because they’re financially independent. They’ve already achieved for themselves what they’re helping their co-investors to attain.
In such a firm, you’re not a customer (the purchaser of products or services). Nor are you a client (recipient of professional support or service). Instead, you’re a partner-shareholder: you stand on a near-equal – rather than in a definitively secondary – position vis-á-vis the firm’s principals. This approach to corporate governance not only eliminates major conflicts of interest between manager-investors and non-executive investors. It also creates a confluence of interest that encourages the long-term orientation and shareholder focus that underpins superior long-term returns.
Investment rewards long-term stewardship
My previous wire highlighted the uncomfortable reality that few advisers, brokers and fund managers are financially independent. That’s because few are investors – and fewer still are value investors. They’re far more likely to be short-term, price-oriented speculators rather than long-term, value-oriented investors.
This is because advisers, brokers and fund managers derive almost all of their income from the labour they sell rather than the capital they own.
Many people – including finance professionals – routinely and unthinkingly call themselves investors. But ask them how much investment income they receive; also request that they express it as a percentage of their total income. If you get a straight answer, it might startle you: both the amount and the percentage are typically quite low – and often lower than their customers’ and clients’!
The income of these so-called professionals, in other words, comes primarily – indeed, overwhelmingly – from salaries. These, in turn, stem from job-based commissions, asset management and other fees, and short-term bonuses, rather than payments of interest, dividends and other income sources derived from ownership of stocks, bonds, real estate and other assets. Still, these employee-speculators insist that they’re investors!
It’s vital to understand the stark difference between – and the vastly different incentives that face – employees (who derive income from the labour they sell) and investors (who derive income from the capital they own).
“Show me the incentive,” says Charlie Munger, “and I’ll show you the behaviour.”
In this regard, three points are key:
- Investors can inventory their capital, but employees can’t store their labour – and what they don’t sell today disappears forever.
- Unlike capital, the value of an average individual’s labour doesn’t accumulate. As young workers gain experience, their salaries tend to rise – until they reach their 40s-50s. At that point, salaries stagnate; and by the time workers turn 60, they’re usually falling. In sharp contrast, and by steadily accumulating capital, investors’ income rises continuously.
- You can bequeath assets – but not a job and its salary – to your heirs. Having frittered their income on granite bench-tops, cruises down the Danube, etc., in their dotage salary-earners own few assets that they can leave to the next generation. Even worse, they usually transmit their spend-it-all-now ethos to their offspring.
For these and other reasons, the incentives and outlooks of employees are short-term and profligate; those of investors (when not corrupted by governments’ poor policies, which these days is, unfortunately, often) tend to be acquisitive and long-term – indeed, they can be inter-generational. Advisors, brokers and funds managers, who are employees and thus oriented towards short-term consumption, insist that they act in the interest of long-term investors. They don’t because they can’t – and they can’t because they lack the incentive. This mismatch of employees’ and customers’/clients’ incentives spawns severe conflicts of interest.
Show me the incentive, I’ll show you the behaviour
The previous paragraph’s last sentence is hardly news. “Evidence of lies, deceit and fraud just keep on coming at the Royal Commission,” ABC News reported on 26 April 2018, “much of it occurred under the noses of directors holding some of the country’s most prestigious positions.” These directors, as well as professional and regulatory bodies, ducked key questions: did they really not know? If not, why not? Whether or not they didn’t, or did know but did nothing, or did know and also abetted misconduct, criminality, etc., is now beside the point – namely that Australia’s financial services industry has been condemned. If it were a stock, it’d be a prime candidate for short sale.
ASIC’s deputy chairman told the Commission on 16 April that “poor conduct and consumer rip-offs” are so widespread that financial advisors and planners are “not entitled to call themselves professionals.” The Australian Financial Review (“The Remarkable Hypocrisy of AMP,” 20 April) concluded that the Commission “has exposed the industry’s gross hypocrisy” – it crows that it upholds the highest standards of ethics whilst picking its clients’ pockets. The Weekend Australian (“System Shaken to Its Core by Rogues,” 28-29 April) was blunt: “Thieves and liars want to get their hands on your money.”
Does anybody seriously believe that the Commission’s recommendations – which the Commonwealth Government accepted virtually in full but has been painfully slow to implement – will significantly change anything for the better?
Tragically for outsiders and conveniently for insiders, very few people comprehend that pervasive incompetence, systematic malfeasance and outright criminality are not problems: they’re merely symptoms of a longstanding underlying disease. The ancient Roman poet, Juvenal, famously asked: “who will guard the guardians?” Don Chipp, the ex-Liberal cabinet minister and first leader of the Australian Democrats, put this question in trenchantly Australian terms: who’ll “keep the bastards honest”? Whether in its classical or contemporary guise, the Commission fumbled an enduring and fundamental problem: how can people in positions of responsibility be held to account? Referring to financial services, we might modify Juvenel’s question: who advises the advisors? Who manages the managers? Who regulates the regulators?
How to mitigate, if not resolve, Juvenel’s ancient problem? Jack Lang, the premier of NSW (1925-27, 1930-31), quipped the key to a young Paul Keating: “always back the horse named self-interest. At least you’ll know it’ll be trying.” What’s absolutely necessary is a radical realignment of incentives such that those of directors, executives and managers match those of shareholders – and that customers and client become shareholders. Unfortunately, the Royal Commission completely overlooked this principle. Its Final Report used the word “incentive” 41 times and “culture” 282 times. The Report’s relentless repetition of the “c” word evokes the witticism misattributed to Hermann Göring: “whenever I hear the word culture, I reach for my revolver.”
If this radical realignment of incentives occurred, what would be the result? Consider as a simple example an investment company that has no employees – only directors (essential administrative functions normally performed by employees have been outsourced). Moreover, these directors receive no salaries, no bonuses and no more than token directors’ fees. Second, this company has no customers or clients – only shareholders. Third, its directors are major shareholders. Finally, shares haven’t been awarded or granted to directors: they’ve paid for them and participated in the company’s DRP on the same terms and conditions as all other shareholders.
This company’s employees can’t cheat its clients: there are neither employees to do the double-dealing nor clients to deceive. Moreover, because the company’s directors are its biggest owners, and their stakes in the company comprise meaningful percentages of their total wealth, through these stakes they have plenty of skin – indeed, for than anybody else – in this company. Hence any attempt by directors to dud the company’s shareholders would – because it’d harm directors more than anybody else – be self-defeating.
Like Warren Buffett, Charlie Munger and others at Berkshire Hathaway, such a company’s director-shareholders possess a strong motive to act as long-term stewards of capital rather than short-term extractors of fees and salaries. This company’s director-shareholders receive not a penny of salary; instead, they receive a percentage of cash profits. In order to increase the dollar amount of their dividends, they must lift their firm’s profitability and reinvest their dividends. Consequently, their incentive is to undertake long-term investment – and in the short-term, to minimise costs.
Conclusion: Buffett’s “Unique ‘Owner-CEO’ method”
“Culture” isn’t unimportant. Ironically, however, the Royal Commission and the babblers in the mainstream media and universities utterly misunderstand why it’s vital. Incentives underpin “culture” – and an alignment of incentives creates an ethical “culture.” Aligned incentives have other happy consequences. For example, they proscribe the inane and fraudulent statements of “corporate values” that have grown like weeds in recent years. The Royal Commission abundantly confirmed that such statements are mere compendia of babble, cant, drivel, hypocrisy and outright bald-faced lies. They’re not merely an insult to the sentient reader’s intelligence. They’re worse than useless: they use flowery language to promise, in effect, that employees will love their customers (as opposed to clients or shareholders) as they love themselves – whilst distracting customers’ attention from employees’ incentives to mislead, cheat and steal.
In diametric contrast, the aforementioned alignment of incentives is very similar to – but even purer than – Warren Buffett’s. He and the CEOs of Berkshire’s wholly-owned subsidiaries receive comparatively low salaries: Buffett’s, for example, has been fixed at $100,000 per year since the 1980s. That’s less than 1% of the median ($US12.5 million) annual compensation of a Fortune 500 CEO. Moreover, neither Buffett nor any of his executives receive options over shares. Critically, however, although their salaries are comparatively modest, Buffett’s and his lieutenants’ net worth is immense. That’s because significant numbers of them have sold to Berkshire the businesses they founded.
In his Letter to Shareholders (1989), Buffett wrote: “Most of [Berkshire’s] managers have no need to work for a living; they show up at the ballpark because they like to hit home runs. And that’s exactly what they do.” In Robert Miles’ words (The Warren Buffett CEO: Secrets from the Berkshire Hathaway Managers, John Wiley & Sons, 2002),
Berkshire has a select group of managers. Primarily, they are centimillionaires who work hard for billionaire board members and long-term millionaire shareholders … This unique structure has led to superior investment and management successes and has proven to be Buffett’s finest cultural and structural strategy (pp. 4-5) … The “owner-CEO” method is the best way to align the interests of the long-term shareholder with those of the manager (p. 350; italics added).