Devoted to Managers and those that seek to improve their management skills

Buffett Believes in a Principled Approach to Executive Pay

Buffett has talked at times about how easy it can be to be misled by a management's return on capital. He said it this way:

“Just quadruple the capital you commit to a savings account and you will quadruple your earnings. A savings account in which interest was reinvested would achieve the same year-by-year increase in earnings—and, at only 8% interest, would quadruple its annual earnings in 18 years.” The point he was making is that the goal of management isn't average risk-free returns, but the goal should always be superior returns.

This is why he has fought at times against what he considers executive pay that's not based upon performance. If you throw more money at something, even if the returns are the same as the year before, over a period of time it will eventually show some growth. But it can make it look like the returns are superior, when in reality they're not.

What's interesting about all of this is that when many people think of Buffett they think of him as risk-averse, which isn't even close to being true. That may depend upon your definition of what risk-averse means. But how I mean it and how Buffett lives it is that he's not afraid to take risk at all, as his returns over the decades have shown. But he won't take risk if he doesn't know an area, and he won't take risk even if he does know a field, unless he knows the chances of high returns are built into the investment.

That can either be done through finding undervalued companies, or it can be done through some of the products of the companies themselves - especially the insurance firms. He's said more than once that he'll insure anything in the world, the only caveat being if you're willing to pay the premium. Buffett took calculated and healthy risks that brought real returns ... which brings us back to the executive pay.

What he's saying is that superior returns must be measured properly, not by simply throwing more money at something and making the same returns as before, but looking like they've increased greatly. That's a way of making it look like a manager is overperfoming, and so is rewarded accordingly, when in fact nothing has really changed at all.

Management pay, in his opinion, should be based upon superior returns, not playing around with money in the safest way possible to make it look like the company has had a strong return on capital when it really hasn't. I think he's right. Yet this is done quite often and many investors or shareholders are never wise to it even happening, even though it's a simple trick to perform and see. I agree that we should have a principled approach to executive pay as well.

I think it would cause business leaders to learn to make decisions based upon the long-term, and train and disipline themselves to know how to grow a company that brings real superior returns, rather than manufactured ones.

Other Buffett Resources:

Wisdom of Warren Buffett

Warren Buffett, investor

Warren Buffett: The trouble with being a legend

Warren Buffett: 'I told you so'

Company growth