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Why I’m Biased Against Stock Options

Someone who listens to the podcast emailed this question:

“I’ve heard Geoff speak about not liking management with tons of stock options but preferring they have raw equity. Could you elaborate on the reasons why? Is it because they have more skin in the game by sharing the downside with raw equity? Thoughts on raw equity vs equity vesting schedule?”

(ASK GEOFF A QUESTION OF YOUR OWN)

This is just a personal bias based on my own experience investing in companies. There is theoretically nothing wrong with using stock options instead of granting shares to someone. And, in practice, later hires are pretty much going to need to be given stock options or some other kind of outright grants. Otherwise, they’ll never build up much equity in the company.

I basically have three concerns about stock options. One is simple enough to sum up in a sentence. Obviously, CEOs and other insiders are very involved in setting the stock options they get. Other things equal, the bigger the option grants the more likely insiders are especially greedy. I’m not sure I want to own stock in a company run by especially greedy people. This might work if you had active control of the company. But, you’re going to be a passive outside shareholder. You don’t really have oversight powers as you would as a 100% private business owner. So, especially greedy insiders are probably ones you don’t want running your company. Big option grants (and low actual stock ownership) can be a symptom of unchecked insider greed.

Okay. We got the simple one out of the way. Now, let’s get into the more nuanced concerns about stock options.

My second concern relates to the influence insiders have on the company’s long-term capital allocation and strategy. The other is simply that I think that from a practical perspective more wealth can be transferred from owners to operators without a shareholder backlash if done via options than via cash.

Let’s talk about concern number one first. Concern number one is that insiders given a lot of options tend not to end up being long-term holders of a lot of stock with a lot of votes attached to it. Therefore, the incentives for insiders are not as long-term as I’d like and the stability of their control over the company is not as secure as I’d like.

When I discuss compensation and stock ownership on the podcast – I’m not really talking about employees. I’m talking about a super select group. My concern is people who are involved – or could easily become involved – in major capital allocation decisions made at corporate. So, basically: the board, C-level executives (especially the CEO and CFO), and major shareholders.

At most companies, it’s narrower than this. Most board members are relatively un-influential and relatively passive. Most major shareholders are institutions that tend to be passive or are shareholders where this stock alone is not large enough to be relevant to their overall performance. So, for …

Warren Buffett’s “Market Value Test” – And How to Use It

Someone who listens to the podcast wrote in with this question:

“…(in a recent episode) you mention that you want to know if the capital allocation has created value or not. I was wondering how you do this kind of exercise practically? Do you look at the increase in book value/equity over time and compare that to the average ROE? When book value increased far less over a certain period of time compared with the historical average ROE I suppose that is a sign of bad capital allocation, right? Or do you have a different approach?”

(ASK GEOFF A QUESTION OF YOUR OWN)

There’s no one right approach that is going to work in every situation. The simpler the company and its business model, the easier it will be to see if capital allocation is working. For example, the stock price may tend to follow the earnings per share and the earnings per share may be driven in part by the capital allocation. That would be the case at a company that acquires other businesses for their reported earnings, issues stock, and/or buys back stock. Earnings per share captures all of that.

But, what if you were trying to analyze Berkshire Hathaway (BRK.B) or Biglari Holdings (BH)? In these cases, management might be allocating capital at times to increase earnings per share and at other times in ways where the value received for the capital outlay is not going to appear in the income statement. If capital is allocated to buying stock, land, etc. EPS may not be helpful in evaluating capital allocation. Now, book value would be a good way to analyze those capital allocation decisions. However, at companies like Berkshire Hathaway and Biglari Holdings you have a mix of operating businesses and investments. The operating businesses are held at unrealistic values for accounting purposes – so, an EPS approach works for judging them, but a book value approach doesn’t. And the investments may be held at realistic values for accounting purposes (they’re marked to market) – however, the underlying (“look-through”) earnings won’t show up when judging the EPS growth of the business. As a result, a pure EPS based approach to judging capital allocation will work for part of these conglomerates and fail for the other part. And a pure book value approach will work for judging capital allocation for part of these conglomerates and fail for another part. You need a mixed approach.

Buffett basically suggests this when he used the “bucket” approach for analyzing Berkshire Hathaway. He did this in some past annual letters. You take operating earnings per share (which excludes investment earnings and insurance underwriting). And you take investments per share. Operating earnings per share is a “flow” number. It needs to be capitalized to translate it into a figure that can be combined with investments per share. Investments per share is a “stock” number. You can either look at it as a “stock” number (which makes sense when trying to come …