Fool Blog: Invest Like a Second-Grader

My eldest son, Cal, recently inquired about the financial crisis, and about investing in general. He also asked what I look at when I'm researching companies. I thought a few examples were in order.

I explained to him that an excellent place to start is to look at the quality of the "rule makers" of a company -- that's what he calls the leaders. For public companies, this begins with the CEO and ends with the board of directors. To illustrate, I looked up the compensation for two equivalent board positions for two excellent companies.

Until last week, Edward M. Liddy served on the board of directors of Goldman Sachs (NYSE: GS  ) and was chairman of the audit committee. Liddy's total compensation last year was $685,770, of which all but $10,000 was issued in stock.

Now, keep in mind that's for four meetings per year. If Liddy spent eight hours in each of his four board meetings, his hourly rate equates to just over $24,000/hour.

As I explained this to Cal, his eyes got big and he blurted out, "That's way too much."

I also checked Berkshire Hathaway (NYSE: BRK-B  ) to see what the chairman of their audit committee earned in 2007. Thomas S. Murphy fills that role at Berkshire; his total compensation was $6,700 last year, all of it paid in cash. On an hourly rate basis, he made about $209/hour.

Cal's response: "I would rather work for that other company."

Is one system better than the other?
I explained to Cal that you can't judge any investment by a single factor. Another thing you'll want to check is how well the rule makers manage and invest the company's money.

One of these two companies repurchased more than $26 billion of their own stock in the five years that ended in November 2007. It also issued quite a bit of stock to employees, getting paid about $4 billion for the newly printed shares. The net result for shareholders was a reduced share count of about 82 million shares, for a net cost to fellow shareholders of over $22 billion. That works out to about $275 per share. Unfortunately, the shares are now around $120, and they've never fetched more than about $250.

Cal: "That was a waste of money. Maybe I don't want to work for them."

I explained that he had it half right. Someone once said that if you want to get rich from an investment bank, you should work for one, not invest in one.

Those few numbers are enough to make a second-grader question whether most directors are truly representing the shareholders' best interests. When push comes to shove, will they step in and question management when things get difficult -- and risk losing their lucrative role as an advisor?

I'm guessing someone will be looking at the roles the directors played at many of the large financial firms that have been in the news of late: Lehman Brothers, Bear Stearns, Countrywide, Fannie Mae (NYSE: FNM  ) , Freddie Mac (NYSE: FRE  ) , Wachovia (NYSE: WB  ) , and AIG (NYSE: AIG  ) .

How do your companies stack up?
For my own diligence, I began checking the "rule makers" of some of our other investments. The head of the audit committee at Limited Brands (NYSE: LTD  ) , whose shares I own, earned $163,000, $66,000 of which came from stock options. Limited also purchased about $5.2 billion of their own shares in the five years that ended in February 2008.

During that time it reduced the share count from 523 million to 346 million, a reduction of about 34%. It also issued some new shares -- collecting $517 million for those. All in, it cost around $27 per share. With the share price currently sitting around $12, it doesn't look like a great use of capital.

For related Foolishness:

Buck Hartzell owns shares of Berkshire Hathaway and The Limited. Cal is still saving his allowance for his first stock purchase. Limited Brands is a Motley Fool Income Investor pick. Limited Brands and Berkshire are Motley Fool Inside Value selections. Berkshire is also a Motley Fool Stock Advisor pick. The Fool owns shares of Berkshire and has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 07, 2009, at 3:35 PM, alexwong0708 wrote:

    Hi

    Nice article. I do have a question about Berkshire though.

    What you do think of Berkshire's Board? They are pretty much Buffett's long time friends and family members. So far it has worked wonder to Berkshire because Buffett is one of a kind. However, don't you think it is very dangerous that the board and the CEO are that close? And Berkshire is just a special case.

    In my CFA studies, one of the key points in the ethics chapter is that the board has to be distant from the CEO. In fact, the writers suggest that a high turnover rate in order to have a successful company. Of course, for the sake of passing the exam, I memorized it. That brings up an interesting question.

    In general, shareholders don't want to the board to be so close to the CEOs, but a high turnover rate sounds terrible either. That would incentivize the board to make short term decisions. To maximize their income, they may tend to agree with the CEO more often. What do you think?

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