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According to Warren Buffett, "In looking for someone to hire, you look for three qualities: integrity, intelligence, and energy. But the most important is integrity, because if they don't have that, the other two qualities, intelligence and energy, are going to kill you."
Now, it might seem like Buffett was talking about people like Dennis Kozlowski, who was found guilty of stealing $600 million at Tyco (NYSE: TYC ) , or Martin Grass, convicted for overseeing a $1.6 billion accounting fraud at Rite Aid (NYSE: RAD ) . But management doesn't need to commit a felony to cost you money.
Sardar Biglari, of Biglari Holdings (NYSE: BH ) , formerly known as Steak n Shake, is showing just how far management can go to rip off shareholders, and it doesn't seem to be breaking a single law to do it.
Paving with good intentions
Steak n Shake had shown slow profitable growth for years, but it faltered in 2007 and 2008. Biglari began buying shares, eventually building an 8.5% stake in the company. Then, he began a heated campaign, complete with promotional billboards around the company headquarters, to win two seats on the board.
Biglari's argument was simple -- Steak 'n Shake had underperformed the peer group, and management had destroyed value. In contrast, he would run the company for the shareholders. In a February 2008 letter, Biglari wrote, "Not only will I refuse extra remuneration for the time I intend to commit, but I also will not accept any stock options. The reason is simple: We are one of the largest shareholders; thus, we plan to make money with you, not off you."
About a month later, Biglari won two seats, bumped out the chairman and CEO, and began taking control of the company. Steak n Shake returned to profitability in 2009, and the stock jumped.
Finally, this year, Biglari renamed the company Biglari Holdings, seemingly telegraphing that the company would become his investment vehicle.
What's yours is mine
However, now it seems like Biglari actually meant to telegraph something else. Biglari Holdings is acquiring Biglari Capital, which acts as general partner of Biglari's Lion Fund hedge fund, for an amount equal to its assets. In the process, it's enacting one of the sweetest compensation agreements I've ever seen at a public company.
When Biglari Holdings grows, Biglari will take a quarter of the book value growth above the level of 5%, exclusively for himself. If book value declines, Biglari won't get this extraordinary compensation until the returns exceed a 5% annual growth rate over the highest book value. Roughly half of the after-tax value of the payment must be spent on shares of Biglari Holdings. Essentially, Biglari's going to use the company's assets to take the company from the shareholders, piece by piece.
Now, 25% of growth over 5% might not seem like very much, but it will make a huge difference in long-term returns. By my calculations, if Warren Buffett had made the same deal when he took over Berkshire Hathaway, it would have cost shareholders over 80% of their future returns.
In a May 6 letter to outraged shareholders, Biglari defended the move as simply an innovative compensation scheme that aligns his interests with shareholders. But 5% is pretty close to the level that U.S. 30-year bonds yield right now, when interest rates are near record lows. So, if Biglari just does a tiny bit better than government bonds, he'll get a nice payday. Maybe he should consider indexing. S&P 500 companies typically post an aggregate return on equity of 10% to 12% over the long term. Biglari could buy an index fund and relax on the beach, doing nothing and draining millions from shareholders year after year.
The amazing thing is that Biglari appears to think he's the good guy defending shareholder rights. He's now attempting to take over another business, Fremont Michigan Insurance. In an incredibly brazen move, Fremont has managed to lobby Michigan's legislature to change state corporate law in a manner that has the effect of entrenching the company's management.
To show its outrage, on the very same day that Biglari's egregious compensation scheme was filed with the SEC, Biglari Holdings published a press release saying, "Fremont shareholders do not need a CEO who displays total disregard for shareholder rights and value."
Maybe Biglari Holdings doesn't need one either.
Look for alternatives
Buffett summarizes the investment lesson well: "When you hire someone to run your business, you are entrusting him or her with the piggy bank. If these people are smart and hardworking, they are going to make you a lot of money, but it they aren't honest, they will find lots of clever ways to make all your money theirs."
Buffett's absolutely right. These sorts of "jockey" situations, where a brilliant investor works on your behalf at a public company, can work out great. When the jockey has integrity and truly wants a partnership with shareholders, the long-term returns can be extraordinarily high. In fact, after the decline caused by this compensation arrangement, our own Motley Fool Special Ops team thinks at its current valuation, Biglari Holdings has a greater margin of safety that compensates for Biglari taking a huge chunk of shareholders' future value off the top.
If you'd rather steer clear, though, there are alternatives. Buffett's Berkshire Hathaway is the most obvious example, but there are a bunch of others as well. Cumming and Steinberg with Leucadia National (NYSE: LUK ) . Bruce Flatt and his team at Brookfield Asset Management (NYSE: BAM ) . Sears Holdings' Eddie Lampert. Terra Nova Royalty's Michael Smith. All these guys have proven to be expert investors, and done it with integrity. They offer shareholders a way to outperform the market simply by buying shares and holding for the long term.
The Foolish bottom line
Of course, often the jockey's investing prowess is already priced into the stock, but occasionally, it isn't. In such case, the returns can be even better, as the stock's return to fair value magnifies the jockey's gains. These are the jockey stocks on which you should focus.