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By rclosch
February 27, 2002

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This is topic about which I have posted before.

Enron has done the market a favor by bringing into focus the importance of assessing the integrity of management before making an investment. So I thought that this would a good time to resurrect and expand on this topic. If you have not read my earlier post, here is a link.

This is about using actions to give us clues about the character of the people that are running a business. The list below is tentative, and I would appreciate comments about the indicators included or not included. I would also like to hear how people feel about the relative importance (ranking) of the factors listed below.

So what do we look for in the actions of CEO's that indicate they have the character that will help made our partnership a profitable adventure?

1. Ownership. We want are managers to act like owners. Perhaps the best indicator for this behavior is when the CEO owns a big piece (10% or better) of the company.

2. Options. Ownership of options is not the same thing as owning stocks. If you own a lot of the companies stock you have a lot to lose if the price goes down, or if the company files for chapter 11. If you own options you benefit only if the price goes up, and have nothing to loose if the price goes down. These are very different incentives and they can and will result in very different behavior.

3. Other Peoples Money. Money that comes from stock offerings and retained earnings is shareholder money. But Most CEO's think that since the can sign a check, the money is theirs to spend as they like. We do not want managers that engage in mergers for ego gratification or who buy back stock to keep their options in the money. In either case they are using shareholder money to promote their personal goals.

4. No Pumping. New economy managers feel that pumping the stock is part of their job. But when a stock gets over priced it means that new shareholders are entering with a lot of risk. In contrast to this think of Berkshire's famous prospectus for the sale of the B Shares, where Berkshire offered stock of sale but Warren said that neither he nor Charlie would buy the stock at current prices.

5. Lumpy Earnings. Smooth earnings growth looks pretty, and it makes Wall Street happy; but it is a profoundly unnatural condition. Businesses are cyclical. The Economy is cyclical. Pretty earnings are generally a sign that there is an artist at work in the accounting department.

6. Executive Compensation. Options or cash, executive compensation is an expense that the shareholders pay. Obscene compensation is an indication that the managers love theirs paychecks more than they do the business.

7. Give us the bad news. Think how different the Enron story would have been if the managers had followed this rule instead of always pumping the stock.

8. Under-Promising. Time and again the disasters of the last two years were the result of management trying to meet growth targets that were absurd, unrealistic, and totally unsupported by economic reality.

9. The $60 million Dollar house. Otherwise known as the Global Crossing indicator. If the CEO builds a house that costs 90 million dollars do not buy the stock.

10. Annual Reports. See link at the beginning of this post.

Do I expect to find a lot of companies where the management displays all of the above behavior? Not really, there is only one company that I know of that qualifies on all of these points and everyone here already owns it.

Berkshire is in fact a very complex Company, but one that is comfortable for me to own, because all of the above character tests have been met. Even with a simple business it is impossible for the investor to know everything. In every investment the investor has to have faith in the people that are handing their money, so if the management fails the integrity test, they need to find a new home for the money.


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