One Secret to Uncover Great Investments

Management’s incentives are often given short-shrift by investors in the market as a criterion when it comes to evaluating shares for investment. Investors who know the power of incentives however, might just be in possession of a secret to uncover great investments. Why is that so? Let’s start with the town of Omaha, Nebraska in the USA.

Every May, Omaha buzzes with life as tens of thousands of investors around the world descend upon the hometown of Warren Buffett, arguably the greatest – and likely the most famous – investor of our generation.

It’s that time of the year when Buffett would hold his famous Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) Annual Shareholder Meetings. And while these meetings are by now extremely well-known not just within the investing community but also amongst the general public, there’s another equally noteworthy but relatively unknown meeting that takes place in Omaha, often just a day after Buffett’s event.

That low-key gathering is none other than Markel’s (NYSE: MKL) meeting for shareholders (as opposed to a formal Annual Shareholder Meeting) in which the company’s top leaders welcome questions related to investing and the company – and occasionally anything under the sun – from anyone present in the venue. The Richmond, Virginia, U.S.A-based Markel, much like Berkshire, has a core insurance business that helps generate profitable insurance premiums – also known as ‘float’ – by which it then invests in private companies, publicly-listed shares, or fixed income securities (i.e. bonds).

The company has been an extremely successful investment for long-term investors with its shares having gained some 7,531% to its current price of US$635.70 since its 1986 listing at a price of US$8.33 per share. The S&P 500 (one of the most widely-quoted American stock market indices) in comparison, has advanced by just roughly 700%. Of course, Markel’s share price growth did not come about in a vacuum. It happened because the company’s book value per share – a very useful measure of an insurance company’s economic value – has also jumped by 13,852% from US$3.42 back then to US$477 today.

As I had the opportunity to visit Berkshire’s shareholder meeting this year, I resolved to make a visit to Markel’s meeting a priority in my to-do list. I had also promised to bring to readers of The Motley Fool Singapore some of my personal takeaways from the Berkshire event. Consider some insights from Markel’s meeting as part of my Berkshire-related takeaway too.

Coming back to Markel, the company’s Chief Investment Officer, Tom Gayner, deserves some introduction. Over the two decades ended 31 Dec 2013, Gayner has helped led Markel’s investment portfolio (consisting of shares and fixed income securities) to a compounded annual return of 13%. Compared with the S&P 500’s annualized returns of 8.6% in the same period, Gayner’s investing acumen becomes clear. In fact, Gaynor’s investing accomplishments are even stronger than the figures suggest considering that Markel’s investment portfolio has a large proportion of bonds which generally give lower annualised returns when compared with shares.

Gayner’s investing performance is one of a number of strong reasons that have led a growing but tiny group of shareholders and investors to attend Markel’s annual event in Omaha.

In any case, Gayner’s excellent decades-long track record makes his views on investing extremely noteworthy. During this year’s meeting, he shared a particularly interesting insight that might prove to be extremely useful for even investors here in Singapore. Gayner said that executives at Markel take up to five years to earn restricted stock which then take another three years to vest. In other words, it takes up to eight years before Markel’s management can actually get hold of the rewards from such stock-based compensation.

For a measure of how long-term Markel’s restricted stock awards are, we can compare it to a similar program from SingTel, (SGX: Z74), the largest company within the Straits Times Index (SGX: ^STI) with a weighting of around 10%. In SingTel’s latest 2013 annual report, it was stated that the company’s top management earn share awards that are based on a “three-year performance period from 1 April 2013 to 31 March 2016.” So instead of taking up to five years to earn share awards like Markel’s management, SingTel’s top executives take only three.

Markel’s management team is also primarily rewarded based on the compounded annual growth rate of the insurer’s per-share book value over rolling five-year periods (for added measure, an insurance company that grows its per-share book value is in essence helping build value for shareholders.)

Now, this is useful for investors to know because tracking the incentive structure of a company’s top executives can give investors great insight into the alignment of management and shareholders’ interests. Companies that aim to reward management with incentives that are based on a long-time horizon can help maximize (though it cannot guarantee) the chances that a company’s top lieutenants would help build the company for the long-term and hence also maximize the chances of the company being a great long-term investment.

Rewarding management based on short-term success can lead to all sorts of unsavoury and unsustainable behaviour. For instance, if management’s rewarded based on short-term revenue growth, it’s easy for management to engage in careless expansion through the use of massive leverage to expand capacity and push products or services out as quickly as possible; in the event of any downturn though, the leverage that was used will become a double-edged sword and hurt the company and of course, shareholders.

In light of that, it’s perhaps no wonder that Markel has managed to grow the way it did over the past 28 years since its listing with its insistence on rewarding its employees based on its long-term corporate performance.

As Charlie Munger once said, “I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.“ Incentives are too important to be ignored.

Before I end, I’ll just like to point out that I’d be back with more Berkshire-related coverage and insights. Come back for more!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway and Markel.