Charlie Munger is widely quoted in value investing community for his multidisciplinary ideas. However, he has some unconventional advice on the subject of corporate governance also which deserves a discussion. Let’s look at some of the insights from Munger on the issue of governance.
Munger believes more in the spirit of corporate governance rather than enforcement of compliance rules and regulations. If the intention is not right, people can always bend the rules and find workarounds for carrying out unethical practices without breaking the law. But when you know that the intentions are right then even an occasional instance of non-compliance doesn’t bother you because you trust the person and know that things will eventually get sorted out.
Munger is of the opinion that different companies have different cultures and you cannot come up with a one-size-fits-all solution in form generic compliance rules. An organization is made up of diverse set of people with different interests and values. Such collection of people behaves as a complex adaptive system. The moment complex rules are infused to command more control it invariably results in unintended consequence. So the solution is not to device more rules but to make the system simpler.
In the annual meeting for Wesco Financials in 2007, Munger pointed out –
A lot of people think if you just had more process and more compliance—checks and double checks and so forth—you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.
This brings us to the Munger’s first idea for simplifying the corporate governance puzzle.
Seamless Web of Deserved Trust
A system in which the individuals making decisions do not bear the consequences of those decisions seems incompatible with a seamless web of deserved trust. Munger explains –
Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character.
Moreover, unethical behavior is contagious. Gresham’s law says that bad values (or currency or people) drive out the good values from a system. If you find that it’s easy to cheat and steal in an organization, it’s just a matter of time before majority of the people in that system start exhibiting dishonest and unethical behaviour. Even if everybody was absolutely honest to begin with. Such is the human behaviour.
Once you have ensured that people you are working with are basically good and honest in their conduct, it behooves you to delegate to them as much as possible. You want to empower them to take decisions without second guessing their thinking every time. Munger explains with Buffett’s example –
When you have a really complicated place and a good CEO, you want him to have power to speak for the place in dealing with outsiders….Berkshire Hathaway of course is raised that way. Can you imagine Warren Buffett saying to somebody, “Well I’m sorry I have to go back and check with my directors?” I mean, of course he has to go back to check with his directors, but he knows what they’re going to say, and everybody knows that what he says is going to govern.
“Easier said than done”, you might say. So how do you create such a responsible culture? Surprisingly the answer can be found in a text written about 3,800 years ago.
Written in 1745 B.C., the Code of Hammurabi says –
If a builder builds a house and the house collapses and causes the death of the owner of the house – the builder shall be put to death. If it causes the death of the son of the owner of the house, a son of that builder shall be put to death.
It looks like they were much more advanced 3,800 years ago than we are today. The modern version of Hammurabi’s code is known as having skin in the game.
A similar issue pervades the institutional money management industry. The fund managers have no downsides. They continue making a fixed percentage of assets under management every year irrespective of the performance. No wonder a sub-par performance in majority of the funds is so rampant. No skin in the game!
When the decision maker’s profits and losses are directly aligned to the organization’s profits and losses, odds are high that you will see a sense of responsibility in people. For that matter allocating stock options is the wrong way to align the management and shareholder interests. If management uses their own money to buy the equity a more responsible behavior from them can be expected.
The first sign of unethical behaviour is the tendency to hide the facts. An aggressive accounting is one of the first avenues where dishonest management turns to.
Aggressive accounting is the harbinger of overconfidence, aggressive practice and/or plain misconduct. According to Charlie Munger ninety-nine percent of the problems come from being too optimistic.
Problem with aggressive accounting is that it almost always starts small with small fudges. Unfortunately, it’s a slippery slope from there. After the accounting fraud came out, chairman of Satyam Computer Services Mr. Ramalinga Raju described his situation as: “It was like riding a tiger, not knowing how to get off without being eaten,” while referring to the widening gap between the real and artificial numbers in the company’s books.
Being conservative in reporting the financials assures that a sufficient margin of safety has been accounted for. Conservative accounting is not only a sign of humility but it makes perfect rational and economic sense.
In modern corporate world, the CEO pay has skyrocketed to unprecedented levels. In my last organization, the board fired two CEOs in a span of two and a half years because of their failure to grow the revenue. In spite of an obvious inability to produce results those CEOs departed with multi million dollars severance packages. No rewards for guessing as to where that severance money came from? From shareholders pockets of course!
Charlie Munger goes as far as saying this –
I would argue that when you rise high enough in American business, you’ve got a moral duty to be underpaid – not to get all that you can, but to actually be underpaid.
So it’s not unfair to say that when somebody is favoured by life he or she should voluntarily take less from the system. It goes without saying that not just the CEO but the board of directors also shouldn’t get paid more than a nominal amount. When directors appoint a CEO, he tends to return the favour by increasing the directors’ fees who in turn reciprocate by further increasing the CEO pay and this vicious circle produces unreasonable remuneration numbers very soon.
How does corporate governance issue affect a small investor like us? After all the issue of improving the corporate governance through activism or intervention is not a small investor’s cup of tea. Warren Buffett once said –
You can never make a good deal with a bad person.
If you rethink about Berkshire’s acquisition strategy, it should be obvious to you by now as to why Munger and Buffett buy businesses which are run by self motivated managements who operate the business not for money but because they love their work. This simplifies Buffett and Munger’s life a lot. They hardly have to worry about problems arising because of dishonest management.
Buying a stock of a company indirectly makes the management your partner in the business. When you ignore any of the criteria mentioned above you are effectively agreeing to work with a potentially dishonest partner. Which means you are compromising with your margin of safety. It makes not just ethical but a perfectly rational sense to work with an honest management. In that sense honesty indeed is the best policy.
To conclude, it’s imperative that you should start thinking about corporate governance the way Munger thinks and give it its fair share while making a stock purchase decision.