Good one Adam...Can I disagree in the way the "returning capital" was interpreted? Two assumptions: (1) Capital can be returned mostly near to the end of the year, considering the same is of no further use; (2) There is no fixed income earned on idle capital available in the checking account. Now comparing apples to apples (if the total return earned on capital remains at 20%); Two outcomes: 1) If entire 100Mill allocated was used, it means a bonus of 500k...viz. 10% of (100*20%-100*15%); (2) If only 90Mil used and balance 10Mil returned...bonus should be 300k ! ....viz.. 10% of (90*20%-100*15%). While Buffett allocated 100 Mil assuming the same would earn minimum 15% return (benchmark), the manager used only 90 Mil and returned the balance 10Mil (Though the manager is rewarded for good performance on using 90Mil, he will be slightly penalized for excess budgeting and keeping 10Mil capital idle). In your calculation, you assumed 22.22% return on 90Mil to arrive at the same 20Mil return on capital and considered 15% benchmark return on 90Mil to arrive at 650k bonus! (While Buffett is expecting his entire money, 100Mil should work for him at 15%)
I don't see why a manager should be penalised for overbudgeting if they are already incentivized for returning capital. Also it is not possible to accurately estimate the budget you would need and excess money would be needed to serve as a margin of error
I think it's more in the big picture. If you can do the same amount of business (same sales, margins, earnings) with less money, then you'll be rewarded.
I feel this principle extends to pretty much all businesses. So if you know how Buffett manages his companies, it goes a long way to maintaining a profitable business (but it is not the only factor of course)
I'm a little late in responding here...In your counter-example you cite reducing capital to $90m but with the same return on capital. In that case the manager has shrunk the business and rightly earns less. In this case it would fall to $450,000 or 10%, just as capital has shrunk by 10%. Now it might have been rational to do this (it's a hypothetical after all). In which case if they kept the $100m then the return would be 18% (the $18m earnings at 20% on $90m), and the manager's bonus would have fallen to $300,000.
It's been 2 years, I don't think he will respond XD. Reading through what you and Satya said, my point is that if, as Satya suggested, the manager is penalised for not using capital and returning it, the manager will then be incentivised to retain capital and keep the money in the bank. At least that way it will earn interest which will be counted as earnings. he will not return it because then his pay will drop from more than (adding interest from cash account) 450k to 300k
No probably not! Haha. I'm not sure it would benefit the manager to do that. Why retain money and earn 5% when you have a 15% hurdle rate? I think the incentive structure does work. If the business naturally shrinks they will be better off returning capital. Now on the flipside, it does pay the manager to find ways to profitably expand the business. They can always request more capital from BRK HQ.
Just out of curiosity, in Buffett's letters, he often states that small companies are unable to "move the needle" even if they are very profitable, implying that due to Berkshire Hathaway's (Brk) huge size, these companies won't make a difference in Brk's profitability. However, why doesn't he just buy larger quantities of such small but profitable companies? Is it because it is too much trouble to take over a new company and Buffett wants to minimise the number of companies he takes over?
You have it right. Although BRK does make a fair number of bolt-on acquisitions each year, not all of which get reported on individually. I think it would get very busy and also introduce more risk/complexity that could muddle things. One $10bn acquisition is far different than one hundred $100 million acquisitions. All of which require time/effort/legal and the oversight after the fact.
Good one Adam...Can I disagree in the way the "returning capital" was interpreted? Two assumptions: (1) Capital can be returned mostly near to the end of the year, considering the same is of no further use; (2) There is no fixed income earned on idle capital available in the checking account. Now comparing apples to apples (if the total return earned on capital remains at 20%); Two outcomes: 1) If entire 100Mill allocated was used, it means a bonus of 500k...viz. 10% of (100*20%-100*15%); (2) If only 90Mil used and balance 10Mil returned...bonus should be 300k ! ....viz.. 10% of (90*20%-100*15%). While Buffett allocated 100 Mil assuming the same would earn minimum 15% return (benchmark), the manager used only 90 Mil and returned the balance 10Mil (Though the manager is rewarded for good performance on using 90Mil, he will be slightly penalized for excess budgeting and keeping 10Mil capital idle). In your calculation, you assumed 22.22% return on 90Mil to arrive at the same 20Mil return on capital and considered 15% benchmark return on 90Mil to arrive at 650k bonus! (While Buffett is expecting his entire money, 100Mil should work for him at 15%)
I don't see why a manager should be penalised for overbudgeting if they are already incentivized for returning capital. Also it is not possible to accurately estimate the budget you would need and excess money would be needed to serve as a margin of error
I think it's more in the big picture. If you can do the same amount of business (same sales, margins, earnings) with less money, then you'll be rewarded.
I feel this principle extends to pretty much all businesses. So if you know how Buffett manages his companies, it goes a long way to maintaining a profitable business (but it is not the only factor of course)
I'm a little late in responding here...In your counter-example you cite reducing capital to $90m but with the same return on capital. In that case the manager has shrunk the business and rightly earns less. In this case it would fall to $450,000 or 10%, just as capital has shrunk by 10%. Now it might have been rational to do this (it's a hypothetical after all). In which case if they kept the $100m then the return would be 18% (the $18m earnings at 20% on $90m), and the manager's bonus would have fallen to $300,000.
It's been 2 years, I don't think he will respond XD. Reading through what you and Satya said, my point is that if, as Satya suggested, the manager is penalised for not using capital and returning it, the manager will then be incentivised to retain capital and keep the money in the bank. At least that way it will earn interest which will be counted as earnings. he will not return it because then his pay will drop from more than (adding interest from cash account) 450k to 300k
No probably not! Haha. I'm not sure it would benefit the manager to do that. Why retain money and earn 5% when you have a 15% hurdle rate? I think the incentive structure does work. If the business naturally shrinks they will be better off returning capital. Now on the flipside, it does pay the manager to find ways to profitably expand the business. They can always request more capital from BRK HQ.
Just out of curiosity, in Buffett's letters, he often states that small companies are unable to "move the needle" even if they are very profitable, implying that due to Berkshire Hathaway's (Brk) huge size, these companies won't make a difference in Brk's profitability. However, why doesn't he just buy larger quantities of such small but profitable companies? Is it because it is too much trouble to take over a new company and Buffett wants to minimise the number of companies he takes over?
You have it right. Although BRK does make a fair number of bolt-on acquisitions each year, not all of which get reported on individually. I think it would get very busy and also introduce more risk/complexity that could muddle things. One $10bn acquisition is far different than one hundred $100 million acquisitions. All of which require time/effort/legal and the oversight after the fact.