Hugh Chavez and Reputation Capital

Venezuelan predident and general all-around jerk (I can think of better descriptors, but this is a generally family-friendly blog) Hugo Chavez was a very good example of a free cash flow problem on a national scale. He was flush with cash from Venezuela's huge oil reserves, and used oil wealth to play the part of loudmouth and anti-US demnagogue. Along the way, he hammered many of the large-multinational oil companies with increased taxes, nationalization of their oil fields, and raids on their offices.

Now, with oil prices dropping, the Venezuelan economy is sputtering, and Chavez is suffering from cash shortages. So, he's reaching out to the same companies he previously gave the boot to (while seizing their assets). He's offering them access to Venezuela's oil fields. But it looks like his past actions might be causing some second thoughts:

Under the current bidding rules, the onus for financing the new projects lies with the foreign companies, even though Petróleos de Venezuela would maintain control. Banks might balk at such a prospect. Distrust also lingers in dealing with Petróleos de Venezuela.

"An agreement on a piece of paper means nothing in Venezuela because of the way Chávez abruptly changes the rules of the game," said a Venezuelan oil executive who has had dealings with oil companies from China, Russia and other countries.

Imagine that - reputation capital actually matters.

I've used Chavez for years as a walking, talking (or, at least, braying) example of country risk. Now I can him for an example of teh efdects of losing reputation capital, too.

Of course, I'm sure psychology professors get to use him in examples too.

How Much Should CEOs Be Paid?

There's a great editorial in today's WSJ by Robert Reich, titled "CEOs Deserve Their Pay (note: online subscription may be required). He starts out with the usual facts that get compensation activists so lathered up: the average CEO compensation for a Fortune 500 firm made almost $11 million last year (about 364 times the average employee's salary), and the 20 highest-paid execs earned an average of 436 million.

Reich then goes on to explain the increase in CEO pay over time as a rational consequence of increasing competition. In other words, 50 years ago, most large firms were in oligopolistic industries, with stable unions and predictable revenue streams. So, CEOs were almost like quasi-bureaucrats.

In contrast, now the level of competition is so fierce (and entry barriers so low) that even small differences in managerial quality can result in huge changes in profitability and market value. So, having a slightly better CEO can result in big gains to shareholder wealth. Not surprisingly, shareholders (or actually, boards of directors acting on the behalf of shareholders) realize this, and end up bidding up the price of good CEOs:

So how does the modern corporation attract and keep consumers and investors (who also have better and better comparative information)? How does it distinguish itself? More and more, that depends on its CEO -- who has to be sufficiently clever, ruthless and driven to find and pull the levers that will deliver competitive advantage.

There are no standard textbook moves, no well-established strategies to draw upon. If there were, rivals would already be using them. The pool of proven talent is small because so few executives have been tested and succeeded. And the boards of major companies do not want to risk error. The cost of recruiting the wrong person can be very large -- and readily apparent in the deteriorating value of a company's shares. Boards are willing to pay more and more for CEOs and other top executives because their rivals are paying more and more for them. Former Home Depot CEO Robert Nardelli to the contrary notwithstanding, the pay is usually worth it to investors.

RTWT here

All in all, it's a great piece. But alas, after such great writing, Reich can't help himself, and finally reverts to type:

This economic explanation for sky-high CEO pay does not justify it socially or morally. It only means that investors think CEOs are worth it. As citizens, though, most of us disapprove. About 80% of Americans polled by the Los Angeles Times and Bloomberg in early 2006 said CEOs are overpaid. The reaction was roughly the same regardless of the respondent's income or political affiliation. But if America wants to rein in executive pay, the answer isn't more shareholder rights. Just as with the compensation of Hollywood celebrities or private-equity and hedge fund managers, the answer -- for anyone truly concerned -- is a higher marginal tax rate on the super pay of those in super demand. (emphasis mine)

Ah well. Other than that line, it's still a great piece, and well worth reading.

If You're Paying, I'll Have Top Sirloin (From Catallarchy)

Patri Friedman over at Catallarchy gives us an example of how "splitting the bill" is a bad way of paying for things:

Suppose the tab is split not at each table but across the 100 diners that evening across all the tables. Now adding the $4 drink and dessert costs only 4¢. Splurging is easy to justify now. In fact you won’t just add a drink and dessert; you’ll upgrade to the steak and add a bottle of wine. Suppose you and everyone else each orders $40 worth of food. The tab for the entire restaurant will be $4000. Divided by the 100 diners, your bill comes to $40. Here is the irony. Like my neighbor at the theater, you’ll get your “fair share.” The stranger at the restaurant a few tables over pays for your meal, but you also help subsidize his. It all “evens out.” But this outcome is a disaster. When you dine alone, you spend $6. The extra $34 of steak and other treats are not worth it. But in competition with the others, you’ve chosen a meal far out of your price range whose enjoyment falls far short of its cost.

Click here for the whole article.

As we tell even our introductory finance students, a similar problem exists with CEOs of large publicly held corporations. IT's the classic Jensen & Meckling problem: they typically hold far less than 5% of the firm's outstanding common stock. So, while they get 100% of the beenfit from a perquisite (like a thick carpet in their office, expensive artwork on their walls, or a membership in the country club) they pay only a fraction of the cost. As a result, they overconsume. Rationally, we should anticipate this, and take steps to make sure that other mechanisms are in place to offset this.

Warren Buffet's Annual Letter

Berkshire Hathaway has just come out with their 2004 annual report. Warren Buffett's letter to shareholders is always worth reading, both for what he says and for the clarity and style with which he says it. A couple of sections deserve particular note:

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.

There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

He also mentions that BH has a big stockpile of cash ($43 Billion), and that they resisted the temptation to spend it (negative-NPV projects, anyone?):

I didn’t do that job very well last year. My hope was to make several multi-billion dollar acquisitions that would add new and significant streams of earnings to the many we already have. But I struck out. Additionally, I found very few attractive securities to buy. Berkshire therefore ended the year with $43 billion of cash equivalents, not a happy position. Charlie and I will work to translate some of this hoard into more interesting assets during 2005, though we can’t promise success.

This provides a good setting for discussing the agency problems related to free cash flow, managers' incentives to build empires, and so on (like I've said before, I'm an agency/governance kind of guy - unlike Haley Joel Osment, I see agency problems everywhere).

Click here for the whole letter.

On day 1 in my advanced corporate course, we go over a case based on a takeover executed done by Berkshire Hathaway. As a part of it, we go through Buffett's investment philosophy and compare/contrast it to commonly held finance theory. In his various writings, Buffett repeatedly mentions "intrinsic value".

It's also pretty instructive for students to read Berkshire's "Owners' Manual (starting on page 73 of the 2004 annaul report).