• JULY 30, 2008

Lessons from Warren Buffett - XLVIII...

Last week, we read Warren Buffett complain about failings of independent directors in his letter to shareholders for the year 2002. Let us go further down the same letter and see what other investment wisdom he has on offer.

'Independent' directors: How independent are they?
It is a known fact that Buffett pays a great deal of attention to the management of companies before investing in them. And the reasons behind this obsession may not be difficult to find. Since it is the management that is responsible for making most of the capital allocation decisions in a business, which in turn are central for creating long-term shareholder value, it is imperative that a management allocates capital in the most rational manner possible.

However, as we saw in the last article, the list of managers or CEOs with a 'quick rich' syndrome is swelling to dangerous proportions, thus forcing shareholders to pin all their hopes on the board of a company or more importantly on the independent directors for a bail out. But as mentioned by Buffett, most independent directors (including him) on several occasions have failed in their attempt to protect the interest of shareholders owing to a variety of reasons.


After narrating his experience as an independent director, the master moves on and gives one more example where independent directors have failed miserably to protect shareholder interest. The companies under consideration are investment companies (mutual funds). The master says that directors in these companies have only two major roles, that of hiring the best possible manager and negotiating with him for the best possible fee. However, even while performing these basic duties, the independent directors have failed their shareholders and he goes on to cite a 62-year case study from which he has derived his findings.

Even in an era where shareholdings have gotten concentrated, some institutions find it difficult to make management changes necessary to create long-term shareholder value because these very institutions have been found to be sailing in the same boat i.e., neglecting shareholder value so that only a handful of people benefit. Buffett goes on to add that thankfully there have been some people at some institutions that by virtue of their voting power have forced CEOs to take rational decisions.

Let us hear in Buffett's own words, his take on the issue:

Master's golden words
Buffett says, "So that we may further see the failings of 'independence', let's look at a 62-year case study covering thousands of companies. Since 1940, federal law has mandated that a large proportion of the directors of investment companies (most of these mutual funds) be independent. The requirement was originally 40% and now it is 50%. In any case, the typical fund has long operated with a majority of directors who qualify as independent. These directors and the entire board have many perfunctory duties, but in actuality have only two important responsibilities: obtaining the best possible investment manager and negotiating with that manager for the lowest possible fee. When you are seeking investment help yourself, these two goals are the only ones that count, and directors acting for other investors should have exactly the same priorities. Yet when it comes to independent directors pursuing either goal, their record has been absolutely pathetic."

On the increased ownership concentration and how certain people are forcing managers to act rational, Buffett has the following to say - "Getting rid of mediocre CEOs and eliminating overreaching by the able ones requires action by owners - big owners. The logistics aren't that tough: The ownership of stock has grown increasingly concentrated in recent decades, and today it would be easy for institutional managers to exert their will on problem situations. Twenty, or even fewer, of the largest institutions, acting together, could effectively reform corporate governance at a given company, simply by withholding their votes for directors who were tolerating odious behavior."

He goes on, in my view, this kind of concerted action is the only way that corporate stewardship can be meaningfully improved. Unfortunately, certain major investing institutions have 'glass house' problems in arguing for better governance elsewhere; they would shudder, for example, at the thought of their own performance and fees being closely inspected by their own boards. But Jack Bogle of Vanguard fame, Chris Davis of Davis Advisors, and Bill Miller of Legg Mason are now offering leadership in getting CEOs to treat their owners properly. Pension funds, as well as other fiduciaries, will reap better investment returns in the future if they support these men."

Lessons from Warren Buffett Series - Previous article | Next article | All Articles
Try the Warren Buffett Quiz

Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (Research Analyst) bearing Registration No. INH000000537 (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA, Canada or the European Union countries, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

Equitymaster Agora Research Private Limited (Research Analyst)
103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407