"Show me the incentive and I will show you the outcome" - Charlie Munger
Welcome to Special Situation Investing Episode 71.
Whenever the two hosts of this show meet in person, it’s impossible for us to avoid talking shop. One recent discussion became so engrossing that, to the great amusement of our wives, we stared at a single graph for an hour without exchanging a word. It was shortly after that I asked my co-host: “Why do you think we enjoy investing so much?” He replied with wise words, as he does, and then he posed the same question to me.
In answering, I felt I couldn’t succinctly put to words what intrigued me most. That question rattled around in my brain for weeks until I finally stumbled upon the answer in a book.
While James Dale Davidson and Lord William Rees-Mogg are best known for coauthoring The Sovereign Individual, it was an earlier book of theirs that gave me my answer. In Blood in the Streets: Investment Profits in a World Gone Mad, the two authors claim the key to becoming a good investor is “[seeing] reality as it is, because every investment is ultimately a reality test.”
That’s why I love investing. Because it’s a test on understanding reality correctly, and if right, it financially rewards success.
As we all know, this challenge isn’t easy because understanding reality with its infinite complexity is anything but simple. But like many challenges, the work can be rewarding and, for many of us, the work itself is enjoyable. Among other things, understanding reality—and by extension, being a good investor— requires humility, intellectual curiosity, and a breath and depth of wisdom that leads to robust critical thinking.
That last requirement—critical thinking—is so essential. In the same book, Davidson and Rees-Mogg put it well. They write:
The slowness of most people to think deeply about the world around them gives a great advantage to people who do think.
We’re sure you can attest, as we can, to the fact that all of the great investors are also great thinkers. One can’t help but be inspired by the originality and quality of thought displayed by the likes of Warren Buffett, Joel Greenblatt, Charlie Munger, Murray Stahl and others. This leads us to ask, “How can we develop the ability to think deeply?”
This question led us to reading everything we can get our hands on about Charlie Munger. Not only is he a solid family man, an uber-successful investor, and hilarious wit, he also attributes much of his success to his ability to think. He claims he has a systematic thinking process, one that he’s employed and honed over decades. Thankfully, he’s shared his process with anyone willing to listen.
Episode 66 of this show, titled Modeling Munger’s Mind, was our humble attempt at outlining Munger’s mental-model-based thinking process. As a memory jogger, let’s quickly review the core tenets of the process: a two-track analysis, mental models, and using a checklist.
First, the two track analysis asks the following questions:
What are the factors that really govern the interests involved, rationally considered? And…what are the subconscious influences where the brain at a subconscious level is automatically forming conclusions in various ways?
Secondly, to process through these two tracks of thought, Munger runs through dozens of mental models. These are the big ideas from all the major disciplines that describe how the world and humans operate. And lastly, because there’s so many models (Munger says about one hundred should suffice), its helpful to organize them in a checklist format.
Today, we’re diving a level deeper into a mental model derived from the major discipline of psychology—incentives. This is one of Munger’s favorite mental models. In fact, when giving a talk on 25 human misjudgments, he discusses incentives first. He introduces the concept—which he terms the “reward and punishment superresponse tendency”— in the following way:
I place this tendency first in my discussion because almost everyone thinks he fully recognizes how important incentives and disincentives are in changing cognition and behavior. But this is not often so. For instance, I think I’ve been in the top five percent of my age cohort almost all my adult life in understanding the power of incentives and yet I’ve always underestimated that power. Never a years passes but I get some surprise that pushes a little further my appreciation of incentives super-power.
So if Munger is correct, we all stand to benefit from developing our appreciation for the power of incentives and sharpening our ability to use the model to improve our thinking.
What are incentives
As we pointed out in last week’s episode, Bank to Basics, it’s foundational to any quality discussion to first define terms. Therefore, according to the Mariam-Webster dictionary, incentives are defined as:
something that incites or has a tendency to incite to determination or action.
Dumbing it down for us, we’d say, an incentive is something that motivates people to act in a certain way.
Robert Breedlove, the host of the What is Money Podcast, adds further color to the description, saying:
Humans are characters of the emergent properties of the incentive structures they are in. So people are going to do whatever’s profitable to them. Whether that’s violence or that’s charity work.
Incentives are omnipresent
Munger likely puts such emphasis on understanding this model because incentives, and the incentive structures they create, are everywhere. Whether it’s realized or not, we are constantly both creating and responding to incentives. Their influence can’t be escaped.
It could be desires for power, money, sex, prestige, peace, revenge, or an endless list of instinctual human motivations, but there’s no escaping the push and pull of incentives. From religions, to geopolitics, to sports, to education, to family relations, all structures and institutions of human society are a complex web of interacting incentives. And the world of investing is no exception.
When investors ask such questions as, what will a company’s management do, how will the market react to this news, how will a geopolitical conflict resolve, will the demand for this commodity rise or fall, will momentum in the market persist or reverse, they’re really asking how the incentives governing the situation will play out.
Incentives are powerful motivators
Not only are incentives universal, they are also powerfully motivational. A few anecdotal stories from investing greats help drive this point home.
Munger often recounts a story of a general counsel who advised a company’s CEO to do the right thing even though it wasn’t legally required. Ultimately, the CEO didn’t do the right thing because it was uncomfortable and he cared more about maintaining his position and reputation. The matter blew up and the general counsel and the CEO were both disgraced and lost their jobs. Munger argues the general counsel could have persuaded the CEO if only he had shown his boss how doing the right thing was also the best way to maintain his prestige and position. He could have been successful if only he had understood and leveraged the incentives correctly.
Another of Munger’s favorite examples of the power of incentives is an anecdote about the Federal Express company. As is well know, FedEx’s business model relies on all on its packages flowing in and out of its main hub and headquarters in Memphis Tennessee, every night. As the story goes, at one time the company was struggling to process the tremendous flow of packages and get them sent out on time. Faced with a crisis, FedEx changed the worker’s pay structure from paying by the hour to paying by the shift. After the change, once the work for a shift was done, workers were allowed to go home. Sufficiently incentivized, the workers easily completed their work on time.
Unsurprisingly, Warren Buffett also seems to intentionally tap into the power of incentives. As chronicled in his partnership and shareholder letters, Buffett’s investing life is full of examples of where incentives were key to snatching success from the clutches of failure. From the beginning, he was careful to ensure that his incentives were aligned with first his partners and later with fellow shareholders. He did this in part by maintaining the vast majority of his own wealth first in the partnership and then in Berkshire Hathaway. During the partnership years, Buffett even had his pay structured such that if he didn’t make his partners more than 6%, he received no pay. With him so aligned with his partners, it’s easy to see how this motivated Buffett to always do right by those whose money he managed.
Another story from Buffett’s partnership years ripe with incentives is his takeover and turnaround of Demster Mills. Consider that Buffett’s success was largely due to hiring Harry Bottle to turnaround the company. Buffett motivated Bottle by presenting him with a challenge and compensating him handsomely for meeting and exceeding expectations. Bottle n turn incentivized the Dempster employees to reduce inventories by painting a line on the wall and threatening to fire folks if the inventory stacks were above the line. After that first goal was met, he painted a new, lower line and repeated the process.
In a tongue and cheek comment, Buffett once said it’d be easy to solve the United States’ ballooning national deficit, something politicians seem perpetually unwilling or unable to do. His solution was based on incentives. He said:
I could end the deficit in 5 minutes. You just pass a law that says that anytime there is a deficit of more than 3% of GDP all sitting members of congress are ineligible for reelection.
While the stories of Buffett and Munger and their investment success provide near endless examples of the importance of getting incentives correct, it’s not just the greatest investors that benefit from good incentive structures.
One common method of applying the concept of incentives is by investing in companies with high insider ownership. The idea is since the insiders have their own wealth at stake, they will be motivated to act in the best interest of all shareholders. This method is more effective than most investors know as show by one of favorite investors, Murray Stahl. In one of his FRMO Corp shareholder letters Stahl shared a fascinating exercise he once ran. He wrote:
I began to examine the market indices, starting with the S&P 500…I wanted to see if I could extract how much of the S&P return was due to the owner-operators [or insiders]…I began looking at companies like Wal-Mart at the time when Sam Walton ran the company and he owned most of the stock, or Hewlett-Packard, in the days when Mr. Hewlett and Mr. Packard ran the company, or Microsoft in its Bill Gates era.
If you tried to replicate that exercise, you would look at the S&P 500…since the day it began in 1957, extract all the positions in which there were owner-operators that you could identify, and then recalculate the S&P as if there never were any owner-operators…I absolutely promise you, if you did that calculation, you would never buy the S&P. What I’m telling you is that the bulk of the return of the indices…was earned by these owner-operators.
If this is true, and we have no doubt it is, then companies with insider’s incentives aligned is the difference between the famous S&P500 being investable and not.
Learn to use incentives
So now we hope we all are even just a bit more convinced of just how powerful a tool a deep understanding of incentives is in the hand of an investor. We’d even argue that correctly predicting the incentives involved is the closest thing possible to knowing the future. Along these lines, Munger says:
Show me the incentive and I will show you the outcome.
And what investor wouldn’t benefit from knowing the future?
Here’s the funny thing, once one learns to think about incentives and use them to make decisions from an investor’s perspective, it opens a whole new level of understanding about the world. Incentives will appear everywhere. At least that’s been our experience. We invite you to join us as we follow in the shadow of the greatest investors. We bet it’ll be worth your time.
With that we’ve concluded another episode of Special Situation Investing. One of our goals with this show is for it to deepen our own investing knowledge. We can honestly say that it has done just that. Forcing ourselves to summarize our research in a succinct and understandable way has paid dividends. We hope you are getting as much from the show as we are and its proving instrumental in your growth as well.
As we wrap up, all we have left to say is thank you for your continued support. It’s much appreciated. One of the easiest ways to show your support is by simply becoming one of our free Substack subscribers.
Alright, we hope you have a great week and we’ll see you again on the next episode.
Substack-Only Bonus
Speaking of Charlie Munger, check out this recent interview with the 99 year old himself.
Incentive superpower