On Biglari Holdings and Type X Behavior

In November of last year, I wrote “The Restaurant Investor” about Steak n Shake, Sardar Biglari, and what it takes for a restaurant to succeed. In the article, I mentioned that Steak n Shake (now Biglari Holdings) was on solid financial footing and that Biglari would likely start pursuing a holding-company strategy by investing excess cash flow into better opportunities. While this did happen, a few other “revelations” came up over the past six months that changed my view on the company. Anyone who follows BH already knows what I’m talking about, but below I’ve included my thoughts on the situation from my most recent letter to investors:

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Most everyone has heard of the “Type A” and “Type B” personality classifications. In Dan Pink’s book Drive, he adapts MIT management professor Douglas McGregor’s ideas to put forth two more classifications: Type X and Type I. Type X behavior is fueled by extrinsic motivation—external rewards like money and recognition. Type I behavior is fueled by intrinsic motivation—the inherent satisfaction of the activity itself. “I don’t mean to say that Type X people always neglect the inherent enjoyment of what they do, or that Type I people resist any outside goodies of any kind,” Pink says. “But for Type X’s, the main motivator is external rewards. Any deeper satisfaction is welcome, but secondary. For Type I’s, the main motivator is the freedom, challenge, and purpose of the undertaking itself. Any other gains are welcome, but mainly as a bonus.”

Pink lists some well-known examples of both types: Warren Buffett, Oprah Winfrey, and Bruce Springsteen are Type I’s. Donald Trump, Jack Welch, and Simon Cowell are Type X’s. So it’s clear that both personalities can be successful. People can also change over time. But Type I’s almost always outperform in the long run. They’re also the people you want working for you.

On April 30, Biglari Holdings announced that its new compensation agreement with CEO Sardar Biglari would provide him with 25% of the gain in Book Value over an annual hurdle rate of 5%. So if the Book Value of the company went up 13%, Biglari would receive 2% of the company’s equity. At its current size, that amounts to around $7 million, including his regular salary. Continue reading “On Biglari Holdings and Type X Behavior”

Wisdom, Virtue and Some Common Sense

In one of the best TED talks I’ve seen, here is Barry Schwartz:

The talk applies to everything we do but (staying on subject) I’m going to talk about its relation to business.

In my post The Real Causes of the Financial Crisis, I talked about how misaligned incentives led the system astray. But even if you properly incentivize people to do the right thing, that doesn’t mean everything is going to work out. In my previous post, I left it at “However, there’s no perfect solution.” But now I’d like to elaborate.

Dick Fuld, Jimmy Cayne and other financial execs had significant share ownership relative to their personal net worth. In other words, their interests were strongly aligned with shareholders. But that didn’t stop them from making bad decisions that were not only harmful to their company, but bad for society as a whole.

Optimally, you want management that doesn’t need incentives to do the right thing. Good incentives can help, but they aren’t going to cut it. Financial managers in particular need risk aversion ingrained in their personality. They need to be willing to stray from the herd and not follow the crowd. They need to have the wisdom, as Barry Schwartz described it, to do the right thing.

In looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if they don’t have the first, the other two will kill you. … If you hire somebody without the first, you really want them to be dumb and lazy.
Warren Buffett

In terms of business and finance, you can’t find a better example of a wise person than Warren Buffett.

As an investor or an employee, you want a business leader who is passionate about their company and the product they are selling—not about the money.* Qualities like this can be very difficult to determine. Buffett not only shares them, but he’s good at seeing them in others (one of the major reasons he is so successful).

In business school, you’re not taught to have character. You’re given the numbers, the statistics, the “how to” in a step-by-step fashion. But sometimes, its better to focus on common sense instead of what the figures say. Wisdom, virtue and common sense: all things that can’t be taught, no matter how prestigious the school.

* One last note — if I were the shareholder of a company that has received TARP funds, and will now have salary/bonus caps at $500k, here’s what I’d think: 1) if management gets paid a little less while we’re receiving a safety net from our government, that’s fine. 2) If one of my managers wants to jump ship so he can get paid more somewhere else, then great. It turns out I didn’t want him at the company in the first place.

The Real Causes of the Financial Crisis

(The following is an excerpt from the most recent letter to the partners of Braewick Holdings LP. I’ll be posting a presentation that goes along with this commentary shortly.)

There have been many explanations thrown around of how we got ourselves into this mess. However, I have a slightly different take on what really caused the problem—and what hasn’t been fixed yet.

The public always enjoys finding someone to burn at the stake. Who is to blame for the current mess? Many culprits have been named: greedy executives, The Fed, short sellers, Democrats, Republicans, CDO’s, CDS’s, real estate speculators, and so on. However, the real issues are more systemic. Derivatives and bad mortgages may be where the problem started, but in and of themselves, did not cause this mess.

In my view, there were three problems that led to the collapse of financial markets: misaligned incentives, poor risk management, and needless complexity. All three problems are not specific to the current crisis, but are widespread and must be addressed to avoid future dilemmas.

If You Give A Mouse a Cookie…

He’s going to want some milk. And if you give a Wall Street executive a $30 million bonus, he’s going to want a bigger one (and he’ll use the same methods to get it—after all, it worked the first time, didn’t it?).

Misaligned incentives were pervasive. And because incentives drive behavior, things are eventually not going to turn out as desired.

This occurred on almost every level. Executives were being rewarded for taking risks with only short-term payoffs. Mortgage originators made money based on the volume of mortgages given, not on their quality. Rating agencies getting paid by the companies they have to subjectively rate (causing a huge conflict of interest). Home buyers were incentivized to buy a house they couldn’t afford with low down payments, teaser rates, no-documentation Adjustable Rate Mortgages, and 0% interest.

Many of the asset managers (including banks, hedge funds, and insurance companies) were given incentives to take huge risks with the firm’s capital only because they produced outsized short-term gains. They were given very large bonuses or a cut of the profits with no downside risk (other than a pink slip and severance payment). There was no link between immediate actions and their future consequences.

Business managers and decision makers need to constantly look at how their incentives are structured. People will naturally do things in their own self-interest, and managers need to react accordingly. Some incentives aren’t so obvious—giving a trader a cut of the profits may not sound bad at all. But even if it’s not their intent, people usually end up gaming the incentive in their favor. If traders aren’t punished for taking long-term risks in pursuit of profit, then guess what—that’s what they’ll do. Continue reading “The Real Causes of the Financial Crisis”

Decisions in the face of uncertainty

Studying Students’ Reaction to Chance

An interesting article on a contest held at University of Virginia’s Darden School of Business. The contest split 269 students into two groups:

1. The first chooses one of two unmarked briefcases. One has a check for $18,750, and the other has nothing. Before opening the case, they are offered a chance to receive a fixed amount of cash in its place. It’s their choice.

2. The second group is given the cash upfront, and then offered the chance to buy one of the briefcases. For the student mentioned in the article, he was given $3,000. He could have walked away with the $3k, or bought the right to choose one of the cases.

The research showed that “buyers” (the second group) were more likely to keep the cash. Of course that isn’t rational, because the expected value of the case selection is $9,375 (a 50% chance of getting the $18,750 check).

The students admitted the decision is easier on paper, and more difficult when you have a handful of cash.

Overall, I’m glad Darden is doing research like this and teaching the students about decision making in the face of uncertainty. More schools should be doing the same.