Imperfect Substitutions For Success And Prosperity

Someone that attended my high school is currently the manager of a McDonald’s franchise in St. Louis. Among other things, he brought up the fact that his compensation and opportunities for advancement are tied to the speed at which orders are filled. There is a screen that appears for the McDonald’s workers to see after a customer places an order, and a McDonald’s worker presses a button to signal that the order is completed. This is how the company manages efficiency. The logic is that customers served within three minutes of placing their order will be happier and more likely to return than if the order takes six minutes.

But this system is not a perfect substitute. It doesn’t actually measure the time it takes a customer to receive an order, but rather, the speed at which a McDonald’s employee can press a button. Like anything else when the incentive system doesn’t perfectly capture what is sought, the system gets games. The especially industrious employees at McDonald’s get in the habit of pressing the button once the delivery time seems believably fast, and then carry out the rest of the order from memory. The customer doesn’t get the speedy service that is indicated on the averages sent to the franchise owner and McDonald’s headquarters, and the improvement doesn’t happen quite like planned.

This is one of the things that makes life interesting because it is difficult to get right at the essence of something. So we settle for substitutes that aren’t quite right. When people think about students that attend Ivy League schools, the assumption is that those are the smartest young people that America is producing. That is close, but not quite right. There’s no magic laser beam that Harvard Admissions points at the general population that reveals the 4,000 eighteen year olds with the best combination of brilliance, creativity, work ethic, and personality (and we might not even agree those are the traits that should be measured).

Instead, we settle for proxies like the SAT or ACT that are supposed to be close proxies, but still aren’t quite right. There are plenty of smart young people that can’t hawk their potential appropriately in three hours of multiple choice questions, and there are plenty of young people that are naturally smart and can get coached to correctly answer these types of questions but don’t have the ability to think critically and independently.

These inaccurate measurements lead to interesting outcomes. If someone gets into criminal legal trouble in St. Louis, and has a lot of money to spend on legal fees, they are not going to call a graduate of Harvard Law School. They are not going to call a graduate of Stanford Law School. They are not going to call a graduate of Yale Law School. They are going to call a man that graduated from California Western. And this happens across all industries, professions, you name it.

It is because there is a difference between technique and commitment. When you succeed in high school and college, a portion of the success stems from being able to parrot back information. You learn certain techniques, commit a squared plus b squared equals c squared to memory, and plug your way to success. It’s not critical thinking that is essential in this environment, but the ability to regurgitate the narrow lessons that are taught. This skill set is useful when you operate in a closed, self-contained universe where all the problems are similar to each other.

It is less useful when problems are open-ended, and broad philosophical approaches mixed with a persevering work ethic become better indicators of problem-solving and general effectiveness. This is tricky to measure—how do you know ahead of time who will put in 100 hours to get the project done because he regards mission completion as a moral duty? How do you know ahead of time which businessmen will create an incentive structure that rewards female-sellers with jewelry and male-sellers with sports tickets (or vice versa if preferred) as a way of spurring sales? How can you predict which executive can offer soothing words and new perks to retain a client that is threatening to leave after something goes wrong? How do you know ahead of time which gas station owner will set up a lottery system after each gas purchase over $20 that gives customers a 1 in 7 chance of receiving a free soda, thus giving his gas station a positive differentiation attribute in an area that is usually commodified? This type of potential is not easy to recognize, and it’s even harder to create a system that recognizes in advance people with these capabilities.

Imperfect substitutes exist in the business world as well. It had originally become fashionable to tie executive compensation at major corporations to stock price. After some trial and error, it became clear this form was imperfect because it doesn’t take into account goosed short-term profits, P/E multiple expansion or contraction, and other things that don’t directly measure business performance. Say what you want about Immelt at General Electric, but stock-price compensation would have been unfair given that he took over GE at a time when the company was trading at 50x profits. Even if he ran the company wonderfully, an eventual reversion towards 20x profits would erode away any business growth that he actually delivered.

The follow-up trend involved tying executive compensation to earnings per share growth. This is what IBM pioneered, and exists to this day. While profits per share are quite important, it doesn’t quite capture creativity, long-term product development, and moat protection because those things are subjective and involve uncertainty. Earnings per share correlates to success in those areas, but does not perfectly capture this.

Like anything else, it ends up getting gamed. IBM engages in large share repurchases and layoffs because it delivers certainty and profits now, and earnings per share increases even if long-term product development gets underinvested. In other words, the incentive exists for IBM to grow earnings per share while they are there—it does not perfectly capture long-term loyalty to the best interests of the business.

This does not mean that IBM is a bad investment. It probably will do well for owners over the long term. It is cheap, and a lot of shares are currently getting reduced, and that does boost earnings per share (which is an important metric). But some product development and robustness of IBM’s business creativity is getting sacrificed, though not enough to prevent it from building wealth for shareholders.

A good example of getting the incentives right involves studying Warren Buffett’s relationship with Chuck Huggins at See’s Candies. He gave Huggins a compensation structure that involved growing market share, creating new products, opening new stores, and sending more profits to Berkshire Hathaway each year. Buffett famously told him, “I hope I write larger and larger checks to you each year.” That kind of attitude isn’t common, but it led to a wonderful relationship that lasted over four decades and gave Warren Buffett over $1 billion in excess chocolate cash to invest from an initial investment of only $25 million. Interesting what happens when you get the incentives right, no?


Originally posted 2015-03-30 23:08:00.

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