2003

Click here to read the letter.

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🧠 Key Takeaways

• While stock options may not directly hit earnings, that doesn’t mean they’re free. Stock options dilute shareholders, and companies usually end up buying back stock to offset that dilution, which is a real cash expense that shows up on the cash flow statement.

• The more you learn about derivatives, the less comfortable you become. Not because you don’t understand them, but because the more that you do understand them, the more you realize how much hidden risk they come with.

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✍️ Memorable Quotes

“When CEOs (or their representatives) have met with compensation committees, too often one side - the CEO’s - has cared far more than the other about what bargain is struck. A CEO, for example, will always regard the difference between receiving options for 100,000 shares or for 500,000 as monumental. To a comp committee, however, the difference may seem unimportant - particularly if, as has been the case at most companies, neither grant will have any effect on reported earnings. Under these conditions, the negotiation often has a ‘play-money’ quality.”

I think what Warren is getting at here is that CEO compensation negotiations are a bit of a joke. You’ve got two sides at the negotiating table, but only one of them (the CEO) actually seems to have an interest in what’s being negotiated.

Whether they get stock options for 100,000 shares or 500,000 is obviously a massive deal to them. But to the compensation committee—who are supposed to protect shareholders—it doesn’t make a difference. Why is that?

Because neither amount of stock options makes a difference to reported earnings, so it feels like they’re just haggling over “play money.” If it doesn’t affect the income statement, the compensation committee doesn’t take it seriously.

But as Warren and Charlie have talked about extensively, this accounting treatment is a mistake. Stock options may not directly hit earnings, but that doesn’t mean they’re free.

Stock options dilute shareholders, and companies usually end up buying back stock to offset that dilution, which is a real cash expense that shows up on the cash flow statement.

So the idea that options don’t matter is unfounded. There is a real cost, but shareholders just don’t see it at first glance.

“If our derivatives experience - and the Freddie Mac shenanigans of mind-blowing size and audacity that were revealed last year - makes you suspicious of accounting in this arena, consider yourself wised up. No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwin’s words, ‘Ignorance more frequently begets confidence than does knowledge.’”

Warren’s basically saying that the more you learn about derivatives, the less comfortable you become. Not because you don’t understand them, but because the more that you do understand them, the more you realize how much hidden risk they come with.

That’s why he references Darwin’s quote. People who don’t understand derivatives—or businesses with large exposure to them—feel confident about them, and people who actually do understand them get nervous.

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