Friday, Jun 4th 2021

How to predict the future


“Show me the incentives and I will show you the outcome.” — Charlie Munger

Intelligent investing can sometimes look, from the outside, like soothsaying: successful investors appear to divine the future of a company through mysterious means, and reap the hearty benefits of their preternatural foresight.

Of course, as investors, we aren’t gazing into a crystal ball. We’re analyzing companies and industries through a series of mental models. And one of the most powerful among them is the study of subtle drivers of behavior: incentives.

Incentives come in many different forms, in business as in life. They may take the form of large sums of cash, the desire to be recognized and admired, the pursuit of growth: any human motivation you can think of can, in theory, be an incentive.

Businesses are acutely aware of this reality, and they design their organizations through incentives, via compensation structures and cultural programs. For example, employees at Valve spend 100% of their time on self-directed projects, in a bid to create a greater sense of ownership among employees. At other companies, incentive programs are often built around stock options, employee wellness, or new hire referrals.

“Life is hell,” wrote the author Janet Frame, “but at least there are prizes.” Understanding the incentives at play—knowing what “prizes” a company holds in its employees’ sights—is fundamental for investors to develop and act on a likely vision of the future.

Charlie Munger, Warren Buffett’s right-hand man, gives an example of how the Federal Express was able to boost productivity by shifting their employees’ compensation plan from an hourly rate to a per-shift basis:

"The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in one central location each night. And the system has no integrity if the whole shift can’t be done fast. And Federal Express had one hell of a time getting the thing to work.

And they tried moral suasion, they tried everything in the world, and finally somebody got the happy thought that they were paying the night shift by the hour, and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked."

In short, creating solid incentive plans is essential for organizations to achieve their end goals. For investors, it’s important to analyze both an organization’s “incentive plan” and the incentives of the individuals impacted by that “plan.” Whether these two factors align or clash, investors can derive meaningful signal and build conviction around forecasts.

In a world that’s otherwise inherently difficult to predict, at least there are prizes.

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