Canadian Solar Industry: 16 Billion Addressable Market ?

Photovoltaic Energy: Is the Tipping Point Approaching?


The renewable energy industry is not new, nor is most of the processes used to convert renewables into useable energy new. What is new however is the adoption by consumers at an impressive pace, driven by compelling forces such as climate change, ecosystem destruction, or other tragedies pertaining to exploration, development and transportation of non-renewable energies.

Solar technology was invented in the middle of the 19th century during the industrial revolution to heat water that fuelled steam engines. Edmond Becquerel discovered the photovoltaic effects in 1839 while Russell Ohl was awarded a solar cell patent in 1939 and is credited for discovering P-N junction, which is used as a diode to control the electrical current flow in one direction. (PBS, 1999)


How Solar Panels Work

 Photons are emitted from the sun in waves that travel towards earth eventually striking glass, conductive material and metal compounds known as solar panels. Silicone is a common chemical used as a conductive layer and when the photon strikes the tin dioxide and silicone the photon becomes excited, emitting an electron into the positive layer. The electron then travels from the positive layer into the negative layer and into the wired current creating what we call electricity. During the process the photon travels through a catalyst that allows the process to be reset and accept new electrons.


We will be focusing most of our research attention towards the solar industry specifically but due to the “lumped” reporting of renewable energy and the energy industry as a whole, some guess work will unfortunately be made. The renewable energy industry is classified as wind, geothermal, solar, tidal, and biomass or other sources of energy that can be replenished naturally within a human’s ordinary lifetime.


 The year over year growth of the OECD renewable energy consumption from 2011 to 2012 was 13.2% while North America grew individually by 11.6%. OECD counties accounted for 71.3% of the global consumption, while the U.S alone made up 21.4% of global consumption. (BP Statistical Review, 2013) This bodes well for Canada who exported virtually all energy that was not domestically consumed to the United States.


Solar City the leading provider of solar panel installations in the United States expects 70% annual growth from 2013-2018, targeting one million customers. At the end of 2013 the United States overtook Germany as the leader in solar panel installation and new available capacity. (Solar City 10-K, 2013)


Tariffs and trade restrictions on solar PV between various countries produce short-term strengths for domestic manufactures but impose higher costs to consumers. It would be expected that boarders open up further and tax benefits are scaled back as the industry reaches a self-catalytic tipping point. We are seeing the process unfold as large integrated oil companies expand their renewable presence because of the threat of niche entrants. The International Energy Agency estimates that PV could supply 33% of the world’s electricity as soon as 2060 while it currently only supplies about 1%. (IEA, 2013)




The Canadian market accounts for 1.8% of the global consumption of renewables and grew consumption 10.5% YOY. Canada’s energy sector employs over 280,000 people, contributing to roughly 9.5% (about 107 billion) of the 1.124 trillion GDP. (NRCAN, 2012)


  • 98.4% of Canadian energy exports are to the U.S (NRCAN, 2012)
  • 16.9% of primary energy supply is from renewables (NRCAN, 2010)
  • 8,200 people were directly employed by the solar industry in 2012 with expectations of 74,000 employed by 2018, an employment CAGR of 37% (CSA, 2011)
  • The average Canadian uses 800 Kwh a month at an average cost of 0.10-0.15/Kwh (Ontario Hydro, 2012)
  • In 2010 a total of 588.9 terawatt hours of electricity were generated while solar contributed roughly 3% or 17.667 billion Kwh. (NRCAN, 2010)
  • Ontario is a major player in the North American Solar industry, ranking top 5 (by state or province) for solar capacity installations since 2010.
  • Total solar PV capacity in Canada is expected to increase from 291 megawatts in 2010 to 12,000 megawatts in 2025 (CanSIA, 2011)Canada’s installed capacity for solar has seen average annual growth of 9.5% since 2000, reaching a capacity of 819 megawatts of thermal power in 2011. The 2008-2011 period however experienced catalytic and robust growth of installed capacity for solar power, reaching an annual average growth rate of 147.3%. (CSA, 2011)


Based on 17,640 GWH produced by PV and a sale price of 10-15 cents per Kwh when converted to electricity, we find a contribution of about 2-3 billion dollars towards GDP, roughly 0.18-0.27% of the total. Solar City estimates that the total current addressable market in North America is about 63 billion in U.S dollars, using a 14-cent per Kwh assumption. The Canadian electricity market under our assumptions is slightly smaller at 15.75 billion using the assumptions of 0.10/Kwh, 4500 Kwh consumed daily by all Canadians (35 million).



The solar industry has large upfront capital costs as well as on going maintenance. The capital costs are associated with financing inventory, customer leases, on-going operations, technological changes, and the skillful labor that is required for research, development and installation. Currently the Canadian government allows accelerated depreciation of 50% on solar panels, photovoltaic producing assets and costs incurred including feasibility, environmental and site approval studies. (CRA, 2012)


The solar industry is unique regarding the stakeholders as the capital suppliers are also primary customers of the product market and are partial owners of the organizations assets creating an opportunity for complete synergy or dysfunction. The government of Canada has also implemented strategic policy under the headline banners of REDI (Renewable Energy Development Initiative) and LTEP (Long Term Energy Plan) to spur investment, fueling supply and quicker consumer adoption rates as costs and margins are reduced. Because of the long term life of the useful asset an opportunity is created for residential consumers inclined to finance the debt over 20-30 years using the cost savings of their utility bill or cash flow from resale of electricity.


(Figure 1: CSA, 2011)


(Figure 2: CSA, 2011) 

The jobs created by investments in PV are more efficient in terms of jobs produced per GWh and the initial cost of that job shown in both figure one and figure two (above).

The renewable industry as a whole and the solar industry specifically cater to a relatively new trend, the triple bottom line. The triple bottom line is the product of p cubed, or people, planet and profit. Consumers are willing to pay more for the utility that is gained from sustainable purchasing methods, which is evident judging by today’s consumer trends. As consumers continue to adopt disruptive technologies the dynamics of the external market are changed and as Christensen notes in his renowned book Innovators Dilemma, markets that do not exist can’t be measured.

An industry’s profitability is a function of interactions between: 1) Suppliers 2) Buyers 3) Competition 4) Product Substitutes 5) Market Entrants. Studying the dynamics of game theory (prisoners dilemma) and the asymmetric payoffs of convexity are sure to lead to a more even playing field, quite possibly even a competitive edge.

Appendix (A) – Conversion Chart


W = Watt 1000 W = 1 KW
KW = Kilowatt 1000 KW = 1 MW
MW = Megawatt 1000 MW = 1 GW
GW = Gigawatt 1000 GW = 1 TW
TW = Terawatt

Charlie Munger: Whats Wrong With Economics

“Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step-by-step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day-by-day, and at the end of the day – if you live long enough – like most people, you will get out of life what you deserve.” – Charlie Munger

[Ed Wexler, Poor Charlie’s Almanack]

Charlie Munger is a brilliant man and I cannot believe how neglected he is in the shadow of Buffett and Berkshire. Charlie gave an insightful lecture titled Academic Economics: Strengths and Faults after Considering Interdisciplinary Needs and gave it on Oct. 3rd, 2003 to the Herb Kay Undergraduates at the University of Santa Barbara Economics Department.

It is the 9th talk in the (Must Read) book, Poor Charlie’s Almanack. Charlie gives much deserved praise to Adam Smith, John Maynard Keynes, Riccardo and Paul Krugman in the beginning of the lecture, although he clearly favored Smith.

Adam Smith was so good a thinker and so good a writer that, in his own time, Emmanuel Kant, then the greatest intellectual in Germany, simply announced there was nobody in Germany to equal Adam Smith. Well, Voltaire, being an even pithier speaker than Kant, immediately said, Oh well, France does not have anybody who can even be compared to Adam Smith.

As Charlie always does, he leaves the apprentice to reach for the answer, explanation, reasoning and judgment. [Hint: Read Wealth of NationsThe Principles of Political Economy and Taxation, and General Theory of Employment, Interest and Money.

  • He explains he has this tendency of leaving questions unanswered because of the way his father taught him, leaving analogies open to interpretation and attribution.

So What’s Wrong With Economics?

Charlie puts forth nine simple ideas to help the economics discipline progress in the years to come and obtain a multidisciplinary attitude along the way.

1) Fatal Un-Connectedness, Leading To “Man With A Hammer Syndrome,” Often Causing Overweighing What Can Be Counted

Simply stated, Overweighing what can be counted, an excessive reliance on quantitative measures leads to and causes fallability. 

As Einstein once said famously “All that can be counted, does not count.”

And Charlie added . . .

[Humans] (1) overweigh the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. 

One of the most important factors in business cannot be counted. Culture.

Sure you could make up some asinine balanced scorecard, fitting the model to the mood, or you could use your multidisciplinary knowledge in history, biology and psychology to develop an intrinsic model of what has worked and why

What makes a strong culture? What kind of culture does your dream job entail? Why?

Who do you not want to work for? Why? What makes a weak culture? Why? 

2) Failure To Follow The Fundamental Full Attribution Ethos of Hard Science

“What’s wrong with the way Mankiw does economics is that he grabs from other disciplines without attribution. He doesn’t label the grabbed items as physics or biology or psychology, or game theory, or whatever they really are, fully attributing the concept to the basic knowledge from which it came. If you don’t do that, it’s like running a business with a sloppy filing system. It reduces your power to be as good as you can be.”

Attribution helps memory retention through structural recognition of the problem and relates to ones own experience and knowledge for better understanding.

3) Physics Envy

The envy of physics can be simplified into mistaking soft science for hard science and attempting to oversimplify what is dynamically complex. Everything should be made as simple as possible, but no more simple.

Charlie illustrates the point with Washington Post. Washington Post in the early 70s was trading at “a fifth of what an orangutan could figure was the plain value per share by just counting up values and dividing” but because some partner at McKinsey had been educated in capital asset pricing model, beta, efficient market theory and even worse, believed what he was taught, a stock buyback program was neglected.

At the time it was conventional wisdom that companies should not buyback shares on the premise that the market is efficient. This means there is no advantage in buying shares. Luckily for Washington Post shareholders, Warren Buffett (TradesPortfolio) came along and convinced the board to buy 50% of outstanding shares, creating over a billion dollars in value in the process. The rest is history.

The moral of the story being soft sciences are not governed by laws but rather plausible rules or heuristics that are easily broken. The second example of physics envy is of a rustic legislator that attempted to have a law passed to round Pi to 3.2, allowing school children to make computations easier. Luckily the law did not pass, as architects and quantum physics will agree.

4) Too Much Emphasis on Macroeconomics

“There’s too much emphasis on macroeconomics and not enough on microeconomics. I think this is wrong. It’s like trying to master medicine without knowing anatomy and chemistry.”

Charlie gives us a problem to solve to illustrate the lesson at hand.

Business: Tire Chain, Les Schwab

Sales: Hundreds of Millions from zero in 50 years

Founder: No formal education and is now age 80.

How did he do it?

Well, let’s think about it with some microeconomic fluency.

Is there some wave that Schwab could have caught?

The minute you ask the question, the answer pops in. The Japanese had a zero position in tires and they grew rapidly. So this guy must have ridden that wave some in the early times. Then the slow following success has to have some other causes.

“He must have a very clever incentive structure driving his people. And a clever personnel selection system, etc. And he must be pretty good at advertising. Which he is. He is an artist.”

Charlie explains extreme success is likely to be caused by some combination of the following factors, surfing the wave being the most important:

A) Extreme maximization or minimization of one or two variables.

B) Adding success factors so that a bigger combination drives success, often in non-linear fashion, as one is reminded by the concept of breakpoint and the concept of critical mass in physics. Often results are not linear. You get a little bit more mass, and you get a lollapalooza result.

C) An extreme of good performance over many factors.

D) Catching and riding some sort of big wave.

Microeconomics and smaller subconscious cause and effect relationships are the governors of macroeconomics, much like quantum physics governing macrophysics, macrophysics meaning visible and measurable to the naked eye.

5) Too Little Synthesis in Economics

This section can quickly be explained by a problem that Charlie had proposed in combination with the Riccardo comparative advantage and Smiths pin factory observation.

  • Comparative advantage states, it is beneficial for two countries to trade, even though one of them may be able to produce every kind of item more cheaply than others.
  • Adam Smiths pin factory is an observation he made and detailed in the wealth of nations. Smith found that ten workers were able to produce 48,000 pins per day because of the divided and specialized labor. If each worker handled all the steps required to make a pin, he could only make twenty per day. It pays to embrace specialized labor.

Charlie provides an example of a delinquent hotel property, in a bad neighborhood, that had caused nothing but problems and losses in the past. The previous owner (like most of us) encountered the problem of functional fixedness, a problem solving inhibitor. It took a new chap with very little conventional knowledge to turn the ship around. Of all things he needed the hotel as a hub, to store elderly travelers overnight. A shuttle bus picked them up and dropped them off (at Disneyland) so there was no need for the parking lot.

Breaking the functional fixedness of a typical hotel revenue model and turning the parking lot into a putting green solved the problem. Specialization and comparative advantage at its finest.

6) Extreme and Counterproductive Psychological Ignorance

Here I want to give you a very simple problem. I specialize in simple problems.

You own a small casino in Las Vegas. It has fifty standard slot machines. Identical in appearance, they’re identical in the function.

They have exactly the same payout ratios. 

The things that cause the payouts are exactly the same. 

They occur in the same percentages. But there’s one machine in this group of slot machines that, no matter where you put it among the fifty, in fairly short order, when you go to the machines at the end of the day, there will be 25% more winnings from this one machine than from any other machine. What is different about that heavy winning machine? 

Male: More people play it. 

Charles Munger: No, no, I want to know why more people play it. What’s different about that machine is people have used modern electronics to give a higher ratio of near misses. That machine is going bar, bar, lemon. Bar, bar, grapefruit, way more often than normal machines, and that will cause heavier play. How do you get an answer like that? Easy. Obviously, there’s a psychological cause: That machine is doing something to trigger some basic psychological response. 

7) Too Little Attention to Second and Higher Order Effects

This fallability is quite understandable, because the consequences have consequences, and the consequences of the consequences have consequences, and so on. It gets very complicated, very quickly. 

Higher order effects can attributed to cause and effect relationships as well as posterior probabilities. Thinking about the 2nd and 3rd level order effects in a “fish bone” style is a great way to train. 

– New incentives cause expected behavior to deviate because it is based on past incentives (Medicare exuberantly underestimated by over 1000%)

– Investing in textile looms. How much of the proceeds from capital investments will stay at home (in the owners pockets) versus the consumers pocket (in the form of lower prices).

Game theory or dynamical systems are also a great place to start to understand higher order effects.

8) Not Enough Attention to the Concept of Febezzlement

If you have embezzlement that is not known to the embezzled, it has a wonderful Keynesian stimulating effect on the economy because the guy who’s been embezzled thinks he is rich as he always was and spends accordingly, and the guy that has stolen the money gets new purchasing power.

Although anyone with background knowledge in algebra will understand this effect is quickly cancelled out upon discovery of the embezzlement. Essentially a legal, yet unethical, juiced up wealth effect.

Febezzlement = the functional equivalent of embezzlement.

9) Not Enough Attention to Virtue and Vice Effects

The last point Charlie made is best taught with the story he used regarding the differences in attitude, integrity, culture and how social proofing/envy take hold in his speech to Stanford University Law School Address.

“I have a friend who made an industrial product at a plant in Texas not far from the border. He was in a low-margin, tough business. He got massive fraud in the works compensation system – to the point that his premiums reached double-digit percentage of payroll. And it was not that dangerous to produce his product. It’s not like he was a demolition contractor or something.

[The friend wasn’t able to convince the workers to stop the fraud]

So my friend closed his plant and moved the work to Utah among a community of believing Mormons. Well, the Mormons aren’t into workers’ compensation fraud – at least they aren’t in my friend’s plant. And guess what his workers compensation expense is today? It’s two percent of payroll – down from double digits. 

Letting the slop run causes this sort of tragedy. You must stop slop early. It’s very hard to stop slop and moral failure if you let it run a while.”

The last point can be distilled or simplified into four main points.

  • Trust, Virtue, Honesty and Integrity.

Keynes once said: “It’s not bringing in the new ideas that’s so hard. It’s getting rid of the old ones.” And Einstein said it better, attributing his success to “curiosity, concentration, perseverance and self-criticism.

By self-criticism he meant becoming good at destroying your own best-loved and hardest-won ideas. If you can get really good at destroying your own wrong ideas, that is a great gift.

Always look for disconfirming evidence. 

Munger Problem: Achieve Higher Physical Volume By Increasing The Price?

Achieve Higher Physical Volume By Increasing The Price?


Now tell me several instances when, if you want the physical volume to go up, the correct answer is to raise the price?

“You have studied supply and demand curves. You have learned that when you raise the price, ordinarily the volume you can sell goes down, and when you reduce the price, the volume you can sell goes up. Is that right? That’s what you’ve learned?” They all nod yes. And I say, “Now tell me several instances when, if you want the physical volume to go up, the correct answer is to increase the price?” And there’s this long and ghastly pause. And finally, in each of the two business schools in which I’ve tried this, maybe one person in fifty could name one instance. And nobody has yet to come up with the main answer that I like.”

Answer: There are four categories of answers to this problem. A few people get the first category but rarely any of the others.

  1. Luxury goods: Raising the price can improve the products ability as a “show-off “item, i.e., by raising the price the utility of the goods is improved to someone engaging in conspicuous consumption. Further, people will frequently assume that the high price equates to a better product, and this can sometimes lead to increased sales.
  2. Non-luxury goods: same as factor cited above, i.e., the higher the price conveys information assumed to be correct by the consumer, that the higher prices connotes higher value. This can especially apply to industrial goods where high reliability is an important factor.
  3. Raise the price and use the extra revenue in legal ways to make the product work better or to make the sales system work better.
  4. Raise the price and use the extra revenue in illegal or unethical ways to drive sales by the functional equivalent of bribing purchasing agents or in other ways detrimental to the end consumer, i.e., mutual fund commission practices. [This is the answer Charlie likes most, but never gets]

I found the following problem to be fascinating. From my personal thoughts I was able to come up with the answer luxury goods (I have background experience at Luxottica Retail) as well as an answer that was not provided, although it does relate to number 4. The tactic I thought of (among others) is using stimuli that are addictive, nicotine, etc. to create operant conditioning while slowly raising the price as the social proof factor materializes. If the price is relatively inelastic (determined by observing behavior), the additional funds can be used to market/sell additional product, boosting revenue and creating a lollapalooza effect of marketing, price raises, social proofing, operant conditioning, critical mass, etc. The example is also relatable to pharmaceuticals.

This happened in the case of my friend Bill Ballhaus. When he was head of Beckman Instruments it produced some complicated product where if it failed it caused enormous damage to the purchaser. It wasn’t a pump at the bottom of an oil well, but that’s a good mental example. And he realized that the reason this thing was selling so poorly, even though it was better than anybody else’s product, was because it was priced lower. It made people think it was a low quality gizmo. So he raised the price by 20% or so and the volume went way up.

But only one in fifty (2%) can come up with this sole instance in a modern business school – one of the business schools being Stanford, which is hard to get into. And nobody has yet come up with the main answer that I like. Suppose you raise that price, and use the extra money to bribe the other guy’s purchasing agent? (Laughter). Is that going to work? And are there functional equivalents in economics – microeconomics – of raising the price and using the extra sales proceeds to drive sales higher? And of course there are zillion, once you’ve made that mental jump. It’s so simple.

Now let us quickly reexamine the problem with the benefit of hindsight bias and frame the questions in such a manner a physicist or algebraist would.

Invert. Always Invert. – Carl Jacobi


When can we lower the price and lose sales volume? How?

  • Products associated with reliability or quality, deterioration of social proof and operant conditioning overtime to competitors.

When can’t we raise the price and increase sales volume?

  • Obviously not everyone would be able to exploit such a pricing process or else the government would step in with price controls. The answer is likely to come from non-regulated or minimal regulated industries.

Of course none of these answers are definite and at best are messy and uncertain.

Why did Max Planck, one of the smartest people who ever lived, give up economics?

“It was too hard. The best solution you can get is messy and uncertain at best.”

Entrepreneur Arbitrage Spreads and The Commonality Of Locality

There is a great book that was written in 2000 by Amar Bhide called “The Origin and Evolution of New Businesses.”

In “The Origin and Evolution of New Businesses,” Bhide’s research showed that almost all businesses are started to take advantage of an arbitrage spread and in “Competition Demystified,” Bruce Greenwald also explains the concept of locality of a business. (The importance of thinking local.)

The two abstract concepts “arbitrage spread and locality” had me thinking for the last few weeks about how an effective business uses these advantages to start and continue to use it as an advantage whilethey scale. There are two types or start-ups described by Bhide: the first, a promising start up like Microsoft, Google, Soda Stream, or Tesla, and the second a marginal start-up like a gas station, landscaping business, motel, hair salon or convenience store.

Marginal startups have low uncertainty, low investment requirements and low likely profit. Promising startups have high uncertainty, low investment requirements and low likely profit.

When it comes to locality of a business a mental model should be made. Think back to just the last few weeks as we watched the Olympic Games unfold in Russia or even the last time you heard about someone you knew from high school, post secondary school or a past job, complete or succeed at something astonishing, publicly.

A greater connection is made with someone (or something) that has a prior associationestablished. This association comes from perceiving a commonality.

In the case of the Olympics maybe you knew someone who grew up in your province or state, even a town close to your own, or quite possibly the same town itself. Did you find yourself cheering them on and telling friends about their triumphs?

Why do we feel a greater connection to the athletes that are “closest to home?”

Why do local businesses and products create an emotional response?

This is because of the commonality of locality, or having an association that is pleasant to the subconscious mind. Small businesses in small towns know this effect quite well as likely does Wal-Mart and other encroaching box stores on the opposite side of the spectrum.

Think Local”

We have likely all heard variations of this saying at one point or another in our lives but have we thought of the metaphorical keys it may hold? In the present business environment where the flow information is quicker, transportation is cheaper, and today’s competitive advantages may be undone in relatively little time, it is important to have a concentrated strategy.

As Greenwald explains, competitive advantages that lead to market dominance are more likely to be found when the distribution and consumption takes place locally versus a large and scattered geographic region. This is ironically because competitive advantages tend to be specific, concentrated and local versus general, vague and diffuse. The more distance or time distribution must be traveled to meet consumption, the higher the costs of logistics. The less distance a message has to travel the quicker information can be absorbed. The stronger the connection or association to the service or product, the greater the emotional attachment.

Thinking local in a globalized world seems to be very counter-intuitive and framed as a paradox. Upon closer examination we find that if emerging markets follow the path of the developed markets the majority of their services and manufacturing will be consumed locally. We consume the majority of what we produce and import goods to make up for the insufficient capacity and excess demand. To paraphrase Adam Smith, the wealth of a nation is determined by what surplus can be produced relative to the demands of the country of origin and traded to other countries that have sufficient demand, creating a positive trade balance.

“The key to investing is … determining the competitive advantage of any given company and the durability of that advantage.” – Warren Buffett (TradesPortfolio

Are entrepreneurs risk takers?

Gates’ opportunity cost when he dropped out of Harvard to start Microsoft (MSFT) was exceptionally low. His labor was probably not worth very much in market at the time. If Microsoft failed he could have simply returned to Harvard to finish his degree.

One could state Gates faced uncertainty and ambiguity, but not risk.

Think back to our example of the gas station attendant for a moment. This gas station attendant realizes that there are no gas stations for nearly 30-mile radius and that people are forced to drive all the way to fill-up. He uses some of his savings to open up shop and he faces little risk of failure, as people will need to fill their cars with gas and an alternative is 30-miles away. If the venture does fail the man can go back to working as an attendant at another gas station or find another job. Things begin doing well for him but he is not likely to end up a billionaire as a result.

The arbitrage spread is the 30 miles between gas stations.

As business begins to boom and becomes more profitable competitors begin to encroach, opening gas stations 20 miles away, than 15 miles and finally 10 miles away, until the arbitrage spread is dissolved. He was collecting the spread until other entrants show up. The durable portion of the equation comes from being able to maintain or increase the arbitrage spread. The gas station has a wonderful competitive advantage when it starts, but that advantage is not durable. Hence it would make a poor investment.

Arbitrage spread comes from three “advantage pools”

1. Supply
2. Demand
3. Scalability

The good news is that the arbitrage spread can last for years. Given enough time, durable barriers to entry may be created such as a brand or supplier discount. Jumping from niche to niche, taking advantage of new arbitrage spreads is the only way to scale, usually the result of demand and supply opportunities.

“Durable competitive advantage is usually the result of unpredictable and rare random events, like IBM’s call to Microsoft to sell them a PC operating system when Microsoft had never built an operating system before and did not have one to sell. These events have no pattern and cannot be forecast when a startup is being formed. They happen to a very small minority. Once a startup has acquired a durable competitive advantage, and investors get an opportunity to buy in well below intrinsic value, backup the truck.” – Mohnish Pabrai (Trades,Portfolio)

Isolating Incentives: Where Are The Carrots Aligned?

Incentives: There is much to be said about incentives and how they influence our individual and collective actions, for better or for worse. It was incentives that unfortunately helped cause the last recession, extravagantly compensating Moody’s credit analysts by quantity (piecework) of rated ABS, MBS and CDSs. Quality of work deteriorated and everything was quickly rated AAA even though it shouldn’t have. Without the credit rating agencies’ blessing, banks would not be able to sell the securities and pension funds unable to buy, suppressing a large portion of both demand and supply.

Real Estate Commission Example

A great example examining the influences of incentives is real estate agents. (There is provided below a quick three-minute video from “Freakonomics.”) Essentially, the real estate agents are influenced by quantity or “closing time” as opposed to looking out for the house seller or buyer, achieving the highest or lowest closing price regardless of closing time.

We can also all think about the typical example of the stock broker who has an incentive to turn our portfolio for commission, inducing us to trade/gamble our hard-earned savings. Fund managers have an incentive to hug the index to keep their job, continually collecting fees from AUM. Established (wealthy, schloarly or political) people are more risk averse, as they have a position to protect and plenty of options. People in poverty or that are not established have fewer options and thus are induced to be risk seeking. The list is endless.

A great quote by Steven Levitt from “Freakonomics” holds true now more then ever while the global bankers (BOJ, BOC, PBOC, FED, ECB, BOE) are holding the golden carrot, artificially creating demand for the lower end of the yield curve, systematically suppressing interest rates. This pushes investors all over the world to reach further up the risk curve for an equivalent return they may have earned otherwise. Historical risk adjusted returns (theoretically) suffer.

“An incentive is a bullet, a key: an often tiny object with astonishing power to change a situation.” – Steven Levitt

Warren Buffett (TradesPortfolio) and Charlie Munger have been advocates of understanding incentives, the biases they cause and have talked numerous times about incentives over the years. Thinking about the incentives involved in a typical situation is a form of inverting the situation, examining it from the other parties’ point of view. Usually, identifying incentives is a great way to avoid a toxic situation or to partake in an enriching one.

So Why, As an Investor Could This Be Beneficial?

Well think about management’s ownership and how this may benefit you. We have all heard the phrase “aligned incentives” but what does it mean? It means that the parties involved are striving towards a similar incentive or goal with reciprocity as the targeted outcome. These are the situations (as investors and business owners) we want to be involved in.

But take the incentives of a management team facing fraud allegations (think Enron’s Jeff Skilling), willing to fight until the bitter end. Not only is their job at stake, but personnel criminal charges are also a possibility.

Identifying where incentives are aligned can be difficult, but if or when a plausible scenario is identified where incentives are aligned in a positive manner, it is best to ride the wave, so to speak.

One personal example of my own that comes to mind is JPMorgan (JPM).

Jamie Dimon bought roughly $20 million worth of JPMorgan shares in the summer of 2012 after the London Whale loss. This instantly caught my attention because I knew it was a large loss (cut the stock 25%) and Dimon already owned a large portion of stock. With the $20 million purchase he was putting his money where his mouth was when he told the Street it was a one-off situation. From what I can recall from my research, he had a net worth of $200 million at the time, most in JPM common shares. The new purchase represented a 10% net worth bet on a horse that he would be jockeying.

The point is, I purchased 200 shares the next morning at $33 (it went to $30 or $31) doing absolutely no research other than on Jamie Dimon’s compensation and incentives, reading the 2011 annual report, and seeing JPMorgan was valued under B/V after a quick balance sheet examination. I sold the shares shortly after in the fall of 2012 for just shy of $40 or a 20% return in three months. The moral of the story: Ride the bigger fishes’ currents, it is a lot less work.

Stock options that are awarded can also be influential incentives behind the company’s performance (or GAAP-reported performance). Stock option induced incentives can create short-term thinking and a desire to achieve analysts’ estimates, sacrificing long-termshareholder value because the ones with the options have no skin in the game, hence one of the reasons Warren Buffett is not fond of (and does not issue) options but pays bonuses in cash on a pay-for-performance basis.

Executive Compensation 

The following is an excerpt from Buffett (TradesPortfolio) regarding executive compensation and identifying executive incentive structure, i.e. compensation.

Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock.

Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.

Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from shareholders into a variety of disappointing projects and acquisitions. Even if these initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was supposed to occur when Fred was issued options.

A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces less extreme results but still can provide lush rewards for managers who achieve nothing.

CEOs understand this math and know that every dime paid out in dividends reduces the value of all outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow forget to tell shareholders that fixed-price options give them capital that is free.

It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists. (“Whose bread I eat, his song I sing.”)

Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets. Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all- too-prevalent rule is that nothing succeeds like failure.

Huge severance payments, lavish perks and outsized payments for ho-hum performance often occur because comp committees have become slaves to comparative data. The drill is simple: Three or so directors – not chosen by chance – are bombarded for a few hours before a board meeting with pay statistics that perpetually ratchet upwards. Additionally, the committee is told about new perks that other managers are receiving. In this manner, outlandish “goodies” are showered upon CEOs simply because of a corporate version of the argument we all used when children: “But, Mom, all the other kids have one.” When comp committees follow this “logic,” yesterday’s most egregious excess becomes today’s baseline.

Comp committees should adopt the attitude of Hank Greenberg, the Detroit slugger and a boyhood hero of mine. Hank’s son, Steve, at one time was a player’s agent. Representing an outfielder in negotiations with a major league club, Steve sounded out his dad about the size of the signing bonus he should ask for. Hank, a true pay-for-performance guy, got straight to the point, “What did he hit last year?” When Steve answered “.246,” Hank’s comeback was immediate: “Ask for a uniform.”

(Let me pause for a brief confession: In criticizing comp committee behavior, I don’t speak as a true insider. Though I have served as a director of twenty public companies, only one CEO has put me on his comp committee. Hmmmm . . .) 

Avoid Excessive Top-Heavy Compensation Structures 

As we can see, identifying outright ownership is an important variable to isolate as it directly aligns with our position, direct ownership through common shares. Stock options, hidden conflicts of interest (consulting fees, kicked to self owned subs or friends), salaries, bonuses and other “perks” can be examined with a search on the Internet and proxy statements (specifically DEF 14A).

If we find incentives are not aligned and compensation is abused at the expense of shareholders, it is time to flip the next rock and move on. If we find incentives are aligned it is time to dig deeper or buy a stake in the business. For the rest of 2014 and beyond let us all practice identifying incentives and inverting situations we face whether investing related or personal, proverbially standing in the shoes of others.

“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. Never a year passes that I don’t get some surprise that pushes my limit a little farther.” – Charlie Munger