IBM: Incentives Are Most Important

| About: International Business (IBM)

Let's start off by telling readers that this article won't try to analyze the minute details of IBM's (NYSE:IBM) business workings or make any forecasts on revenues for a few reasons. Number one, I am horribly qualified. Number two, and more importantly, I don't think that is where we shareholders should be looking. Those things will take care of themselves as long as proper incentives are used company wide.

As Richard Dawkins once said in his book The Blind Watchmaker "For any given level of complex organization, satisfying explanations may normally be attained if we peel the hierarchy down one or two layers from our starting layer, but no more." He gave an example of how we might describe the workings of a car in terms of spark plugs, ignition, cylinders and fuel injectors. He said, "But if you asked me how a motor car worked you would think me somewhat pompous if I answered in terms of Newton's laws and the laws of thermodynamics." Companies, especially large companies such as IBM, are complex organizations. If we focus on the short term minute details (i.e. specific technology, forecast revenues, etc,.), we might get lost in the information and start overlooking the important wider picture. One of the wider picture aspects that I am trying to focus on more, that I believe will help me as a long-term investor, are the incentives management and workers have in the company. Long-term shareholders want to have a management and group of employees with incentives aligned with them.

Why Focus On Incentives?

Let's peel back one layer and see why incentives are important. Incentives are one of the most important forces in human nature, yet humans often underestimate its full power. These incentives are so powerful that they can change how a person goes about their work or life. Recall Charlie Munger's example with Federal Express (NYSE:FDX). The night shift was having all sorts of problems getting packages moved fast enough. Everything was tried but it wasn't until someone changed the worker's pay from hourly to pay by the shift did the system work better.

We all have some sort of incentive caused bias and we investors should continually be reminded of them and the incentive caused biases related to all of our investments. It is fairly certain that a company with properly incentivized management and employees good things will happen for all, including shareholders.

IBM Employees Have Proper Incentives

What initially sparked my article was the quote that Ginni Rometty made in the Q4 results "…in view of the companies overall full year results, my senior team and I have recommended that we forgo our personal annual incentive payments for 2013." Some might say that of course if management doesn't perform well, then they shouldn't receive incentive pay. What I see is a management team that is willing to give up their incentives for the betterment of the company's long-term success. It makes sense when management, CEO and SVPs, own $208 million in IBM shares (According to most recent Def14A).

Let's start by first exploring the incentive structure at IBM

IBM is not unlike many other companies with compensation paid in salary and other performance based incentives. What I find different is that all IBM employees make a Personal Business Commitment or PBC that outlines the quantitative and qualitative goals they seek to achieve in that year. These goals aren't created in a vacuum. Individuals and their respective managers tailor each PBC to meet the goals of the department and the whole company. PBCs are powerful because written commitments establish the goal as being congruent with the employee's self-image. An interesting example given by Robert Cialdini in his book Influence is how the Chinese brainwashed American prisoners of war in the Korean War and got them to re-write their self image by becoming believers in Communism. The Chinese were able to do this by frequently asking the American prisoners to make mildly anti-American or pro-Communist statements which were then elevated to more substantive requests. A prisoner would get asked to write a list of what is wrong with America, write it down and sign it, followed by an essay. PBCs work on the same powerful levels of influence as the Chinese brainwashing, but are for the greater good of the employee, company and shareholders.

PBCs also act as the assessment method by which employees get bonus assignments, salary adjustments and future career development opportunities. There are four levels on the PBC scale - one being the highest and four the lowest - which act as measuring sticks for personal performance and business performance. When the company is not performing on all cylinders management and all employee annual performance pay is reduced.

We already know that the CEO and SVPs will be losing annual incentive pay which last year made up 17-27% of their total compensation. Lower ranked workers won't have lost that much of their total compensation but are likely to have small if any year-end bonuses. Add to the fact that management is one of the most shareholder friendly teams with their exceptional capital allocation (use of large share repurchases), we can assume they have the long-term in mind and employees incentives are aligned for the long-term. When long-term incentives are properly in place with talented individuals, it is only a matter of time for them to work hard on achieving the best long-term goals for success.

Disclosure: I am long IBM, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As an owner of IBM and contributor for Seeking Alpha, I have two incentive caused biases. I have an incentive to write positive things about IBM and have an incentive to write this article in a timely fashion. Even though these biases are present, I try to take time in providing the facts and a unique perspective on investing using multiple mental models. This article is in no way a recommendation to buy or sell. Please do your own research and remember to keep incentive caused biases in mind when you invest.