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Good Reading -- March 2012

If you're going to Omaha in May for the Berkshire meeting and would like to meet up, please let me know. I'm going to try (again) to organize a dinner or something.

Facts and Figures

  • The U.S. has 3.3x more Treasury debt outstanding than it did a decade ago, but prices have rallied as yields have plunged by approximately two thirds (Source: Grant's)

  • California has 12% of the U.S. population but one-third of its welfare recipients. (Source: a worthwhile op-ed by two Stanford professors)

  • There are 40 dividend-focused mutual funds that own Apple stock (which has never paid a dividend) and 50 more small and midcap mutual funds that own Apple (which has the largest market cap in the world) (Source: Morningstar)


  • "The Villain" -- a long and excellent profile of Ben Bernanke and his stewardship of the Fed by preeminent financial writer Roger Lowenstein. Highly recommended. This is one of the best articles I've read in a long time. I think it's a fair and balanced look at the man and his policies. Hopefully it will someday be another excellent book in the Lowenstein collection.

  • "Where Asia's Richest Man is Putting His Money Now" -- a fascinating profile of Li Ka-shing.

  • Charlie Rose interviews Daniel Kahneman

  • "Luv and War at 30,000 feet" -- interesting profile of Southwest Airlines.

  • "Groupthink: The Brainstorming Myth" -- a look at creativity and decision-making in groups by Jonah Lehrer.


  • Baupost 2011 letter to investors -- if you don't already have a pdf copy and want one, let me know. One of the best investor letters I've ever read.

Copied Below

  • "Too Much Cash in the Corner Office" -- Roger Lowenstein weighs in on executive compensation.

  • "The Trillions the Government Doesn't Account For" -- a look at accounting in light of the government's future obligations.

  • "Investors Should Ignore the Rustles in the Undergrowth" -- an op-ed in the FT spurred in part by the recent focus on quarterly reporting by public companies.

Too Much Cash in the Corner Office

By Roger Lowenstein February 29, 2012 4:25 PM EST

Chief executive officers are not the only highly paid people in America. It’s just their misfortune that, thanks to disclosure rules, they’re among the most visible. This proxy season coincides with an electoral cycle in which income inequality has become a populist issue for candidates in both parties, which means CEO paychecks will be scrutinized as never before. And what can’t evade discovery is that, even among the very rich, CEOs have been consistently overpaid.

By overpaid, I don’t mean merely highly paid. We live in a capitalist country, and talent is entitled to fetch its price. But to take just one shining example, Larry Ellison, CEO of Oracle, has gorged himself on more than $60 million in stock options every year since 2008. Even if Ellison did groundbreaking work and was a juggernaut of management brilliance, abusive would not be too strong a word.

Fixing CEO pay—making it more reflective of what executives are truly worth—would go a long way toward restoring America’s faith in business, and in equal treatment. How, is the $60 million question.

One myth should be cleared at the outset. In 2008, the CEOs who run companies in the Standard & Poor’s 500-stock index earned, in total, less than 1 percent of what everyone who’s a 1 percenter earned. So it’s unfair to blame CEOs alone for fostering inequality. Defenders of the system cite such data to advance a larger claim. Pay for public company CEOs has risen, they say, for the same reasons it has for movie stars, real estate moguls, and private entrepreneurs: Globalization and technology has created a wider market. Even President Obama, no friend of the very rich, acknowledged in December that “over the last few decades, huge advances in technology have allowed businesses to do more with less, and made it easier for them to set up shop and hire workers anywhere in the world.” Read thoughtfully, that implies that 1 percenters are taking home more because, in an economic sense, they’re earning it.

“The system has worked,” says Steven Kaplan, a professor at Chicago Booth School of Business. From 2000 to 2010, compensation for the median CEO in the S&P 500 rose from $5 million to just over $8 million. (Those figures represent actual dollars received; when calculated by the value of options at the time of grants, pay over the period began and ended at $8 million.) Kaplan asserts that CEOs are “paid for performance.” In a literal sense this is true; CEOs did earn more when their companies succeeded. But they earned so much, as well, for ordinary and unquantifiable performance as to undermine the intended effect. Apple’s new CEO, Tim Cook, may turn out to be every bit as good as Steve Jobs, or he may not. Apple’s board did not wait to find out. In his very first year as CEO, Cook was awarded a pay package worth $378 million over 10 years.

The real explanation for sky-high pay lies in the “agency” problem. Agents exploit their role as intermediaries. They thrive in imperfect markets in which pay scales do not respond quickly, if at all, to results. Hedge fund managers who deliver mediocre returns get rich thanks to their role as agents. Mortgage traders employed by banks got huge bonuses in the fat years but ducked responsibility for losses; they got a free ride on their employers’ capital.

So do some CEOs—though certainly not all. (Steve Ballmer of Microsoft, for example, gets no options and total compensation of $1.4 million.) But all CEOs compete in a warped marketplace. How often does the head of Company X leave for Company Y? How often does a corporation sack its head? It happens more than it used to, but the market remains inflexible, and firings are rarely for reasons of expense. Consider that Philippe Dauman, the chief executive of Viacom, speared $84 million in 2010, and that Eugene Isenberg of Nabors Industries was awarded $100 million last year for agreeing to relinquish his job. These may be anomalies, but it’s hard to imagine them happening in any rational marketplace. The agency problem in the corner office is as old as public ownership, though it was most famously brought to light in the 1980s by Harvard Business School professor Michael Jensen, who observed that CEOs, unlike private entrepreneurs, owned little stock and had scant stake in the common corporate purpose. In a 1989 Harvard Business Review article, “Eclipse of the Public Corporation,” Jensen suggested that public shareholders had become passé. Of course, there was nowhere near enough private capital to replace the mass of public investors. For the public companies that remained un-eclipsed, Jensen reckoned, the next best thing would be to shower stock options on the executives, endowing them with the same incentives as their peers at private firms.

If Harvard Business School thought stock options were good for America, corporate executives were perfectly willing to take them. “Pay for performance” was the mantra, but in the aftermath of the dot-com bubble it became abundantly clear, not least to Jensen, that options had not performed as hoped.

Executives who were shielded from losses chased the upside and exposed their firms to excessive risk—Bernie Ebbers at WorldCom and Ken Lay at Enron being just two examples. When bucketfuls of options were awarded year after year, executives had nothing to lose. In 2008, after promoting Vikram Pandit to CEO, Citigroup gave him $29 million in stock awards plus $8.4 million in options. Alas, the stock cratered. Compensating Pandit (but not, of course, the public shareholders) for this bad luck, Citi’s directors last year agreed to 500,000 more stock options and a $10 million stock award. These will reward Pandit for earning back the capital that, under his tenure, Citi had previously lost. The problem is systemic. From 2000 to 2010, shareholders lost 14 percent playing the S&P 500. But CEOs kept raking it in.

Jensen, still looking for solutions, has only gotten more outraged. In a blistering new paper, “CEO Bonus Plans: And How to Fix Them,” co-authored with Kevin Murphy, he observes that “almost all CEO and executive bonus plans have serious design flaws.” The pair find, across the board, that bonuses are ripe for gaming and executives benefit from too much upside with little downside. Jensen and Murphy propose that guaranteed salaries be lower and bonuses higher—with bonuses deposited into a notional bonus “bank” and paid out over time. Poor performance would reduce the exec’s “deposit.”

That’s a fine start, but why stop there? It also makes sense to reduce the number of overlapping incentives. (Oracle paid its new president, Mark Hurd, in six different ways in 2011, totaling $78 million.) As Murphy says, “It was never our intention that companies would layer options for free on top of all these other forms of pay.” Stock grants and options should be dished out only at far less frequent intervals. Otherwise, execs get a bump merely for recouping prior losses. Also, huge exit packages, which make a mockery of Kaplan’s claim that failed CEOs suffer real punishment, have to be curbed. The best way to ensure such reforms is for Congress to legislate binding shareholder votes on any package worth more than, say, $5 million. Let shareholders be their own agents.

The trillions the government doesn’t account for

By Bryan R. Lawrence, Published: March 1, Washington Post

Bryan R. Lawrence is founder of Oakcliff Capital, a New York-based investment partnership.

Accounting standards may seem like a sleep-inducing subject to many people. But when retirement promises are improperly accounted for, companies and governments can go bankrupt, and hardworking Americans who have relied on the promises can suffer.

General Motors made its first retirement promises to workers in 1950. Under the accounting rules of the time, GM did not have to recognize the current cost of these future promises, as they were considered immaterial to the company’s operations.

Forty-two years later, Americans’ longer life spans and increasingly expensive health care had dramatically increased the cost. The Financial Accounting Standards Board, a private organization given responsibility by the U.S. government for setting private-sector accounting rules, decided that corporate retirement promises had become material, and it required GM and other companies to begin recognizing their current cost.

The $33 billion charge GM recorded in 1992 was equal to 29 percent of the company’s revenue — well above the 5 percent threshold that accountants commonly use to gauge whether a liability is material. Seventeen years later, these retirement promises were a major factor in GM filing for bankruptcy.

Given this history, consider the Treasury Department’s decision to not accrue for Social Security and Medicare promises. The current cost of these programs is calculated each year by the Government Accountability Office, and described in great detailin appendices. But Treasury’s “Citizen’s Guide” to the GAO financials does not accrue for Social Security or Medicare promises, even though it does accrue for the cost of retirement promises to federal employees and veterans.

This decision is embraced by virtually every one of our elected leaders and accepted by virtually all of our journalists. The $1.3 trillion budget deficit would be $4.2 trillion if the change in the current cost of Social Security and Medicare promises during fiscal 2011 were included. Why is this cost excluded?

It is not because the promises are immaterial. Remember that 5 percent threshold? The current costs of Medicare and Social Security total $33.8 trillion, which is more than 1,400 percent of the federal government’s 2011 revenue.

Instead, the legal reason for this exclusion is that the government follows “obligation-based” accounting standards, which require the recognition of future promises not when they become material but only when they are legally binding.

Since the U.S. government made its first retirement promises in 1935, it has seen the economics of Social Security and Medicare affected by the same demographic and cost trends experienced by the private sector. But because the government can rescind its Social Security and Medicare promises, it does not have to recognize their current costs, even though they are material to its financial condition.

They are also material to the financial expectations of tens of millions of Americans. The typical U.S. household has been promised retirement payments totaling $1.2 million, more than 1,200 percent of its median net worth of $96,000.

Is it acceptable that our leaders are able to promise trillions of dollars to the voters but do not have to recognize the cost because their promises can be rescinded?

If the accounting rules for the private sector changed when corporate retirement promises approached a third of annual revenue, why haven’t those for the government changed when its promises have grown to 14 times its annual revenue?

Americans know something is wrong, and they know hard choices about promises and taxes need to be made. They deserve a clear accounting and an honest discussion of how to fix the system.

Investors should ignore the rustles in the undergrowth

29 February 2012, Financial Times

In the past few months, I have discovered that almost no one supports the obligation on listed companies to produce quarterly accounts or interim management statements. The European Union is now engaged in the slow process of removing this requirement.

This issue is the tip of a large iceberg. The common reaction to every failure in financial markets has been to demand more disclosure and greater transparency. And, viewed in the abstract, who could dispute the merits of disclosure and transparency? You can never have too much information.

But you can. There are costs to providing information, which is why these obligations have proved unpopular with companies. There are also costs entailed in processing information – even if the only processing you undertake is to recognise that you want to discard it. Many people resent junk mail as they throw it away and pay to have spam filters installed on their computers. They are not convinced by the argument that you never know when you might need counterfeit Viagra or a replica Rolex.

But these direct costs of unwanted data are often small relative to the indirect costs. Even if information is useless or misleading, it influences behaviour. This effect may be hard-wired: our ancestors looked for clues that might help them to spot wild game or hostile tribes, and had to accept that most of the rustles in the undergrowth were the wind rather than the meat.

It was not long before charlatans exploited the need for reassurance in an uncertain world to tell their customers they could make better decisions by examining the entrails of sacrificial animals and observing the movements of the planets. Not everyone has the confidence to tell respected authorities, whether they are priests or chartered accountants, that they are talking nonsense.

Even if the tendency to absorb what we do not need to know is not in our genes, it is certainly part of our conditioning. If we had not been required to pay attention to information we thought at the time was useless, few of us would have learnt much at school.

One experiment in behavioural economics nicely illustrates the problem. The subjects were asked questions to which they did not know the answer, such as: “How many African countries are members of the UN?” At the front of the room, a man rotated a wheel with numbers on it. The figure displayed by the wheel had considerable influence on the estimates: the higher the number, the more independent African countries the respondents believed there were.

In conditions of ignorance, people seize on any information available, even if their reason should tell them that it is irrelevant. Just watch the occupants of the airport lounge fiddling with their BlackBerrys. Few people with an investment portfolio can resist the temptation to check its value whenever they get a chance – even though they know, or ought to know, that most short-term share price movements are only the noise of rustling undergrowth.

Annual reporting dates from a time when agriculture was the principal form of economic activity and there are still some businesses – such as retailers – for which the year is probably a relevant timescale. But for many others business – oil companies or builders – the relevant timescale for measuring the consequences of actions is much longer. When I asked a group to think of an entity for which the relevant cycle was three months, the only suggestion offered was banks.

That judgement could hardly be more wrong. The underlying profitability of most financial activities can be judged only over a complete business cycle – or longer. The damage done by presenting spurious profit figures, derived by marking assets to delusionary market values or computed from hypothetical model-based valuations, has been literally incalculable.

The tyranny of quarterly earnings has created a dysfunctional cycle of smoothed and exaggerated numbers and relations between companies and analysts based on earnings guidance, an activity almost unconnected to the real business of the company and to assessing its progress. “Never mind the quality, feel the length” has been the guiding principle of corporate disclosure for too long. It is time companies and their investors got together to identify information, usually sector specific, relevant to their joint needs.

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