The ham sandwich test, credit for which goes to Warren Buffett, asks whether a company you’re invested in has such a great business with such high barriers to entry that it could be run by a ham sandwich. I’m increasingly beginning to think that ADT will be subject to this test, and we’ll see how good a business it is in spite of their management.

ADT has a great competitive position. They are by far the biggest home security business with 25% residential market share. Their target market is higher income households who have more to protect and the means to pay for it. They ought to be able to steadily acquire far smaller firms, increasing market share and finding operating synergies.

Instead, they are seeing rising customer attrition, barely growing revenues and declining profits. The big cable companies are looking at home security as an attractive service that they can bundle with cable and internet, making switching costs higher for consumers. And yet, their enthusiasm for home security cannot be driven by the execution of ADT’s business plan.

Last year Keith Meister of Corvex completely outfoxed (or “outbullied”, might be more appropriate) ADT’s CEO Gursahaney by selling stock back to the company as part of a stock buy back program Meister had himself advocated. His access to the company’s books and records had given Meister a far more negative view of ADT than Gursahaney, and as subsequent events have shown these two do not belong at remotely the same poker table.

After ADT announced it had bought back Corvex’s stake at $44.01, the stock collapsed and is currently around $30. Leon Cooperman of Omega asked the best question on today’s earnings call when he noted that ADT’s buybacks represented a far bigger investment than their acquisitions or capex, and asked what type of analysis management had done to assess that $44 a share represented a good return on invested capital.

One would think that such a question demands a quantitative response, something that describes the expected return on invested capital with a number. But since the answer to Cooperman’s question consisted of vague optimistic statements about the business the answer was clearly, “No, we have not done that analysis”.

Of course it’s possible that Gursahaney is smarter than I give him credit for, and that the return on capital decision for buying back Corvex’s stake was less important than getting rid of an investor likely to be vocal in his criticism of the company, even at the cost of poorly allocating shareholder capital. In which case some other adjective is more appropriate, but even so this explanation is no more shareholder friendly.

Which sounds like a company entering the ham sandwich test. For our part, we are modestly invested in ADT, in no small part because we believe there’s some chance another company (Comcast? Google?) will find ADT’s current market cap of $5.5 billion a bite-sized way to obtain a leading position in home security at a time when more and more devices are linked – the “internet of things”. Somebody needs to put current management out of its misery.

The shareholder vote on Coke’s (KO) compensation plan last week was disappointing in several ways. The plan itself is overly generous to management, contemplating as it does up to 500 million of share issuance to executives depending on certain performance targets. KO’s proxy statement revealed that it could transfer up to 14.2% of the company, around $24 BN in value, to participants in the plan. I wrote about this a couple of weeks ago. KO is a great company to be sure, but is not exactly synonymous with great new products or high growth. Over the past ten years EPS has grown at 7.7% p.a., which is not bad for such a big company but hardly the stuff of innovation. In recent years EPS growth has slowed.

KO enjoys operating margins solidly above 20% and only needs to reinvest a fraction of its operating cashflow back into the business. Consequently, last year they returned around $1.92 per share to investors through dividends and buybacks. It would seem that the first objective of management should be to continue improving the great business they’re running, building on a unique franchise that’s been around since 1892. It’s not that the company could be run by a ham sandwich (as Warren Buffett did NOT say, although he knows who did), but every day when they turn on the lights the company is going to generate almost $130 million in revenue. They don’t need a Steve Jobs.

So the compensation plan seemed unnecessarily generous for the purpose of overseeing this highly profitable franchise. That it passed the recent shareholder vote so overwhelmingly was a disappointment.

A second disappointment was Warren Buffett’s reaction to the compensation issue. Berkshire Hathaway (BRK) owns 9% of KO, and has at least that much influence over an issue like this. Yet it turned out that Berkshire abstained on the vote. He told Becky Quick on CNBC that he loved Coke and didn’t want to vote against management, even though he disapproved of the plan. It was a surprising admission that he didn’t want to rock the boat although he still expressed his view.

So the third disappointment is my speculation of how Warren Buffett, as strong a proponent of equitable returns to shareholders as anyone out there, came to offer such a limp reason for his inaction on this issue. Buffett’s not on the board of KO, his son Howard Buffett is. Further, Warren admitted that he hadn’t reviewed the compensation plan in detail until prompted to by David Winters, like us an investor in KO and BRK. Evidently son Howard had not seen anything to dislike in the plan when it was presented to the board nor had he found it worthwhile to raise the issue with his father. To me it looks as if Warren didn’t want to embarrass his son Howard by voting shares against a plan that his son the KO director had endorsed.

Howard is a farmer, but he is one day slated to become non-executive Chairman of BRK when the great man himself is no longer with us. Warren has described his son’s value as maintaining the culture of the conglomerate his father and Charlie Munger built. Howard’s a controversial choice, not at all obviously suited to run any corporation even as a figurehead. Warren Buffett’s clearly made many astute decisions in his life, although he’s modest enough to admit to the occasional mistake too. The time when we’ll learn how well he has managed succession management is sadly getting closer although hopefully still a long way off. We still own BRK and probably will for a long time. But our ownership is in spite of this one element of Berkshire’s succession planning, not because of it.

Today’s FT has a story on the relatively weak corporate governance practiced by tech companies. Jeff Ubben of ValueAct criticized Eric Schmidt’s 2011 payout of over $100 million from Google, and features such as the dual share class (used by Google and other tech companies) were also highlighted. Public shareholders can only buy shares with weaker voting rights (or in the case of Google’s most recent share class, no voting rights at all).

David Einhorn of Greenlight Capital warned of another tech bubble and has identified a group of stocks that he believes could lose up to 90% of their value. It’s an intriguing thought – and who’s in the basket? Candidates would surely have to include Facebook (FB), Amazon (AMZN) and LinkedIn (LKDN), currently priced at forward P/Es of 38, 77 and 71 respectively.

I don’t really see where the problem is. These stocks are just not attractively priced for a long term investor. So presumably the discerning buyer simply looks elsewhere. Traders, those who buy stocks for excitement, and active managers who hold them just so as to avoid underperforming a benchmark of which they’re part will all find reasons to hold these and other companies like them. The thing is though, Google and others don’t need your money. If a basic function of finance is to channel savings from savers to productive types of capital formation, these names don’t do it.

Google, for example, generated $13BN in operating cashflow last year and invested most of that in marketable securities. They don’t need to access the capital markets to finance capital investments. FB has for the last three years generated operating cashflow well in excess of its capex.

These companies and others have gone public and issued equity simply to monetize the wealth created by the founders. The dual share class really says to those new second-class investors that they’ll make money as long as it suits the first-class owners to allow that to happen. It’s an oddly Communist way to operate in a capitalist system, the equivalent of saying, “we don’t need your money, but if you insist we’ll let you in on terms that we ourselves would never accept.”

It shouldn’t be hard to pass on such opportunities. There are many stocks to choose from. Leave such excitement for others.

I don’t always agree with Paul Krugman, but in this op-ed from a couple of days ago he makes some good points about the size of the financial services industry. He’s prompted to do so by Michael Lewis’s new book Flash Boys (although Paul Krugman probably needs little encouragement to whack Wall Street). But the dead straight tunnel from Chicago to New York, built that way to save milliseconds off the time it takes to transmit a market order between the two cities, may be the catalyst that draws a needed review of all this computerized trading activity. The fact that the tunnel was apparently a good investment highlights that the market is not as focused on serving end-users as it should be.

As Krugman points out, drawing on work by Thomas Philippon (whose research I found helpful in writing Bonds Are Not Forever) the financial services industry has grown much faster than GDP since 1980 and the abovementioned tunnel inspires one to question whether more is always better for this sector. Channeling savings to productive forms of capital formation is society’s legitimate objective; the less this is done, the greater should be the subsequent public policy examination of financial services.

Making short term market predictions is a fool’s errand, and consequently we don’t do it. Investing for the long run is hard enough without being confused by all the pundits on cable TV. But underneath the visible noise of market direction an interesting shift is taking place.

We tend to own stocks that are less exciting than most on a day to day basis. Typically these are companies that have at least a decent prospect of generating long term capital gains rather than the more highly taxed short term gains that result from rapid moves. This approach worked reasonably well last year but when the S&P500 is up 32% it’s unlikely that the slow and steady approach will do as well, and it modestly lagged. The bias of investors towards growth over quality dates back to about July the way we measure it.

Over the past month we noticed that the prevailing relationship was shifting, and that low beta, or low volatility stocks were beginning to outperform (noted in our April newsletter). It seemed to coincide with the satiation of so many investors keen to get into the market before the opportunity was missed (although this last piece of evidence is highly qualitative). Some of the worst performers (Facebook, Netflix, Tesla) are of course some of the previously most loved names.

Mike Cembalest at JPMorgan Asset Management  writes intelligently about many aspects of investing. Most recently he put numbers on this phenomenon by noting that on a market cap weighted basis valuations were at a fairly modest 55th percentile P/E of trailing earnings (using data going back to 1983), whereas the median stock’s equivalent P/E was at the 80th percentile. Since larger cap stocks tend to be more stable than mid-caps, it’s a neat way of capturing their relative valuation difference.

Recent market moves have been in the direction of narrowing this gap. We’ve seen this in the our own investment strategies. Generally such regime changes last at least several months, so while we don’t know where the market’s going over the next few weeks, it does appear to be a decent bet that the recent bias away from high growth will continue a good while longer.

Last weekend’s Economist examined the pay-off for students of the investment they make in various degrees. It’s the kind of unsentimental return analysis that needs to take place far more often. Not surprisingly, Engineering graduates enjoy anywhere from $500,000 of additional lifetime earnings to over $1 million (depending on the school from which they graduate). At the other end of the scale an arts graduate from a state school in Kentucky is, after paying for college, worse off than a high school graduate.

No doubt some will quarrel with the numbers, but the toxic combination of plentiful financing for students and tuition inflation that bears no relationship to the economy at large has resulted in debt burdens for thousands of young people that are disproportionate to their ability to pay them off. Making it almost impossible to default on college debt served the admirable public policy purpose of making loans more available, but it’s also resulted in young people taking on mortgage-sized obligations before they were old enough to buy a beer (though who could blame many for making up for lost time as they contemplate their finances?).

It’s a sobering thought when one discusses such issues with the children of friends – I had one such conversation very recently, and the best advice I could offer was to seek a renegotiation of existing debt. In fact, the true villains in this sorry spectacle must be the colleges themselves who have allowed their expenses to rise uncontrollably while their young and generally poorly informed customers sought higher education on virtually any terms available without regard to the return on investment. Institutions of higher education seek to educate, except on the basic economics of whether their young charges are investing their time and money wisely. Surely every applicant for a college loan should receive a disclosure of salary ranges for graduates in their chosen major and years required for repayment?

In my book Bonds Are Not Forever; The Crisis Facing Fixed Income Investors I highlighted the sharp growth in tuition debt and noted how unsustainable it was. It shouldn’t be surprising if over time it becomes a political issue that eventually leads to the inevitable discussion of a Federally-funded bailout of some type. When I researched the issue in 2012-13, tuition debt outstanding was $1 trillion. It’s still growing. It’s another section of the population that is poorly equipped to handle higher interest rates, and shows why “low for a long time” is a pretty good description of the Fed’s intentions for policy rates.

Since I read Flash Boys, those ads for discount brokerage now appear differently to me. I used to think that when, say, TD Ameritrade offers commissions of $9.99 a trade it’s because their platform is so efficient, so geared to enjoy economies of scale, that this low rate was sufficient to generate revenue in excess of its costs. But after reading Michael Lewis’s latest book it’s now dawned on me that an important element in the business model of these firms is to sell their order flow on High Frequency Trading (FHT) outfits or “dark pools”. The payment for order flow concept is a market-based recognition that many investors represent a reliable source of profit for the counterparties to their trades over and above the commissions they pay. So the $9.99 commission doesn’t represent the full return to (in this case) TD Ameritrade from their participation in your business.

It’s all naturally legal and therefore held to be beyond reproach. And perhaps the clients on such terms are naive for assuming that their visible cost of execution (i.e. the commission) was the only cost. But wouldn’t most people like to know if their orders were in effect the subject of a bidding war among the HFT crowd? Wouldn’t you think that the broker is getting you best execution not in the literal sense as defined in the regulations, but actually setting about to do that? If a discount broker can sell your orders on to a profit-seeking algorithm, they may still be providing you with a service but are not obviously working in your best interests.

It just seems as if there’s been a colossal error of judgment. The client might well be staggered to comprehend the economics of the online broker. The HFT apologists are no doubt equally shocked that anybody else is shocked. Hasn’t all this been disclosed? Well, technically I guess it has, but you can’t blame the average retail investor for wondering who they can trust. The brokerage model is full of the potential for principal-agent conflict. Dark pools and HFT algorithms are the latest manifestation. At a minimum, this is a PR disaster. The burden of proof is on those who equate volume with liquidity, who find nothing offensive in computer software being implemented to front-run orders. When it’s worth $300 million to build a perfectly straight fiber-optic line from Chicago to NY so as to transmit orders in a fraction of the time it takes us to blink, the casual observer may be forgiven for assessing that something is very wrong.

In his new book Flash Boys, Michael Lewis describes how Brad Katsuyama at Royal Bank of Canada deduced what the high frequency traders were doing. Brad had been frustrated that whenever he went to trade stocks on a posted price, he’d routinely get a much smaller amount of shares than advertised. 10,000 shares of stock may be offered on several different exchanges and yet he would wind up with a fraction of that.

It turned out that his order was reaching different exchanges at different points in time. Mere milliseconds separated the time at which his orders arrived at each exchange, and yet this was sufficient to allow the HFT traders to see his order when it arrived at the first exchange (BATS), and then swiftly move to buy in front of him at the other exchanges where his order arrived less than a blink of an eye later.

Brad figured this out by inserting software that slowed down his order from reaching the closest exchange, thus ensuring they all arrived simultaneously. When transmitted in this way he was generally successful in trading the amount of shares advertised.

So nice move by the HFT crowd. Very clever, you’ve made your money. It ought to be illegal but of course technology has outpaced the regulatory framework that forbids front running. It’s obviously wrong. This is why the claim by HFT proponents that they merely provide liquidity is so disingenuous.