There’s been plenty of press coverage of the Top 25 hedge fund earners recently, of David Tepper’s $3.5 billion haul and so on. But it’s probably even more striking to estimate what portion of total hedge fund returns these guys took home. It goes like this:

Last year the industry began with $1.8 trillion in AUM and finished with $2 trillion (BarclayHedge), so that’s $1.9 trillion in average assets under management (AUM) for the year; the 5.5% net return to investors (HFRX) was worth $103 billion. The Alpha 25 made their money both from fees and their own investments in their funds. Let’s make the generous and simplifying assumption that average hedge fund fees are 2% with no incentive fee. Fees were therefore $38 billion. So gross hedge fund investment profits (i.e. before fees) were $141 billion.

The Top 25 retained about 15% of the entire industry’s gross profits. What a fantastic haul! That leaves the other 85% for the investors who provided most of the capital, not including of course the cut for the rest of the hedge fund industry that’s not actually in the Top 25. It’s a great business.

http://www.newyorker.com/online/blogs/johncassidy/2014/05/how-hedge-funds-get-away-with-it.html

Yesterday was Williams Companies’ (WMB) Analyst Day. The company gave a strong presentation across each of their divisions. It highlighted the many opportunities to build new infrastructure in response to the shale developments, especially in the Marcellus. WMB’s dividend yield is 3.3% but such is the earning power of the assets they control that management extended their dividend growth forecast of 20% out to 2016 (from 2015) with further strong performance expected beyond that. Much of this is driven by assets held at WMB’s MLP, Williams Partners (WPZ), since WMB owns the General Partner are therefore receives 50% of each additional dollar of distributable cashflow.

WMB controls Transco, a pipeline network that runs from the NE U.S. down to Texas. One of the more memorable pieces of information came when Rory Miller, SVP of the Atlantic-Gulf Operating Area, noted that he’d once asked his team to estimate the cost of rebuilding the Transco system and the figure they came up with was $100 billion (for comparison, WPZ’s enterprise value is $33 billion). This pipeline was first laid 60 years ago, and decades of population growth and development all along the route make the cost of building something similar today prohibitive.

Interestingly, today Goldman upgraded Kinder Morgan (KMI) from Buy to Conviction Buy. Kevin Kaiser of Hedgeye, a small research firm in Connecticut, has been a long-time critic of MLPs and the Kinder complex in particular. KMI owns the GP for Kinder Morgan Partners (KMP) and El Paso (EPB) and while it doesn’t sport the type of growth prospects of WMB we think it’s a similarly attractive security leveraged to the continued development of energy infrastructure in the U.S. Kaiser has long argued that firms such as KMI skimp on maintenance, something not supported by metrics such as operating performance or accident statistics. But the Transco example above suggests that in at least some cases MLPs own assets that are substantially undervalued, at least on a replacement basis.

KMI has been a weak performer over the past year or so, providing at least some vindication for Kaiser (although their business performance has been fine and his negative call on MLPs as a whole has been dead wrong). For our part, we think both companies are very well positioned and are long both WMB and KMI.

The CFA’s bi-monthly magazine includes an article on the gradual mis-reporting of inflation that’s taken place over the years (“Double, Double Toil and Trouble”). Criticism of how the government calculates inflation is not new, and I included a chapter on this in my latest book Bonds Are Not Forever. For a start, it’s hard to take seriously an index which assigns a 24% weighting to Owners Equivalent Rent (OER), a wholly unsatisfactory solution to the problem that owned housing represents an investment that happens to provide a service (which is shelter) whereas the CPI seeks to measure the consumption of goods and services (including shelter) but not the return on investments (such as real estate). OER relies on estimates of what owned housing would rent for if rented, a concept with which very few homeowners have any familiarity. It’s just one example of the white-coated statisticians in their inflation laboratory concocting mathematical potions that have no relevance to the outside world.

John Williams runs ShadowStats.com, and he’s probably one of the better known critics of current practice. One has to acknowledge that the inflation critics are something of a fringe group, and at their most extreme mutter about a widespread conspiracy to cover up the Federal government’s impending bankruptcy. I can’t say I align myself with such extreme views, but nonetheless I do believe that beating inflation as reported is a dangerously low hurdle for an investor to set when planning their retirement.

In the 1990s the calculations were altered to allow for substitution and quality improvements. Both of these can make sense and need not be controversial as long as the user understands what the resulting altered figures mean. Substitution recognizes that the basket of goods and services from whose fluctuating price the CPI is derived changes in real life, and therefore allows that the CPI should reflect these changes. Consumers shift from, say, steak to chicken when relative prices change but also bought fewer vinyl LP records when CDs became available. Clearly, not changing the weights to account for this would mean that the cost of horseshoes would still be a component.

Quality improvements are more subjective in my opinion and rarely seem to include quality deterioration. Commercial flying is a perfect example. When I describe some of the subtleties of calculating inflation in presentations and note that the inflation statistics have incorporated a modest quality improvement in flying in recent years (due to easier cancellation terms) the audience typically laughs at the absurdity of the notion. Longer security lines, poorer food and sometimes surly flight attendants may not resonate with the statisticians who measure such things but are assuredly part of the flying experience for most users of inflation figures.

John Williams gets to the heart of the matter when he argues that in combination, substitution and quality improvements have altered the CPI from measuring the cost of a constant standard of living to the cost of a constant level of satisfaction (constant utility is the economic term). Although the difference may seem trivial don’t be fooled; since living standards generally rise over the time you care more about the cost of maintaining a constant standard relative to your peers and the larger economy. If your lifestyle includes buying the latest ipad you want to maintain that standard, and falling ipad prices (which don’t occur in reality but do occur for inflation statisticians once new model quality improvements are factored in) may give you more utility, but utility isn’t always fungible and you may not have asked for it.

It also occurred to me that in the debates among academicians and government departments about how to calculate inflation, the beneficiaries of the lower inflation camp are invariably well represented. Lower inflation flatters the government’s finances through reduced cost of living adjustments on entitlements as well as tax-bracket creep (since the income bands at which higher tax rates kick in are adjusted up more slowly than they would be otherwise). The tangible and political benefits no doubt invigorate those arguing for a lower-resulting methodology while the benefits to those sincerely advocating a higher-resulting methodology would seem to be far more prosaic.

It’s one more contributing factor to increasing income inequality (since those most exposed to the vicissitudes of inflation calculations rely disproportionately on entitlements and welfare) but it will be no surprise that different inflation calculation methodology has never been much of a hot-button political issue. For investors, you take the world as you find it. Fixed return securities such as bonds provide scant compensation for inflation risk. Someone asked me just the other day what I thought was the best protection against a steady increase in inflation (whether it’s inflation as measured by the government or simply the higher version as experienced). The best answer we have is to invest in equity securities whose underlying businesses possess built-in protection in the form of pricing power. Stable companies with consistently high operating margins; midstream Master Limited Partnerships (MLPs) who often own fee-generating assets whose pricing is inflation linked. These are two of the best forms of defense an investor can adopt. While it’s probably a stretch to assume a government conspiracy, it’s hard to identify participants in the debate whose interest is to err on the side of higher (i.e. more conservative) inflation calculations.

Earlier this week I was at the 67th CFA Institute Annual Conference in Seattle. It enjoyed a record attendance of over 1,800 and I have to say was one of the better organized events I’ve been at, situated in the cavernous Washington State Convention Center. One thing I particularly liked was that the networking doesn’t involve people trying to sell you something, and the fact that delegates are overwhelmingly CFA charter holders results in a good probability of an interesting conversation.

Sheila Blair, former head of the FDIC, gave a very good talk on the regulatory landscape and improvements she would like to see. Canada avoided any sort of financial crisis and in response to a question she concurred that being “a little more Canadian” would be a good thing in the U.S., pointing to campaign finance reform as one area that could reduce the ability of Wall St to influence the legislative process.

I also like the CFA’s new initiative, The Future of Finance which includes as one theme Putting the Investor First. The CFA is a great organization to be taking a leadership role in the debate about the financial services industry and how well it is meeting the needs of clients. As long as unlisted registered REITs, with their egregious underwriting fees, and closed end fund IPOs (which invariably trade to an immediate discount) are part of the landscape there is much room for improvement.

I gave a presentation titled, “The Fallacy of Hedge Funds” which relied on my book, The Hedge Fund Mirage. The audience was very generous with their attention and questions.

Afterwards I did a couple of interviews with the FT, one on hedge funds and the other on High Frequency Trading. HFT was the major topic of conversation at the conference.

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.