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.

I eagerly read anything that Michael Lewis writes. He must be one of the most erudite and entertaining writers of our time. From Liar’s Poker on he’s produced books and essays that are highly entertaining as well as informative. I even enjoyed Moneyball, even though as a Brit I know very little about baseball. It was that good.

So now that he’s turned his focus on High Frequency Trading (HFT), let’s hope it causes a reaction. I’ve always felt that there was little social utility and possibly worse in trading systems that need physical proximity to the exchanges in order to reduce the latency in their order transmission. It’s always looked like high tech front-running, although the data to show this conclusively has been frustratingly absent.

On 60 Minutes last night Michael Lewis discussed his new book – out today so I have not had an opportunity to read it yet. But his description of HFT firms viewing orders and then buying/selling in front of them was compelling. I hope it draws greater regulatory scrutiny. For our part, we almost always enter limit orders rather than market orders. Although this doesn’t make us immune to the transaction tax that HFT likely represents, it’s harder to exploit a participant who has a price at which they’ll trade and doesn’t improve it in response to changing market prices. We’re willing to buy at $50.25, and if we get hit fine but we’re not going to chase it to $50.30. A market order to buy that begins at $50.25 can provoke HFT firms to bid $50.26 or $50.27 in less than the blink of an eye, causing the market order to pay a few pennies more than otherwise needed, perhaps buying from the HFT firm at $50.30. A limit order is less vulnerable but by no means totally immune.

We think that provides us some protection, but we’d all like to know that it really is a level playing field. It also highlights the morally bankrupt activities in some areas of Finance. If what Lewis describes is really accurate, what is the point of such activity? I’m sure we’re all better off for his shining a light in this area.

Interesting perspective on where the IRS is likely to focus from Robert Willens in Barrons today. He notes, “While the IRS is getting more restrictive on REITs and inversions, they are getting more expansive on MLPs, for some unknown reason. They are allowing a broader class of entity to convert to MLP status.”

The proxy statements filed by public companies prior to their annual meetings are not always interesting to read. But Coca-Cola’s (KO) has caught my attention, thanks to some diligent work by David Winters of Wintergreen Advisers, LLC. Like many companies, KO is putting its compensation plan up for a non-binding shareholder vote. However, it turns out that when you wade through the various elements of Annual Incentive Compensation, stock options, Performance Share Units and Restricted Stock, the company has estimated that as much as 500 million shares of KO could transfer from the owners to management depending on meeting various performance metrics. The potential dilution could be as much as 14.2% according to KO’s own documents, some $24BN of value based on its current market capitalization. In 2013, 6,400 employees received some type of long term equity compensation, so this amounts to just under $3.8 million per eligible employee.

What makes this even more staggering is that Berkshire Hathaway (BRK) is the largest shareholder in KO and one would imagine that Warren Buffett’s support of owner-oriented corporate governance would have been more fully reflected in this plan. Perhaps he was unaware of the details, but it looks like a shocking attempt to unreasonably enrich KO’s management.

The details listed above are not prominently featured; KO’s proxy statement that was mailed to shareholders omits the pertinent facts listed above. For those you have to go to the electronic filing and read the supplemental information, something I was only prompted to do by Mr. Winters raising the issue.

An interesting sidebar from my perspective is that the Compensation Committee is chaired by Maria Elena Lagomasino, fondly known as “Mel” (her initials) when she ran the Private Bank catering to Chase Manhattan’s wealthy clients (prior to its merger with JPMorgan). I didn’t work closely with Mel, but she was generally well liked and respected by those that knew her. Sadly, Mel’s judgment in overseeing the development of this plan has come up short. Perhaps she’s trying to create a whole new class of high net worth clients among the ranks of KO’s senior management. 

We are shareholders in KO and BRK (as is Wintergreen Advisers). My faith in the judgment of KO’s management is somewhat shaken by this plan. They note that only 77% of shareholders voted in favor of the 2013 compensation plan last year, and incredibly this 2014 plan was drawn up as a shareholder-oriented response to last year’s low approval rating. We find the 2014 plan an egregious and unnecessary transfer of shareholder wealth to management, and shall be voting against its adoption. We’re interested to hear what Warren Buffett thinks.

Laurence B. Siegel, Research Director at the CFA’s Research Foundation, has written a generous, largely positive review. He has evidently read the book quite carefully and has written one of the more extensive reviews I’ve seen. I am flattered by his kind attention.

Today’s Wall Street Journal has an article that analyzes the transactions costs, or commissions, faced by retail investors in municipal bonds. They find that the cost of buying a typical muni is about twice that of a high grade corporate bond. I wrote about this in my book, Bonds Are Not Forever; The Crisis Facing Fixed Income Investors. The SEC published a 2012 Report on the Municipal Bond Market in which they also identified relatively high transactions costs.

The problem isn’t necessarily the high costs faced by investors; it’s the effort the industry makes to avoid full disclosure. Finance routinely benefits from opaque pricing of its products, from brokers knowing more about pricing than clients. There’s a basic conflict of interest between a municipal bond broker, who wants to sell bonds at a high price, and a retail client who wants to buy them at a low price. The type of price transparency that exists for equities would clearly benefit the clients, but not the brokers since it would impede their ability to charge such a high commission. The industry is generally against improved price disclosure, for obvious reasons.

If brokers had to invest in what they push on their clients, such as overpriced municipal bonds, the problem would probably solve itself quite quickly. But that’s unlikely to happen anytime soon, so in the meantime retail investors in municipal bonds should approach the market with a healthy level of skepticism and recognize that their is no alignment of interests between the retail bond buyer and their broker.

Investors in ADT keenly remember the results of Keith Meister’s stewardship of their company, summarized here in our February newsletter. Keith Meister, who runs Corvex Management, LP, invested in ADT, made a forceful case for the stock being undervalued and took a board seat. With the benefit of information garnered in that role he one day exited his position, humiliating ADT’s guileless CEO in the process by persuading him to repurchase Corvex’s stake at a price it has never subsequently seen. Today ADT trades at less than half the price Corvex assessed it to be worth less than two years ago.

Williams Companies (WMB), today welcomes Keith Meister and an affiliated investor Eric Mandelblatt (manager of Soroban Master Fund, LP) on to their board. Corvex had recently disclosed  along with Soroban ownership of around 10%% of WMB (including options). WMB investors (ourselves included, for we have owned WMB since well before Corvex’s announced involvement) are now wondering whether (or perhaps, when) Corvex will “pull an ADT” and use their vantage point on the board to time their exit. For nobody should assume they are long term investors. Striving for long term capital gains tax treatment is not an issue for an offshore hedge fund.

In the ADT movie, achieving a board seat was a step in the elaborate dance between Meister and Gursahaney (ADT’s hapless CEO) that ultimately ended with Corvex’s abrupt loss of love for the company. As a WMB investor, we liked the company before Corvex showed up, and think perhaps we might be better served if he had focused elsewhere. Given Corvex’s history, WMB’s stock today is weaker as investors price in a modest “Corvex Discount”, the price concession necessary to reflect the inclusion on WMB’s board of one who does not accept a fiduciary obligation to all the shareholders of WMB, but only the investors in Corvex.

We think WMB is a good investment. We now have to include an assessment of when Corvex will switch dance partners and whether his moves will ultimately be value destroying (as they were  for ADT when the company vastly overpaid to buy back its stock). Much depends on whether WMB’s CEO Alan Armstrong is a good poker player, for his skills will at some point be on display through the company’s public moves with their new best friend activist investor. We are, for now, partners with Corvex. WMB remains an attractively priced investment. But we are listening carefully for the music to stop and counting the remaining chairs. This is what investing is like when an activist shows up.

On Saturday, Barron’s ran a front cover piece that was negative on Kinder Morgan (“Yield of Dreams”). Andrew Bary has written many thoughtful pieces for Barron’s over the years. In this case he basically reproduced a negative report written by Hedgeye’s Kevin Kaiser from last year. Kinder Morgan Inc (KMI) was down yesterday because evidently some readers of Barron’s haven’t heard of Kevin Kaiser.

The issue Kaiser raises is whether Kinder Morgan Partners (KMP) and El Paso (EPB) skimp on maintenance in order to increase their Distributable Cash Flow (DCF) of which close to 50% goes to the General Partner, KMI. We like KMI for this reason as we’ve noted before. They benefit from increased assets and cashflows at KMP and EPB without having to put up any capital. Rich Kinder does too, since he owns $8BN of the stock.

As for whether they do skimp on maintenance cap ex or not, the evidence would seem to suggest they don’t. Kinder Morgan’s safety record is at least as good as their peers; their return on invested capital has been consistent and above their cost of capital; their leverage ratios have also remained stable.  From these perspectives, we feel comfortable with their management of these assets. As the development of shale oil and gas creates the need for investments in energy infrastructure, Kinder Morgan will be a significant player (they have a current project backlog of $14BN against an enterprise value of about $100BN). KMI should see growth in cashflows from the increased DCF at the MLPs it controls. Its forward dividend yield is 5%, and expected to grow at 8% over the next several years. Kinder Morgan issued a response to the Barron’s article yesterday.

No doubt KMI has performed poorly in recent months, partly because they lowered their forecast dividend growth from 9-10% last year but also due to negative sentiment caused by Hedgeye’s analysis. We continue to think it’s an attractive investment at current levels.