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.

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.

An obscure dispute between DirecTV and The Weather Channel (TWC) highlights the shifting landscape of the economics behind what you see on TV. DirecTV dropped TWC  from its line-up because they wanted to reduce the current 13 cents per subscriber per month that they pay to carry the service; TWC wanted an increase to 14 cents. Unable to agree on terms, the service was dropped. It’s a big deal for TWC because it’s possible other cable companies will see an opportunity to negotiate better terms. In fact, it’s not clear to me that DirecTV should be paying much, if anything to TWC because they already carry advertising. Charging viewers to watch TWC and also inflicting advertising on them seems a bit much to me. But then, I rarely get my weather information from TV, but instead like millions of others favor the far more precise access offered by the internet.

And that is really the point. In so many ways, TV channels are an increasingly inflexible way to deliver content. You get what they want to deliver when they want to, across several hundred channels, compared with the internet which in effect offers limitless choices of content. The important exception is anything live, most notably sports, for which providers will be able to charge a premium price for the foreseeable future.

News delivery on TV has long struggled to compete with the far more customized content available online. As for shows and movies, Netflix must be one of the best deals around. The quality of online video on a laptop even over a wireless network is quite acceptable in most cases. On a recent trip south for warmer weather, my wife and I didn’t even turn on the TV in our room, instead using Netflix to choose our evening’s viewing.

Like so many developments in technology, it is empowering for the consumer. As I compare my cable bill with my Netflix subscription and ponder how little I watch on live TV beyond the English Premier League, it seems clear that many traditional business models in the fields of entertainment and broadcasting are at risk.

This morning I perused the front page of the Financial Times the old-fashioned way (i.e. by physically holding the newspaper in my hands rather than visiting the website) over breakfast in a NY hotel following a client dinner last night. I was struck by the juxtaposition of two articles. One was: ” ‘Fragile Five’ Fall Short of Taper Threat” discussed the exposure some BRIC countries and others have to a too rapid tapering of the Fed’s policy of QE. We all remember how last Summer’s mere mention of tapering by Ben Bernanke was felt disproportionately in the Emerging Markets.

Incongruously facing this article was: “Christine Lagarde warns of growing threat of deflation.” Clearly, deflation and too-rapid tapering are unlikely to occur at the same time, which just goes to show that even the FT sometimes practices that well used journalistic trick of warning of every danger (including the possibility of no danger) so as to be able to claim foresight when one of the forecasts takes place. The FT’s website, with its far more mobile layout, doesn’t position these stories side by side, but it did highlight for me the many concerns that still confront equity markets.

On a related topic, we’ve noted recently some persistent underperformance of low volatility stocks versus the S&P500. Over the past couple of months Consumer Staples stocks (as reflected by the ETF XLP, for example) are flat while the market itself is up 5%. It’s been a similar story for SPLV. The logical corollary is that high beta, more volatile stocks have been outperforming the averages, in a sign that active managers are increasing their market risk. I’ll stop short of making the obvious prediction that the market must, therefore, be vulnerable to a sell-off, because the data doesn’t necessarily say that. Such outperformance of one sector versus another can persist for quite some time, although ultimately mean reversion occurs and the process reverses itself. We just haven’t identified any reliable tool with which to predict the timing of a reversal. However, if we were journalists this story would be titled, “Outperformance of High Beta Stocks Signals Market Reversal” and, unburdened by the need to deploy capital in response to our opinions, we would eventually be proven right.

Nice piece with Chuck Jaffe of MoneyLife. Here’s the link – go to the December 24th show, starts at the 17 minute mark.

http://www.moneylifeshow.com/archives.asp

I was struck today by an article in the New York Times (“On Jammed Jets, Sardines Turn on One Another”). As airlines pack more people onto planes, the flying experience (as least in Economy Class) becomes ever worse. This was hardly news to anyone who has flown domestically in the U.S. in recent years. Airlines have generally found that, in a market where tickets are bought online and the cheapest fare wins, charging more for better quality is not a winning strategy. Everybody knows that flying commercially in the U.S. has become worse. Seats are smaller with less legroom; food quality has fallen; needed security has trapped us all in terminals that are shopping malls such is the extra time needed to be processed. In short, the quality of flying has gone down.

The statisticians at the Bureau of Labor Statistics (BLS) would not agree. Why should we care what they think? Because this is where the Consumer Price Index (CPI) is calculated. Because products and services are routinely offered in different shapes and formats, simple month-to-month price comparisons don’t capture the complete picture. A jar of peanuts formerly 16 oz but now 18 oz has, if sold at the same price clearly experienced a price drop. So has a new, faster ipad if sold for the price of last year’s. Generally quality improves, and where it does the BLS registers a price decrease which is part of their methodology. But as I discovered when researching my recent book, Bonds Are Not Forever; The Crisis Facing Fixed Income Investors, airfares have mysteriously not registered a quality decrease, although there’s little doubt that’s what happened. Since 2000 the only change the BLS has recorded to the quality of flying is an improvement, due to easier cancellation terms.

In effect, the BLS has miscounted airline fare inflation, in that (for example) an unchanged price with lower quality is just as much of a price increase as if quality was unchanged but the price raised. The problem is that it’s hard to objectively measure how much the quality of flying has deteriorated.

Now it’s not hard to find conspiracy theorists who are convinced the government is deliberately understating inflation so as to curb its spending on all kinds of inflation-linked programs starting with Social Security. Clearly, the Federal government benefits from understated inflation. I am not among those who believe there is intentional manipulation of the statistics going on. It would be impossible to keep secret. But I do think that the inflation statistics produced do not measure what people think they are measuring. Growing your savings pot, or your income, at inflation (after taxes, naturally) isn’t going to maintain your standard of living, as this one simple example shows. Inflation figures have their place, but they’re not that helpful to the average saver.

Mark Zuckerberg, CEO of Facebook (FB) and Rich Kinder, CEO of Kinder Morgan (KMI) would appear to have little in common (though they are both billionaires). However, they share one thing in common in that both recently made transactions in their own stock.

FB has ‘A’ and ‘B’  shares, whose rights are identical other than ‘B’ shares have 10 votes each and can be converted 1:1 into ‘A’ shares. Mark Zuckerberg is exercising an option to buy 60 million B shares and then converting them into ‘A’ shares prior to selling 41.35 million in an upcoming secondary offering.  He says he’ll use most of the proceeds to pay taxes but will still wind up controlling 56.1% of the voting power (compared with 58.8% before the sale) and will have greatly reduced his tax liability since he’ll net $2.2 billion pre-tax with virtually unchanged ownership. On top of which he’s inflicting video commercials on FB users. I am (barely) still a user, but assiduously ignore any advertising.

Meanwhile, Rich Kinder recently spent $27 million buying shares in KMI, bringing his holdings to 231 million worth about $8 billion. You can invest alongside Rich Kinder, but you can’t buy the ‘B’ shares that Zuckerberg owns. Who would you rather be in business with? We own KMI.

The Economist turned its critical eye at quantitative hedge funds recently, noting the poor performance of such “black box” strategies since the 2008 Financial Crisis. The article’s headline (“Computer Says No”) is a wry reference to a British sitcom called Little Britain, a humorous touch that will have been missed by many U.S. readers.

Quant practitioners predictably note the absence of rational markets (isn’t that ALWAYS why managers lose money) and place the blame squarely at policymakers and artificially low interest rates as the reason their models can no longer make reliably profitable predictions. It may also be that this sector of the hedge fund business is overcapitalized, with assets having grown from $91 billion to $215 billion in four years. While the underlying markets such as equities and bonds offerplenty of liquidity, perhaps the inefficiencies such algorithms are meant to identify are being competed away, at least by the big ones.