Corporate Management – Grey Owl Capital Management, LLC

SEC Rules Linking Exec Pay and Stock Price Miss the Mark

On April 29, 2015 the SEC released a Fact Sheet regarding “rules that would provide greater transparency and better inform shareholders.” http://www.sec.gov/news/pressrelease/2015-78.html. The proposed rules would require companies to disclose executive pay and stock performance information for itself and companies in a peer group. This proposal places emphasis entirely on the wrong results and is an example of needless regulation.

Corporate executives should be judged on improvements in the underlying drivers of the business that they control. They should not be judged based on a stock price they don’t control.

Stock price movement often has nothing to do with management. Why should corporate executives be judged by stock price movements (up or down) that are unrelated to their actions? Particularly in the short term, stock prices are influenced by industry activity, interest rates, and the trend of the overall market among other things. For example, a competitor being acquired often raises a company’s stock price. Actavis (ACT) announced the acquisition of Forest Labs on February 18, 2014. In the next 3 days (in a slightly down market) Teva Pharmaceuticals stock rose 6.3%. Is Teva’s stock price move attributable to anything management did? No. So why would an investor use that to judge the appropriateness of executive compensation?

Executives should be judged on how they impact the business. Growth in revenues, earnings per share, and cash flow are all important. Capital allocation is critical. Returns on invested capital and return on equity capital are important indicators of value creation. Corporate executives should have their eye on factors like these, not the gyrations of their stock price. Investors would be well served to do the same.

Can shareholder oriented executive compensation packages incentivize managers to influence fundamentals in a constructive way and improve the value of the company? Yes! But sometimes industry or market factors might cause a company with terrible executive comp policies to also do well. The proposed rules do nothing to help investors distinguish one from the other. Evaluating the effectiveness of executive comp is difficult because executive comp does not always drive stock performance. The SEC is proposing a short-cut to this process that misses the point. The free market understands this and will pay little attention to the information the SEC is requiring to be compiled. The cost of companies complying with this requirement will certainly outweigh the benefit to investors and be a drag (albeit modest) on investor returns.

One Question for Messrs Buffett and Munger

Tomorrow, Saturday May 2nd, 2015, Warren Buffett and Charlie Munger will hold court over a crowd of 40k+. As they do every year, they will spend several hours answering questions about the current and future workings of Berkshire Hathaway. Three journalists and three investment analysts will ask the questions.

If we were given the opportunity to ask a question, we would focus on Berkshire Hathaway Energy -BHE – (formerly MidAmerican Energy) and the threat to traditional utility businesses from distributed generation (DG).

During 2014, BHE provided 9% of Berkshire’s revenue and 11% of pre-tax operating earnings. In the most recent annual letter, Mr. Buffett refers to BHE as one of the “Powerhouse Five” collection of Berkshire’s largest non-insurance businesses. He goes on to write, “a century hence, BNSF and Berkshire Hathaway Energy will still be playing vital roles in our economy.” Later, he adds that BHE has “recession-resistant earnings, which result from these companies offering an essential service on an exclusive basis.”

Their conviction is very high. We wonder if both Messrs Buffett and Munger are underestimating the potential threat from distributed generation (i.e. power generated at the individual household level using solar technology). Is it possible that the developments in Hawaii described in detail in a recent NYTimes article are just the beginning?

BHE has invested $15B in renewable energy generation capabilities and is the largest generator of renewable energy in the US. In addition BHE’s largest subsidiaries are in geographies with no immediate threat (the ratio of sunlight to traditional generation fuel cost is favorable). Yet, solar is not a typical fuel source. It is a technology that behaves according to Moore’s Law – every year it is twice as efficient and half the price as the previous year.

So, if we had the floor for a minute in Omaha tomorrow, here is what we would ask: “Messrs Buffet and Munger, what if technology made it so BHE was no longer the exclusive provider of power in its covered geographies? Doesn’t solar offer the possibility that the distribution component of the regulated utility industry shrinks significantly in size? BHE uses solar as a fuel source, but that alone can’t neutralize the threat. Solar has the potential to be much more than a substitute for coal or gas in the old utility regime. Centralized power generation isn’t necessarily ideal. In the past it was just the only practical option. Today, decentralized power generation is just as practical in a few locations (e.g. Hawaii), but it is becoming so in more and more geographies by the year. The efficiency of solar is increasing and the cost decreasing at a rate commensurate with Moore’s Law – and it should, as solar panels are similar in structure to computer chips. As this trend continues, individual solar power generation will become practical in more and more locations. And so, how can you be so confident in BHE’s ability to earn a “good” return long into the future? Is it possible that solar may be to the utility industry what the internet was to the newspaper business?”

We remain long $BRK, confident in the overall business mix, the broad diversification, and the “moat” that accrues from the structure Mr. Buffett has developed over the last 50 years. We are also optimistic that BHE managers can adjust the business to new realities over time. Still, we would like to hear some additional details on how they think about the distributed generation threat.

Long $BRK.

Three thoughts on the JPMorgan (JPM) trading fiasco

1. Black box finance. In our latest letter, we described how financials led the market for the first quarter and yet, we reminded clients that we don’t own any depository financials. We wrote:

“As we hinted in our first page introduction, we are not particularly bullish on depository financials (i.e. banks). The community banks have too much capacity, significantly limiting growth. The large ‘money-center’ banks are subject to vast new legislation by the name of Dodd-Frank that we believe will significantly reduce their returns relative to historical trends. In addition, the big banks are essentially black boxes. They may trade below stated book value, but does anyone, including the CEOs and CFOs of these immensely complex institutions with their myriad derivative positions, really know what book value is?”

If yesterday’s revelation by JPMorgan CEO Jamie Dimon regarding unforeseen trading losses in their risk management group is not enough empirical evidence to close the case on our point, we don’t know what is.

With highly levered banks, the black box could include positions that completely wipe out equity holders. This thinking on “money-center” banks is not new – we’ve continually emphasized it in both written and oral communications with clients for several years. All investors need to cope with uncertainty but our primary objective is to protect capital, so if there is a meaningful possibility of total loss we will pass. This framework is a hallmark of our investment process. We participate when the range of possible outcomes are all positive, or (for very small positions) when the probability weighted expected outcome is very high. Potential returns between 6% and 12% (see Excelon), are acceptable. Potentially being wiped out is not.

2. Jamie Dimon. Jamie Dimon remains an impressive leader. Frank, tough, and seemingly fair, he has built a career and a bank by methodically putting one foot in front of the other, taking the long view, and (for the most part) acting conservatively. There is a positive potential outcome of this event. If this causes Mr. Dimon to recognize the vast gulf between a 2 trillion dollar bank’s operations and his ability to monitor and control these operations, this event will guide the direction he takes the bank. JPMorgan would become a better institution. In addition, there is some chance that his approach to this issue will further enhance his stature as a banker and a leader. His frank mea culpa yesterday was a start in this direction.

3. Ben Bernanke. The primary culprit here does not receive a JPMorgan paycheck nor work in Manhattan (or London). Rather, his check is signed by Uncle Sam and his office is at 20^th & Constitution Avenue in Washington, DC. While it is still unclear exactly what positions JPMorgan held and holds in its CIO office, financial repression a la Ben Bernanke is likely the root cause of JPMorgan’s current mess. The “London Whale’s” trading activity was just a natural reaction by a profit seeking financial institution to zero interest rates. Bernanke dangled the bait and the whale took it. The Federal Reserve has stated that a primary goal of their financial repression is for investors to “step out on the risk curve” (i.e. microscopic Treasury bill yields force investors to take risk to increase their yield; moving to longer durations, corporate credits, equity, leveraged derivatives, etc.). Like all central planners before them, this Federal Reserve ignores the law of unintended consequences at citizens’ peril.

The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this blog will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

We’ll Buy a “Poor” Capital Allocator Like Microsoft Anytime

Microsoft (MSFT) is as out of favor as out of favor can get. Apple adds “i” to the word “Cloud,” talks about it at a developer conference, and Steve Jobs is on the front page of the Financial Times. Microsoft releases the fastest selling operating system of all time (Windows 7) and then the fastest selling consumer device in history (the Kinect) and newspaper editors and investors alike just yawn. Microsoft can’t innovate, Steve Ballmer inherited a great company but hasn’t really done anything to move it forward, and he allocates capital poorly with dumb acquisitions (Skype) and silly R&D projects (Kin One and Kin Two).

Despite this, or perhaps because of it, we think Microsoft is a spectacular investment opportunity. We have owned Microsoft for several years, trading around the position multiple times. Today it is one of our largest positions. We articulated our thesis at length in a recent quarterly letter. In this brief post, we want to take a look at the claim that Mr. Ballmer has been a poor allocator of capital.

Last week, David Einhorn presented his investment thesis for Microsoft at the Ira Sohn Conference. He was bullish on the stock. He said it is very cheap on both an absolute basis and relative to the market and yet the business is outperforming the average S&P 500 company by a wide margin. Mr. Einhorn believes Microsoft is cheap for a reason. He argued that the number of poor capital allocation decisions on the part of Steve Ballmer has overwhelmed the superior operating performance and good decisions that have been made.

It seems clear that Steve Ballmer IS an “overhang” on the stock as Mr. Einhorn phrased it. The stock would likely appreciate if he was to move on. However, the question of whether Mr. Ballmer truly is a poor capital allocator seems less obvious to us. Remember, it isn’t his fault that the market irrationally bid the stock up to a PE of 70 right when he took over as CEO. So, you can’t judge him on stock performance alone. In addition, we think that the sheer size of Microsoft can cause confusion. Skype may or may not turn out to be a good acquisition. If it is a mistake, the $8.5B price would seem to make it a big one. But, it is only 4.5 months of free cash flow to Microsoft. What has Mr. Ballmer done with the rest of Microsoft’s cash?

From a base of $10.5B in 2000, Microsoft grew free cash flow (i.e. operating cash flow less capital expenses) to $22B in 2010. This is a CAGR (compound annual growth rate) of 7.7%. The total free cash flow generated over this ten year period was $155B. During that same period, Microsoft returned to shareholders $142B in cash via dividends and stock buybacks. In other words, Microsoft returned 92% of all the cash they generated to shareholders!

Let’s now use this information to perform a brief thought exercise. Today, you can purchase Microsoft stock for $24/share or you can buy the entire company for $203B. Imagine you were to buy the entire company today. Next, imagine that Microsoft were to grow free cash flow at the same rate for the next ten years that it did for the previous ten years. This means the firm would generate $360B in free cash flow over the next ten years. Given the firm’s historical need to retain very little capital, further imagine that 92% of all cash generated was returned to shareholders. Let’s assume it is all in the form of share buybacks so we don’t need to worry about taxes. At this point you would have received 1.6x your money back AND you would still own the entire business that is Microsoft: whatever it is that becomes of a cloud development platform (Azure), software as a service (Office 365 and Dynamic CRM), home entertainment (XBox, Kinect, XBox Live), etc., etc. Hmm… maybe Mr. Ballmer has presided over some innovation.

If those are the available investment dynamics, one could certainly do much worse. Perhaps that is exactly Mr. Einhorn’s point. If you buy Microsoft today, you likely get the above investment dynamics. You also get a free call option on Mr. Ballmer’s departure.

A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.

On Buffett’s Berkshire Primer

This past Saturday, Warren Buffett released Berkshire Hathaway’s 2009 annual report and his annual letter to Berkshire shareholders.* The last Friday in February has become like Christmas Eve for value investors the world over. A night of tossing and turning is followed by a mad rush to the computer to download the latest version at 8am on Saturday morning. And then, maybe 30 minutes later, melancholy as we all realize that Mr. Buffett won’t write to us again for 365 days. As admirers of Mr. Buffett, frequent shareholders, and practitioners of the “value” approach to investing, you could count us among the sleep deprived on February 27^th.

Given Berkshire’s recent (and massive) acquisition of Burlington Northern Santa Fe, Mr. Buffett chose to make this year’s letter a primer on the various Berkshire business lines, as well as his value-oriented approach to investing. Here are a few thoughts on areas we found particularly interesting:

Berkshire’s stated book value was $84,487 / share (page 3). Investments totaled $59,034mm with a cost basis of $34,646. If one were to mark these investment to market and then subtract 20% for capital gains taxes (estimate of federal and state), Berkshire’s book value is just over $97,000 / share. As of the close on March 2, 2010, the stock traded at $121,740 or 1.26x “adjusted” book value.
Mr. Buffett has always shunned excessive leverage and talked about its many risks. He often admits that during good times the company’s equity might underperform more leveraged entities. “Sleeping well at night” is the reason he usually provides for this strategy. True enough, but 2008 demonstrated that over a full cycle, low leverage entities such as Berkshire can outperform because they are able to provide liquidity precisely when no one else can and in doing so receive outsized compensation. As he writes on page 4 of the letter, “When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant. At the very peak of the crisis, we poured $15.5 billion into a business world that could otherwise look only to the federal government for help.”
The 17^th century philosopher Frederic Bastiat spoke of “what is seen and what is not seen” in regards to the unintended consequences of laws on the economic sphere. Mr. Buffett recognizes similar risks in over handed management and thus promotes an organizational approach at Berkshire that is as laissez-faire as the political approach recommended by Bastiat. On page 5, Mr. Buffett states, “We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy.”
In the Insurance section beginning on page 6, Mr. Buffett states the two critical aspects of the insurance business: 1) fairly unique in business, insurance operates on a “collect-now, pay-later model” and thus requires “negative” working capital – called “float” and 2) because enough people have recognized how favorable these economics are, the insurance industry as a whole operates at an underwriting loss. Berkshire offers shareholders a unique proposition: the firm has demonstrated an ability to invest the “float” in a very profitable way AND because of the superior managers and compensation structure the Berkshire insurance companies operate under, the firm has consistently operated at an underwriting profit.
In the Utilities section, which begins on page 8, Mr. Buffett provides insight into why Berkshire is now willing to own such capital-intensive business when in the past they avoided them. Two explanations are given: 1) today, Berkshire is so big that Mr. Buffett has no choice but to look at opportunities he would have passed on before and 2) given the regulated nature of utilities, Mr. Buffett seems to believe that he is trading some investment upside for greater certainty. This makes sense to us. Other investors and financial writers (including Whitney Tilson) have articulated a third possibility: because Berkshire pays a “negative” rate on its borrowings (i.e. “float”) investments that would be unprofitable for others can be profitable for them.
The housing market makes its way into the letter on page 12 in the Finance and Financial Products section. Given the lowest-in-fifty-years 2009 housing start number, Mr. Buffett believes that “within a year or so residential housing problems should largely be behind us.” While he is correct in stating that 2009’s 554k starts is well below the 1.2mm annual housing formation number, we think his optimism might be a bit premature. The recession has probably lowered the annual housing formation number and published inventory numbers are too low when bank “real estate owned” is considered.
Mr. Buffett then discusses the structural problems at Clayton Homes that are a result of the government’s housing finance policy. The government artificially lowers the interest rate for conventional mortgages. Therefore, when financing is considered, a traditional home can be cheaper than the manufactured houses sold by Clayton. Mr. Buffett doesn’t say this but this is another example of Bastiat’s “not seen.” It also reminds us that in the current climate, government interference must be a part of the investment calculus.
Berkshire is unlikely to experience the damaging impact of “group think.” In describing Berkshire’s derivative contracts, Mr. Buffett (on pages 15 and 16) assures shareholders that these contracts neither expose Berkshire to extreme leverage nor to counterparty risk. “If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.”
Mr. Buffett concludes the financial section with a well-deserved excoriation of financial company CEOs and directors. However, regarding his defense of investors against the “bail-out” claim, we offer one final quibble with Mr. Buffett. He states, “Collectively, they [shareholders of the largest financial institutions] have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.” If he is using the term “owners” very explicitly, then, with the exception of Bear Stearns shareholders, perhaps he is correct. However, he leaves out the fact that bond holders of these same insolvent institutions, who knowingly assumed the risk of capital loss, were in fact bailed out to the tune of hundreds of billions of dollars and made whole by taxpayers.

That wraps up the highlights as we see them. However, the whole letter is well worth reading and it is available here: http://www.berkshirehathaway.com/letters/2009ltr.pdf

*This discussion should not be construed as a recommendation to buy or sell Berkshire Hathaway.