Moral Hazards of Capitalism

For the upcoming generation of Americans, capitalism does not hold the same cachet as it did for prior generations. A recent survey showed that capitalism as a preferred economic system had dropped from 68% to 49%, despite the clear implosion of "socialist" Venezuela to the south. I believe that the drop in support is caused by an increasing income and wealth gap. In the 1980s, the average CEO made nearly thirty times the average worker. At the present, the spread has moved to nearly three hundred times!

A generational pushback on this seems entirely appropriate. In fact, it is unfortunate that it takes a new set of eyes to identify the unfairness. While it is true that such discrepancies regularly exist between professional sports figures, the assessment of the CEOs performance is a different issue. In professional sports, there is no factor such as the Federal Reserve, to make everyone's score better. By dropping interest rates to support the economy, interest expense goes down and stock prices rise - driving stock options up and richly benefitting CEOs.

The mantra of paying for performance has become so sacred to my generation that little effort has been made to assess how that pay should occur. Warren Buffett recognized early on that stock options had a pernicious effect as they were not recognized in financial statements. Even after they were recognized, their usage had morphed into a necessary item for C-suite compensation packages. Boards and compensation consultants worked together to create highly inflationary C-suite compensation. There is little opposition in the form of money managers and this is only worsening with the prevalence of passively managed funds - and active managers like me who view attempts to control this compensation as futile and thus, unworthy of efforts.

It is unclear to me what the solution could be - short of simply outlawing these complex instruments as a form of executive compensation. That is a radical solution, but surely better than a continuing to damage capitalism's powerful force for lifting standards of living for all.

Deferral of Gratification: the "Real" Deal

The only logical reason for deferring gratification and not spending all of our income is either the hope of increasing our spending power or the fear of not having enough to maintain it. In order to logically defer spending, we need to find a place for our funds with "real" earnings.

Warren Buffett discussed this in Berkshire Hathaway's 1980 annual report stating, "If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real (my emphasis) income from your investment, no matter how much it appreciated in dollars." (I wish all annual reports were so easy to read.)

At least two factors need to be understood before engaging in the act of faith of deferring gratification. First, the place in which funds are stored need to have returns that keep up with inflation. For example, the $9.5 trillion of savings held in U.S. banks (from St. Louis Federal Reserve numbers) represent a significant likely loss of purchasing power with average interest paid under 0.5% while inflation exceeds 1.7%.

Second, Buffett's example shows that taxes must also be considered and today's low rates become even lower with taxes. Historically savers have done better. From 1925 until now, U.S. Treasury Bills (a proxy for savings) have yielded 3.3% while inflation has averaged 2.9%. For 94 years, savers generally increased purchasing power. However, by taking a tax rate even as low as 20%, the saver loses purchasing power. That's the "real" deal.

ESG: Doing Good by Doing Well?

A recent study reported that the market value of U.S. companies qualifying as Environmental, Social and Governance (ESG) companies made up 26% of the $46 trillion managed by professional investors. I had long been a skeptic of ESG investing due to its initial exclusion of industries such as defense and alcohol. However, ESG has evolved and now includes all legal industries, looking for best practices within industries. The results have been powerful:

1) ESG companies have outperformed non-ESG companies by 3% per year over the past five years, and
2) 90% of bankruptcies (15 of 17) from 2005-2015 in the S&P500 could have been avoided by not purchasing companies with low ESG scores.

In reviewing financial statements, I have lightly scanned the "ESG" portion of their reports. However, I am beginning to form respect for these ESG components. For me, they represent the likelihood that those companies have their act together. If a company can not only compete in today's global economy, but can also find ways to improve their impact in the world, it may be highlighting the degree to which such companies are either competing favorably or being managed effectively enough to move down the "to-do" list.

Pension Plans: Rear-View Investing

In the 1978 Annual Report of Berkshire Hathaway (BRK), Warren Buffett wrote,"pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities - breaking the record low figure set in 1974 and tied in 1977." At the same time, Chairman Buffett was aggressively purchasing equities for BRK. But with flawlessly poor timing, the pension managers stumbled badly on their investing responsibilities as equites have generated superior results since those three years.

Those observations came to mind as a recent headline from the WSJ read, "Public Pension Plans Continue to Shift Into U.S. Stocks: 47% of plans’ assets were in U.S. stocks in third quarter, the most since 2007." The article had this graph illustrating pension allocations:

This graph illustrates that pension managers have hardly improved on their timing in the past 40 years. They continue to underweight equities at low prices and lift allocations at higher prices. These timing missteps compound an even more fundamental error. Why would managers with the "longest of investment perspectives" heavily invest in fixed income assets? With investment thinking like this, it is little wonder that pension plans are looking for a government bailout.