Schizoid Scrip

July 1, 2003

Dear Investor:

The market has improved dramatically in the past quarter, due to improving confidence as war, SARS and other ills appear in the rearview mirror. Of course, investors should focus on the road ahead.

Some pundits fret about deflation, but falling prices are only a problem in ever-shrinking manufacturing. It has yet to lay a hand on the service sector: ask anyone who pays insurance premiums, medical bills or tuition. The real danger is a ballooning deficit leading to higher interest rates and inflation, a scenario far more bearish for bonds than stocks. That’s why we focus on keeping duration low in bond holdings, regularly checking in with managers regarding average maturities, and making fund changes where appropriate. The most frightening investment right now is neither internet stock nor pork belly, but a 30-year US Treasury Bond.

Regardless of inflation risk, the longer term prospects for the world economy rest with a more prosaic matter of structural reform. Strangely, shareholders often hold different scrip than executives. The owner (shareholder) holds stock in the hopes of capital appreciation and in turn sustains the risk of loss; the employee (executive) holds options in hopes of a windfall and bears no parallel risk. If this strikes you as unfair, you are probably a fair-minded person. As the world converges toward common currencies, it might be time for CEOs to join in.

Warren Buffett is famous for eschewing options, insisting only on cash and real stock as compensation for employees. His logic is simple: it’s fair.

The roiling debate around expensing options misses the key detail that options themselves, expensed or not, are a poor way to compensate employees, especially when they are shamelessly re-priced in the wake of feeble performance in order to dumb down even the dumbest expectations—and by doing so, compensate dishonest execs.

In Jack: Straight from the Gut, Jack Welch, the revered former CEO of General Electric, recounts how GE Capital employees wished desperately to cash in on the internet boom and asked for stakes in potential start-ups. Welch told them to “take a hike. In our shop, there’s only one currency: GE stock with GE values.” That was a smart approach. Unfortunately, there wasn’t just one currency at the time. There were two: options on GE stock and GE stock itself, and Mr. Welch was a legendary recipient of the former.

Of course, the very expensing of options might write their epitaph. Not likely, though, while options provide a win-win proposition for the competence-challenged. Until times change, it’s a good idea to invest in companies where the CEO owns significant stock, not just options on the passage of time. In our private client accounts, we select fund managers who screen companies for executive ownership criteria, including significant percentages of stock held outright. We also select managers who in turn invest their own dollars in the fund they manage.

The problem of schizoid scrip also infests the world of finance. Brokers are famous for making money on commissions while the customer may or may not make money on capital appreciation. This is an infamous incentive for the broker to “churn” an account, or buy and sell stock in order to pay for his pool renovation—in the same way a dentist fills lots of cavities around the time of his daughter’s wedding. That’s why educated investors turn to money managers, who get paid a percentage of the assets under management—where both manager and client have their eyes on the same prize: capital appreciation. No alignment of interests is perfect: a money manager, for example, may speculate in an effort to earn performance fees in a way that is detrimental to the customer. But for the most part, aligning interests as much as possible is a good thing for everyone—and a tremendous victory for equity (the human value, not the asset class).

The schizoid scandal of the day revolves around “soft dollars,” or the practice of compensating fund managers in creative ways for directing trades toward their brokers. The SEC is looking into this much-abused practice, whereby managers are beholden to trade more and more in order to collect the soft dollars, while the fund does not disclose the amount of hard dollars spent on commissions.

In the management of our Fund, we refuse to accept soft dollars in the belief that it creates a flawed incentive scheme. When we launched, prime brokers were not interested in working with us because we wouldn’t accept soft dollars in exchange for generating large amounts of commissions. We had to go to TD Waterhouse, a more progressive broker. Our boycott of soft dollars was not done out of altruism, but rather a belief that we don’t want to be pressured to trade against our better judgment.

It’s time to seek a common currency. Perhaps, markets will force this convergence, as consumers become more educated over time. If not, money will continue to diverge, like the old Francs and Guilders, modes of payment outdated in the new investment world order.