Corporate Alignment

October 1, 2003

Dear Investor:

The market has surged from the October 2002 lows under the largest combined monetary and fiscal stimulus the world has arguably ever seen; it would not be surprising to witness a significant equity pullback. We expect higher interest rates to eventually encroach upon stock valuations, as the deficit balloons and the economy expands. In anticipation of a weak bond market, we continue to keep duration low, and overweight funds with high-quality corporate debt relative to Treasury bonds. If rates were to rise 100-200 basis points, opportunities in the bond market would arise that might change that strategy, but not yet.

Corporate governance, this time at the NYSE, has garnered the public’s attention in the wake of Richard Grasso’s absurd pay package. Mr. Grasso always appeared to be a good manager, but who knew he was the fattest cat in a large litter? The focus on corporate governance at large companies has been somewhat productive thus far, and we can only hope the same will be true at the NYSE under the weather eye of John Reed.

It’s important to note the positive changes that have occurred at some firms: General Electric, for example, will now grant real stock in lieu of options to its CEO. These stock grants will largely be based on cash flow targets. By receiving the same basic currency as shareholders, the CEO will have his interests in greater alignment. We called for this currency alignment in our quarterly letter of July 1, Schizoid Scrip, and are very glad that someone on the board of GE was thinking the same way. The targeting of cash flow is comforting as well, since cash flow is a much trickier entity to manipulate than earnings. Cash flow is a real number, whereas earnings are a virtual accounting fiction, dependent on variable accounting treatments of such nuanced deductions as depreciation and amortization.

The Corporate Library, a non-profit investor watchdog group led by Nell Minow, has been at the forefront of pressuring corporations to improve their governance, and the public owes much to their efforts. We have been in contact with the Corporate Library over the past several months, working closely with them to increase their clout with fund and pension managers. The recent Corporate Library newsletter featured a piece we wrote on the importance of corporate governance from the perspective of an investment advisor, and we hope to continue trumpeting their vital message wherever we can. If corporate governance changes do take hold in a real way and are not the mere passing fancy of a fickle public, then the equity risk premium should decline over time.

The reality is that every boom-bust cycle spurs regulatory changes, some of which are feeble or counter-productive, while others become true gems of legislation: witness the creation of the Fed in 1913 or of the SEC in 1934. It’s far too early to write the book on Sarbanes-Oxley, but if momentum continues, corporate governance reform could be the new platform for the next round of equity appreciation.