Greed & Options - Asset Reallocation

On November 12, 2006 the New York Times had a great article by Gretchen Morgenson "Why Buybacks Aren't Always Good News." The article requires a subscription to the Times to read but the link will work. In either case I would like to direct you to a piece I wrote in December 2003 about stock options and how companies use them to misallocate capital. The stock buyback program is central to pulling off this shareholder robber.

As per one of the requirements this article will not allow for feedback. - Paul

The Under Reported Scandal
As the end of the year approaches I thought it would be nice to look back and review. The past two years have been filled with accounting scandals, Wall Street scandals and most recently mutual fund scandals, all of which might logically have been expected after the speculative 1999 – 2000 period. Though the biggest scandal, the huge transfer of wealth in corporate America to management and employees from shareholders, has really not yet been aggressively reported.

With all the attention being paid to the blatant Enron, Tyco, Qwest, and World Com frauds, investors have lost focus on the issue of accounting for stock options, or more specifically whether or not they should be included on the income statement as an expense. In my opinion the damage done and going unnoticed from excessive stock option grants, is greater than any of the other corporate scandals of the past few years. Through options, actual cash that belongs to shareholders is being shifted to management under the guise that the activity is a non-cash transaction.

The options culture is fueled by the same themes behind all the recent scandals: greed and a complete lack of fiduciary duty on the part of management to their shareholders. This massive reallocation of capital began in the early 1990’s when options use started growing in popularity. Understand one thing, for most of the Nineties, culminating during the bubble years, and continuing today, there was a paradigm shift in the financial markets. I am not talking about the silly paradigm shift relating to new ways to value technology companies (that is and was pure fiction), I am talking about the powerful shift from running corporations for shareholders to running them for management. To steal a line from Tom Brokaw, this is a massive fleecing of America and it will eventually hurt our capitalist system.

Hoodwinked into Believing Everyone was on the Same Side
In its advent, the stock option was trumpeted as aligning management’s interests with shareholder interests. Instead of being guaranteed excessive cash salaries, management and employees would be forced to have some proverbial skin in the game; they were issued options. If management did not perform, the stock would not go up, and their options would be worthless. Employees loved it, shareholders loved it, essentially everyone loved it; everyone except the few who really cared to understand what was happening.

The Enron, Qwest and World Com scandals were all created by fake accounting in an effort to make earnings per share (EPS) appear better than reality. On Wall Street EPS drives stock prices, and the higher the earnings, the higher the stocks. In the late 1990’s management teams began to manage Wall Street earnings expectations and eventually all companies would "beat the numbers" by a penny a share. Beating Wall Street consensus EPS estimates became the norm and momentum investors bid up stocks to unrealistic valuations. Options play a huge roll in managing EPS, because the use of stock options arbitrarily inflates operating income by underreporting human resource expenses. Successful management teams were able to pay employees exorbitant amounts while at the same time keeping reported salaries level by aggressively using options.

Exploiting the Accounting
Due to the current accounting treatment of options, which will likely change by the end of 2004, companies are not required to count the cost of the options they issue as actual expenses. Therefore, the expense of the option does not have to run through the income statement. This has been a huge boon for technology companies who have been among the most egregious offenders of this practice. Essentially, the companies can pay employees in options while at the same time they do not have to record an expense – free money!

The convoluted reason options enjoy this accounting treatment, is that companies argue options are a non-cash expense, thus they should not be on the income statement. Keeping expenses off the income statement is important to employees and managers trying to increase EPS in any way possible. While technically granting employee options does not entail any immediate cash flow, the option does have value and eventually the grant will have a negative cash flow effect associated to its issuance. The value of the options comes from its time premium, the amount of time between when the option is issued and when the employee exercises the option. Usually this period is measured in years.

Companies further argue that expensing options on the income statement would be double counting. Since options are already included in fully diluted shares outstanding many argue that expensing them on the income statement would be an unfair double whammy. Finally companies maintain that options are too hard to value and cannot be measured accurately. If that were the case, I would assert all the more reason to get rid of them.

In short, all of the arguments against expensing options do not hold water. For years many legendary investors including Warren Buffett have crusaded against the current accounting treatment of stock options. Last year many stock market Bears were able to draw media attention to options, citing them as one of the reasons current stock (especially technology companies) valuations are too rich. In technology companies, the expense of options can account for nearly 50% of net income, and on average I have found that options account for 10% of net income in the quality companies I research daily.

The Shell Game – Follow the Cash
The great stock buyback program is the final piece of the puzzle. For years investors cheered when management announced a company was buying back its stock. Investors felt this was great news because shares outstanding would decrease thus increasing your individual ownership percentage of the company. Plus the company was using free cash flow (FCF) efficiently by not paying out a dividend. Remember dividends historically were taxed at ordinary income rates, and investors would rather get the full buying power of a dollar (through non-taxed buyback programs), versus 60% of the buying power from a taxable dividend. Investors were hooked. Stock buyback plans were welcomed with open arms.

Unfortunately, what really has been happening is more sinister than most investors realize. The true cost of stock options can be found in most buy back programs. The expense can be found on the cash flow statement, under cash flows from financing activities (funny it shows up on the cash flow statement when it’s not supposed to be cash flow). Turns out management has been using share buybacks to offset the dilution caused by employee stock options. Stated clearly, companies have been using FCF, which belongs to shareholders to buyback share dilution caused by employee stock options. Thus, anywhere between 10% and 50% (in some cases higher) of net income belonging to shareholders, has been quietly wasted away on stock options. That, my friends, is a transfer of capital to employees from shareholders.

Conclusion
I believe during 2004 the accounting protection for options will change and companies will have to pay for option abuses. Earnings will go down and stocks will look more expensive. Some technology stocks in particular could see net income cut in half. With all of this taking place, companies that continue to feed at the option trough will likely be rewarded with lower valuations.

At Perpetual Value I buy companies that are either already expensing options or are at least moving in that direction. At the bare minimum, I take into account option dilution in my calculation of free cash flow.

Even if the market does not take the appropriate action by lowering the value of companies that abuse options, I still do not want to own a company that does not have our best interests at heart. Remember as shareholders, we own a small piece of each business. At Perpetual Value we think like business owners, and we won’t stand for or be fooled by the massive use of options to essentially steal shareholder capital. Stop cheering share buyback programs and instead focus on a return of capital.

Why Diversification Doesn’t Make Sense

The Argument for Diversification
For as long as I can remember, the asset management industry has been pushing and promoting diversification. Investors have been brainwashed into thinking that responsible investing requires diversification. I believe just the opposite is true, too much diversification is actually irresponsible and only assures average (or below average) performance and higher brokerage fees, both negatives for investors. The financial industry loves to sing the diversification mantra, but you should avoid being over-diversified.

Chart 1: Dow 30 Stocks vs. S&P 500 Index


This two-year chart of the Dow Jones (top line) versus the S&P 500 Index shows that a portfolio of 30 stocks is as diversified as a portfolio of 500 stocks. In fact many studies show that 15 stocks yield the same diversification benefits.

You hear so much about diversification for the following two reasons. First, if you construct a portfolio of numerous companies, a problem or temporary business downturn at any one company will not ruin your return. This is logical because of the law of averages, while something goes wrong at one company, something will likely be going right at another. The other companies in the portfolio will take up the slack until the poor performer improves. The second, and more insidious, reason diversification is so hyped, is that it acts as a safety net and a fee generator for brokerage firms. If a broker recommends 50 stocks or 10 mutual funds to you, the likelihood that you will experience extremely adverse returns is so low that brokers don’t have to worry about stock selection, they just have to worry about getting you to own enough stocks (or funds). The best part of all this diversification nonsense is that it did not help investors at all during the 2000 – 2003 time period when so many investors suffered extreme losses from the Internet bubble. By pushing so many stocks and funds, brokerage firms have essentially guaranteed hefty fee income. The longer investors believe in the diversification story, the more fees will roll in. When I was first developing the groundwork for the Perpetual Value Fund in 1997, I immediately realized that the industry was not promoting rational diversification, they were promoting over-diversification.

Mutual Funds Wear Halloween Costumes Year-round
Everyday is Halloween for the mutual fund industry. Why? Because funds that are supposed to be actively managed are really just index funds dressed-up as actively managed funds. I would really have no problem with this except you pay 2% - 3% (including all fees) to own an actively managed mutual fund, versus 1/2% to own an index fund (where a fund manager only has to mimic an index, no decision making is required). Mutual funds are so diversified, you would be better off just buying an index fund. Most fund managers have too many stocks in their portfolios, anywhere from 50 to 200 or so. Look at the chart on page one of the Dow Jones Industrial Average versus the S&P 500 Index over the past two years. The lines are nearly identical, yet the Dow only has 30 stocks and the S&P has 500 – adding the additional 470 stocks to a portfolio would have actually hurt the performance.

What Really Happens when you Diversify
Though I picked two years for the chart on page one, almost any timeframe would show the Dow 30 outperforming the S&P 500 Index (even if just slightly). The reason this happens is that the Dow is comprised of the 30 highest quality industrial companies that represent (theoretically) the entire market. By limiting the index to 30 names, the Dow generally represents quality capital allocation opportunities. Compare this to the S&P 500, which does the same thing as the Dow, only it uses 500 companies. Clearly, if you have to make 500 capital allocation decisions, each successive decision will be worse than the prior decision.

That is the problem with over-diversification, every additional asset allocation decision you make is by definition weaker than the previous investment. So what are you left with when you over-diversify? At best average performance, and at worst massive under performance due to the excessive fees you incur buying and selling so many stocks (or funds).

Your performance will be average at best, because you have essentially diversified away all your hard work and research. You have watered your portfolio down with lower quality stocks. You are left with stock market risk not company specific risk, just the opposite of what you want. If the market goes down, your 30 companies will go down, if the market goes up, your 30 companies will go up. By over-diversifying you are leaving your portfolio at the mercy of the markets. Most financial professionals would have you believe this is a wise decision, I am telling you it is not.

Why do all the Research if you are Going to Diversify
As many of you know, I do not believe in a diversified portfolio. At Perpetual Value I can hold a maximum of ten positions, and I have no problem owning as few as four companies. I think the fund’s concentrated portfolio is its biggest selling point. Most investors simply do not have access to a similar product. You may be able to go to a broker and structure a concentrated portfolio, but you can rest assured the broker’s fee will not be contingent on whether or not you make money. The broker gets paid either way. In addition, any mutual fund you buy will have considerably more than 10 positions. The Perpetual Value fund is unique in that I am not scared to run a concentrated portfolio.

I believe that the whole point of portfolio management is to identify above average companies in which to invest. Finding such companies at reasonable prices is nearly impossible. It happens a handful of times a year if we are lucky. That is why the fund is so inactive, patience is a key component of our investment discipline.

Over-diversification is yet another way the financial industry has failed the investing public. It is far better to buy a handful of quality companies than many mediocre companies.

The Sophistication Myth

Keep it Simple
There is an interesting dynamic in the financial industry, complicated and seemingly ultra intelligent systems or investment strategies are thought of as superior to common sense. Frankly I don’t understand this reasoning, it is counterintuitive to lessons everyone learns early in life. Think about it, history is littered with so called sophisticated financial schemes. From the Hunt brothers trying to corner the silver market in 1973, to the mortgage securities derivative scandal of 1994, to the Nobel Laureate geniuses (or maybe more correctly not so bright geniuses) at Long Term Capital Management (LTCM) in 1998 – people have been trying to pitch sure fire, no risk complex systems.

Yet throughout time one thing remains certain, individuals complicating the simple process of financial analysis always come out losers. Note I wrote the process is simple not the execution. Drawing the correct conclusions from essentially unlimited data (noise), is nearly an impossible skill to master. It separates the proverbial men from the boys.

At Perpetual Value I am often asked if I use ‘sophisticated’ strategies – like options and derivatives. Or further what my intellectual edge is, do I have better information than the other portfolio managers, or am I just smarter in certain industries? Unfortunately there is no way to honestly quantify such questions. What portfolio manager is going to say he is dumb? Plain and simple such questions are asked by investors because they want to know if the fund is sexy. Doing realistic research and trying to manage downside risk is not sexy enough for them. They seem to want to believe that their chosen portfolio managers have super, all knowing powers. They essentially want to think they have a sure thing, or at least something to talk about at cocktail parties. While I understand the impetus behind such questions, I believe they are 100% misguided and likely harmful to one’s net worth. There is a difference between a portfolio manager that has an investment strategy that consistently (adjusted for risk) outperforms the broad markets and one that simply has a complicated, computer back tested, and seemingly low risk strategy that will change the world.

The Smartest Minds in the Country
The best example of a sophisticated, untested (for all possibilities) strategy is the Long-Term Capital Management disaster. For those interested I highly recommend Roger Lowenstein’s - When Genius Failed - it is well worth the $15. LTCM was billed as the most complex hedge fund out there, it was once thought of as nearly risk free! LTCM was run by literally the smartest guys in the country. They were math and financial geniuses. You may have heard of the famous options pricing model – the Black-Scholes model – well no less than Mr. Scholes himself was a managing partner in LTCM. LTCM was beyond sophisticated, they were beyond complex – they were actually authoring the efficient market theories others would study in universities around the globe.



The only problem was, they looked at investing like it was a pure science, like a few fundamental laws guided everything. Essentially, as the saying goes, they knew the price of everything (and its likely movements) but the VALUE of nothing. Their strategy weighed heavily on the historic price changes of securities – in essence all ‘complex’ systems rely on historic price movements. It’s funny that doesn’t seem so complex to me, it seems like circular logic, but not complex! See the LTCM guys, believing everything was a science and a mathematical probability, did not believe in the chaos theory. Their equations failed to take into account that historic correlation and liquidity could change based on new unforeseen events. You simply cannot model the chaos of global financial markets – the past won’t always predict the future.

That is the biggest problem with so called sophisticated strategies, they all boil down to using historical results, from liquidity to operating margins, to predict exactly how a security will react
in the future. This is their big secret weapon, talk about a little man behind the curtain. Yet when the future doesn’t act exactly like their models suggest it should, sophisticated strategies tend to blow up magnificently. If you are not careful you lose all your money. See the chart on page one – it happens almost overnight!

It is important for investors to understand that instruments or strategies they perceive as sophisticated such as derivatives and options – are just mathematical formulas based on historical behavior and correlation. The same can be said for complex interest rate spread trading schemes – like LTCM employed – if the future is different then predicted everything falls to pieces. Some managers try to sell you complex black box strategies to make you think they are lowering risk and increasing returns. History shows the exact opposite is true, invariable these strategies are extremely risky.

Another trait most complex portfolio management strategies have is they use leverage – meaning you borrow money to try and enhance your returns. Again there is nothing too complex about borrowing money - any fool can do it. Yet the only thing you are really doing is increasing your risks proportionately to your increased return expectations. Really anyone can understand this, but it never fails, hedge funds that pitch very complex strategies generate a huge buzz and get people interested.

Buzz Isn’t Legal Tender
I am not interested in creating a buzz around Perpetual Value. I am more concerned with attracting investors that believe in our strategy. Investors that are smart enough to understand everything else is just dangerous financial engineering. Perpetual Value employs the most sophisticated strategy known: We think, we make judgements and we have conviction. I challenge other managers to come up with anything more complicated. Thinking is the hardest thing humans do. It’s what separates us from computers. Anyone with a $500 Dell computer can trade bond spreads and make interest rate bets or gamble with short-term put/call strategies. Yet only a select few portfolio managers have the patience to think and analyze.

Can Google really continue its rapid growth, while increasing profits in the face of fierce competition? Can mortgage originators, that have enjoyed years of the lowest interest rates EVER, really go up as interest rates move against them? Can a 106 year old children’s clothing company, with a history of returning over 15% on its invested capital, continue to trade at just 50% of depressed revenues? I am not really sure what a computer would say about those questions, but in my opinion I would say the answer is no. The ability to use logical reasoning is what really separates the best portfolio managers from the worst.

Remember the Great Ones
Think about legendary investors like Peter Lynch, Warren Buffett or John Templeton, all great independent thinkers. Now compare them to John Meriwether (of LTCM fame), junk bond king Michael Milken (his recent philanthropic work aside) or the rogue commodities trader Nick Leeson – they all at one point made hundreds of millions of dollars with their strategies. Yet the only reason anyone knows their names is because their ‘systems’ ultimately failed. Today nobody respects their investment views like the great thinkers previously mentioned.

Over the past 20 months that I have run the fund, the hardest concept to make investors understand is that Perpetual Value’s edge is its investment philosophy and strategy. Just because I don’t try and wow investors with seemingly complex discussions does not mean the fund is somehow unsophisticated, or worse that anyone could generate the same results. The core concepts of free cash flow, return on invested capital, normalized results and price sensitivity are not easy to properly execute. The investment process requires thinking, and most portfolio managers don’t think for themselves or they spend too much time focusing on the wrong things. They focus on the weekly news flow from a company, or they focus on some tiny piece of information that they incorrectly extrapolate into having some greater meaning. The ability to see the forest through the trees is often underestimated.

To date I am very pleased with how Perpetual Value’s investment strategy has performed in a relatively difficult market environment. Anyone can generate decent returns in a bull market, but it is much harder in a flat or down market. I am confident the core principles that comprise Perpetual Value’s strategy will never go out of style.