SA Investing & Trading Blog

Stewards of Capital

13 Oct 2009 Leave a Comment

by Albie in 1

“If I have seen further than others it is because I have stood on the shoulders of giants” ( Isaac Newton)

Dear fellow business owners

I’ve set myself a goal to learn as much as I can from successful investment-, as well as business managers as I could. It is a journey with no end destination and a life long dedication in order to be as successful in investing as I’ve set my goals to be.

In my quest to find honest managers, of money and businesses, I recently discovered Howard Marks. His memo’s to his clients over the years was just released recently on their website . His firm Oaktree Capital has an enviable record and he was also asked to write the foreword for one of the chapters in the newest edition of Security Analysis, by Graham and Dodd, the bible of Investment Analysis. For those interested, a very good interview with him can be read in the newest newsletter of Graham en Doddsville at the following link, http://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=7212104 .

In my reading of his past memo’s, I came upon the one he wrote in 2004, Hey, Steward ! . Here he discusses the breaking down of fiduciary duties of the mutual fund industry and how “Amassing assets under management became the [mutual fund] industry’s primary goal, and how their focus shifted from stewardship to salesmanship.” (Emphasis added). Then lastly he focuses on those fiduciary duties of directors and professional managers of public companies. The whole memo is an excellent read but it is this second part that I quote hereunder which is especially relevant in these days.

Enjoy !!

What Else?

I want to make it clear that just as I do not universally indict mutual fund executives and directors, I don’t think stewardship problems exist only in the mutual fund industry. Most of the shortcomings disclosed in the corporate scandals of 2001-02 – in Enron, WorldCom, Adelphia, HealthSouth and Tyco – stemmed from the failure of executives to act on behalf of the shareholders who own the companies, and from the
failure of directors to police the executives.

The examples are endless: excessive compensation, unwarranted expenditures, phony accounting, and transactions intended only to deceive or obfuscate. In general, executives forgot that they run companies for their owners and instead tried to turn them into personal piggybanks. Or they decided to eschew honest reporting in order to hype results and thus their own economics. Directors of these companies haven’t been accused of wrongdoing, just underachieving. They were too complacent and obliging, and thus asleep at the switch. As Warren Buffett says, “sadly ‘boardroom atmosphere’ almost invariably sedates their fiduciary genes.”

The fundamental questions regarding corporate directors and executives are the same as those I proposed earlier regarding mutual funds: How much ends up in the pockets of the company and its owners, and how much in the pockets of the stewards? What means are used to accomplish this “wealth transfer”? How much is disclosed, and how clearly?

A number of thought-provoking examples were discussed in the Wall Street Journal of December 29, under the headline “Many Companies Report Transactions With Top Officers; ‘Related Party’ Deals Disclosed By 300 Large Corporations; Potential for Conflict.” The article discussed not the headline-grabbing misdeeds of the scandal era, but matters that are routine at America’s largest corporations. Often called “related-party transactions,” they represent deals through which directors or executives receive benefits beyond their standard compensation. Of course, there’s only one possible source for this enrichment: the companies and their shareholders. The Journal and I draw no conclusion about whether these things are proper. But they certainly can serve as fodder for discussing the performance of stewards. Here are a few examples:

A company employs or has business ties with 17 relatives of senior officials.

An executive is reimbursed for making business trips on his airplane.

A company buys “financial advisory services” from a director’s company.

Directors receive hundreds of thousands of dollars in consulting fees, above and beyond their directors’ fees. The fees reward the director/consultants for supplying “general information” or “maintaining and enhancing the company’s strategic alignment.” In the latter case, the recipient happens to be the company’s second-biggest shareholder.

A lawyer serves on a corporate board, and the company gives legal work to his firm.

The son-in-law of a former board chairman runs a real estate joint venture involving the company, to which the company guarantees a minimum level of profitability.

A company sells an amusement park to its controlling shareholder, with the buyer paying half the purchase price in the form of passes to the amusement park he just bought.

The Journal put it succinctly. “All these deals present the risk of conflicts between a company official’s two roles: representative of the shareholder and individual seeking to get the best deal for himself.” They raise significant questions:

Are these deals negotiated at arm’s length? Are the terms the best the company can get?
Who negotiates on behalf of the shareholders? How vehemently?
Where a deal is proposed by a shareholder or shareholder/director with a dominant ownership position, who stands up for the minority shareholders?
How can we be sure director A won’t simply vote for director B’s excessive deal in exchange for director B returning the favor?

As I mentioned above, there has been no allegation – even in Enron, Tyco and Adelphia – of actual director impropriety. Rather, the questions surround the energy put into governance.

After working together for many years, directors develop congenial relationships with each other and with the executives. How strongly will they then fight to resist questionable transactions between the company and their colleagues?

Directors’ fees can run into the hundreds of thousands, perhaps with stock options and perks in addition. Will a director risk this package to fight for some faceless shareholders?

In short, can a director who serves at the pleasure of the chairman police the chairman and his other handpicked directors and executives? How can directors be guaranteed the independence that shareholders need them to have?

The industrial economy achieved great strides because of a number of advances, one of which was the separation of management from ownership (and the accompanying development of a class of professional managers). The caveat, of course, is that managers and directors must serve diligently as stewards, protecting the interests of the firm’s absentee owners. The system only works if the stewards – entrusted with responsibility on behalf of others – are up to the task.

The Bottom Line

As you prepare your estate plan, you count on fiduciaries – lawyers, accountants, executors and trustees – to ensure that your assets will be disposed of as you intend. Would you want one of those fiduciaries to buy assets directly from your estate? Rent office space to your estate? Employ his relatives to serve your estate, for additional fees? Enter into a joint venture with the company you left behind? You’d expect the stewards of your estate to be “purer than Caesar’s wife.” Even with motivations that are entirely honorable, it would be impossible for your fiduciaries to simultaneously represent themselves and your heirs on opposite sides of a transaction and still maintain both the fact and the appearance of fairness. Thus they must content themselves with the compensation they’ve been assigned by you or by law. They must resist the temptation to do business with your estate in a way that could benefit them further . . . and to possibly move a little from your heirs’ pockets to their own. We must expect no less from the stewards that we and our companies do business with every day.

In my memos I try to resist citing Oaktree as the paragon of virtue. But when we founded our company, we established an acid test that we routinely rely on to keep us on the right track. It was stated in our original brochure in 1995, and it has served us well ever since.

It is our fundamental operating principle that if all of our practices were to become known, there must be no one with grounds for complaint.
To put it more simply, we assume everything we do will show up on “page one” some day – that nothing will remain a secret. Will there be a negative reaction? Will anyone object?

It’s a simple test, but it seems every day that the newspapers describe someone whose actions could only have been premised on the assumption that no one – not media, shareholders, clients, auditors or regulators – would learn the truth.
Will directors approve of executives’ actions? Will shareholders feel that directors did their job correctly? Will clients conclude that fiduciaries have put responsibility to them ahead of their own interests? We think the standards for stewards’ behavior are pretty clear cut, which means making these assessments shouldn’t be that hard.

March 16, 2004
Howard Marks

Executive Compensation

01 Oct 2009 Leave a Comment

by Albie in 1

What is necessary to change a person is to change his awareness of himself. – - Abraham Maslow

Dear fellow business owners

Executive Compensation is a hot topic these days and rightly so! There seems to be almost unanimous agreement that it got out of line in the “bubble” times, unless you are one of those that are able to somehow justify that earning $100 million bonuses is defendable? Those bubbly days are gone, but how do you “reset” these expectations of executives? How do you overcome the “anchoring bias” of people to recent levels? Charlie Rose had a very interesting interview with Paul Volcker here Sept 29, http://www.charlierose.com/view/interview/10631 , in which he makes some very sensible comments regarding executive compensation around the 45 min mark.

I am a firm believer of “everything is relative”. There is many evidence and studies done show people value and compare themselves relative to what their peers have or earn. Leaving aside the argument of whether this is the correct way of valuing one’s self worth, it seems to be the judgment in the business world at least. As a simple example, a top banking executive earning $10 million, but earning 10% more than his closest peer with $9 million, would be just as satisfied as if he was earning $100 million vs his peer’s $90 million. So instead of focusing on absolute values of compensation, i.e. $5 million or whatever, the focus should return to relative values and what appropriate compensation at certain levels of executive management are. I would want to see more intelligent debate in the media and public about what “appropriate” is and how to define and measure the definitions and/or requirements of these different levels. Compensation committees can then go and set relative packages around these levels combined with the correct structuring of long term goal achievement instead of rewarding short term speculative behavior with no real long term commitment from management with their own money. But the debate needs to be public, or it run the risk of staying a closed club of boards, executive CEO’s and compensation consultants in which “ you keep on raising me and I keep on raising you!” stays the motto.

But this is my own “utopia” thinking again. What do you think?

Executive Pay and Proper Incentives

18 Sep 2009 Leave a Comment

by Albie in 1

Dear fellow business owners

I am sure you are all as concerned about the trends of executive pay the past few years  as I am.  As shareholders, and the true owners of these businesses, it is our duty to speak up and demand from the directors and boards to structure these compensation structures properly.  The media has a very important responsibility in this regard as well.  I have addressed this issue previously here, http://sastocks.wordpress.com/2009/05/03/aligning-management-with-owner-interests/ , and quotes Warren Buffet again,

“CEOs appoint the comp committee – they don’t look for Dobermans, they look for Cocker Spaniels. In my experience boards have done very little in the way of really thinking through as a owner about “what is the proper way to pay these people and incentivize them not to do the wrong thing?”

Please see below for a very good article in this regard that appeared in the New York Times yesterday.

Best regards

Albie

http://dealbook.blogs.nytimes.com/2009/09/17/blackstone-co-founder-criticizes-bonus-system/

Blackstone Co-Founder Criticizes Bonus System

September 17, 2009, 2:00 pm

The economy may be stabilizing and stocks may be rising, but Peter G. Peterson, the billionaire co-founder of the private equity giant Blackstone Group, isn’t sounding so upbeat.

At a gathering of Wall Street executives on Thursday morning in New York, he expressed deep concerns about the economic security of the United States, and said that the way Wall Street compensates its employees was one of the biggest problems facing the country.

Speaking at a breakfast event held by the Argyle Executive Forum, Mr. Peterson, who was Commerce Secretary under President Richard Nixon, told attendees that long-term, structural challenges related to entitlement spending, deficit spending and health care costs were bankrupting the United States. And he argued that short-term solutions wouldn’t fix the problem.

“Americans have been misinformed and, yes, disinformed, sometimes quite intentionally, by politicians who believe that the American people can’t take the plain, hard truth,” Mr. Peterson said, referring to the $56 trillion in unfunded mandates he says the United States government has on its books. “We have had a lot of experience in bailing out various companies and institutions. We must confront the question: Who is going to bail out America?”

Mr. Peterson addressed another subject that is generating a lot of debate in the United States and Europe: bonuses in the finance industry.

He says that the way Wall Street pays its top employees, reserving large sums for year-end bonuses, is an example of the systemic problems facing the country. He says that the current system rewards short-term gains and doesn’t serve the long-term interests of financial firms’ shareholders.

Speaking to DealBook on the sidelines of the event, Mr. Peterson described how he would set up a better compensation structure: “I would say, ‘you’ve got to put in your own money, the money needs to be paid out based on long-term performance, you’ve got to set aside some of your winnings, have a clawback.” This way, he said, “the public can see their interest and management’s interest as coherent and unified.”

Mr. Peterson made $1.8 billion when Blackstone went public in 2007. In 2008, as he retired from the firm, he announced the formation of the Peter G. Peterson Foundation, which will devote $1 billion of his wealth to educate the public and politicians about the long-term problems facing the country.

Mr. Peterson said Thursday he believed it would take a strong president leading a bipartisan effort with formidable public support to fix these long-term problems,

“I say to all of us, let us get off our respective butts and make it safe for our politicians to make the tough choices, to do the right things not simply for our kids and grandkids but for this remarkable country’s future,” Mr. Peterson said in his speech. “And let us make it unsafe for out politicians to continue to do nothing, continue to deny the undeniable and to continue to pretend that we can sustain the unsustainable.”

– Cyrus Sanati