Noteworthy ideas & observations from our Chairman and Chief Investment Officer Murray Stahl
The Sociology (and Tipping Points) of Stock Compensation
Though most investment professionals understand the accounting methodology for stock and option compensation, few have considered the impact on employee/employer economics during a period of extended share price underperformance. Management courses might discuss the role of equity compensation in aligning the interests of a company and its investors, but this doesn’t necessarily inform valuation models. Since it is the stock price, not the profitability of the business, that determines the value of equity compensation, it is quite possible for employees at a profitable and growing company, but with a stock price that fails to appreciate sufficiently, to suffer a decrease in compensation. Under those circumstances, the demand for higher cash compensation has profit margin implications for the employer. The companies with the greatest exposure, both as a proportion of employee compensation and on the income statement, tend to be IT and social media companies, which are among the largest weightings in the S&P 500 index.
Inflation and Economic Thought
It is interesting to note that the great economists have rarely written about inflation, while historians have frequently, and generally as the root of the demise of an empire. When economists do discuss it, they have generally referred to inflation in the context of a policy tool to moderate economic growth, not with respect to its ruinous effects. The lack of writings on the topic does not lessen its importance to the economy and to individuals. The impact of inflation differs from person to person. For those living on a fixed income, for example, the effect can be devastating. Investors have sought a variety of ways to hedge against inflation. Some have invested in gold, though its actual benefits in this regard have been highly variable. A far preferable method would be via precious metals royalty companies, a business structure that is consistently profitable. Leverage is another hedge – and given the current degree of leverage in the world, inflation is the most likely route out, since it permits the repayment of loans in cheaper currency. So, many will be supportive of the debasement of money. Inflation hedges, therefore, have never been more important to an investor’s portfolio.
The Achievement of Diversification
Does the S&P 500 provide diversification? More than half of the S&P 500 constituents have such low weights that they cannot be considered relevant to the performance of the Index, so investors are getting a concentrated, not a diversified portfolio. What is also clear is that the S&P 500 does not provide diversified exposure to the economy. Rather, the market-capitalization-based weighting biases the index toward businesses with the highest valuations, which are not necessarily those with the largest role in the economy. The companies relegated to rounding errors are actually more representative, on a scale basis, of the broad economy. The problem is equally pronounced in country indexes, which are dominated by a handful of companies that generate the vast majority of their revenues outside of their borders; their local businesses, which would be reflective of their economies, lack the trading liquidity to form an investable index product.
Though such index concentration has rewarded investors during this period of declining interest rates and increasing globalization, should these conditions change, index products would likely need to change as well.
The Transformation of the Fixed Income Asset Class
Fixed income is an investment that is a type of loan. A borrower is obligated to make payments of a predetermined amount, and the principal must be paid on the maturity date. The legal predetermination of the payments is the origin of the term fixed. In other words, fixed means predetermined. This legal definition will not change. An exceedingly low level of interest rates changes the character of this type of investment in extraordinary and not so obvious ways.