July 15, 2022
Before we get into the discussion topic today, here is some good news that has not been widely reported in the media. In Q2 2022, S&P 500 businesses paid out $140.6 billion in dividends, an all-time quarterly record. While this is in nominal dollars and not real dollars, in other words it doesn't account for inflation, it surpasses last quarter's payout of $137.6B and is up 14% from the same quarter in 2021. Note that the dividend payout increase almost *doubled* inflation year-to-year. At the same time, the index is about 10% cheaper to purchase.
Harold Hamm, 13th child of Oklahoma sharecroppers, mild Internet celebrity for writing perhaps the largest paper check the public has ever seen (1), and founder of oil company Continental Resources, is not happy.
One would think that oil at $100 a barrel would make Harold pleased. But your revenue is your price times your volume, and he thinks he can pump more oil. A lot more. The problem is that his public company investors do not necessarily want him to do so, in part for environmental reasons, and in part because they have different incentives. So Harold is trying to buy out the 17% or so of the firm he does not own. This presents two interesting cases, one for the environmental investor, and one for indexing investors.
1. On the environmental side, many of the large Wall St firms, and mutual funds, are now structured to consider environmental variables in their investments. Whether those variables are accurate is a point of discussion, but this industry exists (see One Day In July environmental options here), is growing fast, and has over $35 trillion under management worldwide. The interesting thing is that it's large enough, and powerful enough, to have some influence over a firm like Continental. Just because Harold wants to drill, doesn't mean he gets to.
On the other hand, Harold didn't rise from an Oklahoma pickup truck at age 21 to running Continental by obeying people when he's told "no." So his response is to take Continental private. Maybe it will be his family's money, maybe he'll invite in some rich friends, but one thing that will not happen is the public and the stock index will not share in the profits as he cranks up production. The profits will flow to a very small number of very wealthy people. The environmental investor says: "we want to reduce carbon output" and Harold says "my oil is getting kids to soccer practices, and because we frack America doesn't need Putin's energy." The values are different (at least on the surface) and as such, everyone is maximizing to their priorities. The environmental fund gets better metrics but perhaps worse financial performance without Harold's firm around, and Harold gets more money.
2. This particular case also outlines a weakness in corporate governance and indexing. We've discussed this deficiency in a cursory way in this newsletter previously. One of the problems in indexing is that large funds have common ownership across firms. If you're the indexed investor, in a financial sense you care about the aggregate profits of the index. High prices at the pump may not bother you, as the margins and profits of each barrel of oil are high (2). As the indexed investor you might think "leave the oil in the ground, I'm making just as much money anyway - I'm not going to make any more if production increases, and then there will be more carbon." The oil company executive has a different point of view of course, seeing no value in cartel-like behavior.
This is an easy problem to solve by removing voting rights for index investors. They can ride along but they don't get a management say. That has not happened yet but hopefully it will.
Note that the two issues above surface in many industries. As one example, imagine that a building produces cash flow of X. If you are an indexed REIT holder, and one of the REITs in your index owns the building and sells it to another firm of similar size and capital structure in the index, your cash flow has not changed as the indexer. But the cash flow of the underpinning firms has morphed substantially.
Credit to Matt Levine from Bloomberg who wrote about the two ideas above. We've discussed them a lot with clients over time, and they converged in this example.
Dan Cunningham
1. Clients often ask if large checks, such as IRA Rollovers, will clear if they are in paper form. The answer, based on Harold's check, is yes.
2. This is a simplification of course, as high energy prices tend to negatively affect other industries, which are also represented in the index.
3. Dividend information above source: Dow Jones Indices data.
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