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The Recipe for Agent Orange – The Projection Racket, Pt. 3

Every parent with more than one child knows the trick.

If you have one piece of cake and two children, the piece of cake must be cut in half. Under no circumstance can you be the one who cuts the cake. Neither can you be the one who allocates the slices, nor can you allow any child to perform both the cutting and the choosing. There is but one solution: You must allow one child to cut and the other to choose their slice. Anything else is asking for violence, recriminations and wasted cake.

It is a classic game theory problem in the field of envy-free choice. It also explains some of the thinking behind most nudges, the worst of many terrible ideas to come from the desk of Cass Sunstein. The perception of agency does a lot to help us accept an outcome. After all, if we were responsible for it, surely we made a good decision.

In practice, however, the designer of the nudge doesn't always play fair. Especially if they have stakes. Especially if they are a principal, too. Hey, even the most soft-hearted libertarian paternalist can't be a perfect parent all the time.

Which is why I set up a little principal-involved variation on the envy-free cake experiment with my son. Because kids are weird, his favorite thing to drink is Orange Fanta. Plus, it's his birthday today and he wanted to have what is a pretty rare treat around our house for breakfast. So I filled up one glass with a half cup of Fanta. I filled up another glass with a full cup of it. I added a cup of ice to the glass with half as much. I then presented him with the choice between the tall, well-presented glass with half as much and the short, unassuming glass with twice as much.

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  1. Avatar for Brian Brian says:

    Wow - absolutely fantastic conclusions. B/C passive investing has become so large, their votes on proxy items need to be scrutinized more and they need to become more accountable. I really like the idea of more disclosure on SBC, but it might not go far enough b/c of the rampant corruption. Before 1982, buy-backs were illegal and considered manipulation. Until we make changes on how much capital is being used for SBC, stop buy backs all together for a time until better rules can be put in place. We also need to break some of these companies up and step-up efforts to do away with monopolies! Thanks Rusty great work! Brian

  2. Analysis of the current situation was excellent, as usual. Your reform proposals seem entirely sensible.

    But my reading of this series suggests that the real problem is that political forces have figured out how to successfully promulgate the narratives that convert the historic justification for governance rules into “yea governance!” and “yea share buybacks!” just as they used “yea college!” and “yea patriotism!” and “yea democracy!” to horribly warp other norms and institutions that once served the greater good. And figured out how to use that political power to totally capture the mainstream/business media so that they endlessly repeated the desired narratives and blocked awareness of any alternative views.

    Even if initially enacted, don’t think reforms of this type could survive ongoing attacks from those political forces any more that similar reform efforts have any impact in areas such as tax law or antitrust enforcement.

  3. The huge fund companies spent the ESG window-dressing bullshit era focusing on the ‘E’ and the ‘S’, and completely neglected the ‘G’, which is the only one that ever mattered.

  4. Avatar for rguinn rguinn says:

    Thanks for reading and thanks for joining the conversation, Brian! I, too, worry about the passive investors abdicating their duties most of all, but I don’t want to give the run-of-the-mill active long-only or hedge fund managers a pass, either. They have ignored this part of their work for far too long as well.

  5. Avatar for rguinn rguinn says:

    Once we’re back in a bull market, the ES-or-bust vibe will be back in effect. I don’t think there’s an environment where G matters again. Doesn’t do anything for anyone (except long-term value for shareholders, but who cares about that?).

  6. Avatar for rguinn rguinn says:

    Hubert, astutely observed, and the intractable problem of any BITFD proposal.

    In this case, I do think that we benefit from the wonkishness of those who must be convinced. The exchanges are susceptible to narratives running against them, and the regulators do not like being on the wrong side of reputational risk. As @bhunt has observed, if we’re going to do this, it’s by creating our own effective narratives to make the dangers of these issues real to this narrow set of institutions.

    As you point out, still no mean task.

  7. Jack Bogle applauds.
    Vanguard could fix a lot of this, but sadly neglects the responsibility that comes with its great power…

  8. Avatar for rguinn rguinn says:

    It’s part of the danger of seeing financial markets as a utility to deliver returns, I think. It blinds us to a lot.

  9. Avatar for jewing jewing says:

    Outstanding essay Rusty, made all the more compelling by your proposed remedies. Of them, it seems the most important would be the separation of Chairman and CEO - something that is required in many countries outside the U.S., and the clarification of stock-based compensation.

    There is a reason many countries force the separation of owners and management, and there is no reason it cannot be the same here.

    And on accounting: if one could plainly see how shareholders’ capital is going right back to insiders in the form of sterilization, then I think this racket would be over quickly. Outside shareholders, particularly active fund managers, would quickly see them as another expense.

    The director limitations would be nice to have, though as you mention there are already some marketplace restrictions in place. The ‘say on pay’ clause would also be great for clarification purposes. But I think you would be over 90% of the way there with just the Chair/CEO split and clearer accounting standards.

  10. The idea of a free lunch from indexing is likely to be another sacred cow that will be slaughtered by this bear market. The underpinnings were completely undone by negative interest rates and the valuations they allowed. While it seems obvious to active equity investors with any sort of valuation anchor in their investment process; indexing looked like a magic money machine with max monetary ease accentuated by emergency fiscal policy.

    The math of losing money buying the $17 trillion bond pile that traded for negative yields at the global rate trough was obvious to everyone but those forced into those trades by indexing. Stocks always have the potential optimism that 40 multiples of pro forma revenue forecasts might turn out okay if the company invents a new category and gets all of the market share. But, the logic of buying the most of the most expensive securities fails the test of a secular bear market. The fact that the indexers did not exercise their vote with care either will be part of a change in that free lunch narrative.

  11. I would add two items to your list of corrective measures. First, require companies to disclose each year the % of free cash flow going to share=based compensation. The figures you provide are very compelling, but rarely exposed to the light of day. Second, require companies to disclose where their management teams stand relative to their industry, and where the company’s financial performance stands relative to the industry. The latter, of course, would be subject to much debate about how the metrics are calculated, but at least it would begin to expose the most egregious cases.

  12. Speaking of the illusion of control:

    So many investment vehicles are removed from any actual contact with the people whose money is being invested. This is true of most retirement portfolios, but also of mutual funds, etc.

    So when we talk of “passive investors” it’s useful to remember that the majority of people whose money is invested in the market stand at arms-length from the person actually doing the investing, that “investor” isn’t actually investing their own money, so their motivation to be an activist is relatively limited.

  13. Avatar for Brian Brian says:

    Well said and completely concur!

  14. Great piece Rusty

    One additional idea - remove the tax incentives that favor buybacks over dividends. One way to do this is by creating a dividend imputation system that gives credit for taxes paid by the corporation and thereby removes double taxation of dividends. This is how it works in Australia for example and you mostly don’t see the same egregious SBC issues there.

  15. Avatar for rguinn rguinn says:

    I have no problem with this. I think it would be a useful disclosure.

  16. Avatar for rguinn rguinn says:

    I’m loath to ever introduce a new tax, to be honest, but I also can’t come up with a satisfactory reason why there should be a tax differential. I can absolutely see this being a helpful change. I’ll think about this some more, and I appreciate your suggestion.

  17. Avatar for rguinn rguinn says:

    Absolutely, Christopher. The layers of agents in some cases run 4 or 5 deep. There is zero question that a huge share of “end investors” are so deeply subordinated in agency structure that it would be effectively impossible for them to act as activists. There the responsibility clearly lies with their agents to act better. Those of us who are in a more empowered and less abstracted state, however, retain our responsibility to see activism as part of our role as investors.

  18. Avatar for rguinn rguinn says:

    I have thought this before. I hope you are right. But with your forgiveness, I don’t think we are there yet. I think the objective superiority of passive is very, very canonical at this point, in the same way that P/B value became so ingrained in American institutional investment culture that 15 years of getting its face ripped off did little to dissuade us.

  19. Indexing is surely accepted wisdom at this point and will not succumb easily. I don’t know what the future holds. I would wager that the valuation and mania extremes that were fostered will take more than one bear cycle to be expunged. 2022, in spite of its capital destruction, shows the investor reaction function is still based on the muscle memory of a secular bull market. So many large pools of capital fled negative real interest rates and public markets and are now stuck/gated. It will take seeing how eventual annual needs for liquidity can be handled in those areas or if public markets are the only source. My expectation is for a secular bear market that destroys large swaths of the capital misallocated at zero bound yields with the valuations that discount rate fostered. That seems like it will take 5-10 years at a minimum but involve intervening bull and bear cycles. That sort of uncomfortable journey to nowhere with precious purchasing power squandered along the way was a feature of the unwind of both of the US secular bull markets in the 20th century… Both the 1920’s bull market and the post WW II cycle to the mid-1960’s saw 15+ year periods of no real return in financial assets after the peaks. From a valuation perspective I would argue this financialization led secular bull traces all the way back to 1981. If it has indeed popped, it will not go quickly or quietly.

  20. Agreed! The idea of “Returns” has been so abstracted and cartoonified we will accept financial engineering over economically productive activity as long as it at least appears to be more profitable in the short term - long term consequences be damned. It’s almost like everyone involved really, really wants to believe the Magic Money Machine is real. Heck, the managerial class seems to have figured out how to narrative their way into their own private version of it. At least for now.

    Great post by the way. This is the kind of quality content which keeps me coming back to Epsilon Theory.

  21. Avatar for rguinn rguinn says:

    Thank you, Tim. I really appreciate you saying so, appreciate you reading and appreciate you taking the time to comment.

    And yes, the entire infrastructure of finance and its narratives has been reoriented to frame any stock returns within as little as 1-3 years as being indicative of “value creation.” It is a time horizon that has proven to be well within the capacity of a skilled missionary to navigate with almost no positive momentum on operations. Well, until interest rates changed, that is. Maybe this part of the Long Now gets a little bit better.

  22. Great post. The Fanta example reminded me of a more extreme, though less narrative-laced, story about Evelyn Waugh:

    During the second world war, Evelyn Waugh’s wife managed to procure three bananas for their children. When she brought the fruit home, Evelyn sat down in front of the children, peeled the bananas, poured on cream and sugar, and ate them all. “It would be absurd to say that I never forgave him,” wrote Waugh’s son Auberon many years later, in his autobiography, Will This Do? (1991), “but he was permanently marked down in my estimation from that moment.”

    Any chance there’s a spreadsheet lying around in your research file, sorted by banana eaters… I mean % of free cash flow going to share=based compensation?

  23. Avatar for rguinn rguinn says:

    Hah, yes indeed. More than one, perhaps.

    Although, in fairness, I will confess that my favorite story about my lovely wife includes some similar behavior. When our children misbehave egregiously on a shopping trip, one of her great consolations is to go to the most elaborately sweet place - Cinnabon is the archetype - buy some decadent thing, and sit in the driver’s seat of the car enjoying every bite. Solo. It is the ultimate alpha mom move.

  24. To be clear, the dividend imputation system does not involve a new tax. In fact the opposite, it reduces tax paid by those in receipt of dividends to the extent that the company has paid US corporate tax on the profits that were used to pay the dividend.

    For example, company has $100 per tax profits, pays $25 in corporate tax and has $75 in post tax profits. Company pays a dividend of $75. Since full US tax was already paid, those in receipt of the dividend receive a tax credit of $25. The point is to avoid double taxation at the corporate level and then the shareholder level.

    It’s a large and complicated change and the left would hate it. Probably very hard to achieve. But perhaps there is a simpler way to achieve a similar concept. The differential taxation of dividends vs buybacks is a big problem I think.

  25. Avatar for rguinn rguinn says:

    I hadn’t considered this as much as you have, and I need to. I want to think about this some more. I think this probably should have made my list.

  26. Happy to discuss further if helpful.

    A way to sell it is to stipulate that the tax credit is only available based on the amount of US corporate tax paid (not foreign tax). That’s normally how these dividend imputation tax credit systems work in any event. At the margin that helps encourage investment in the US rather than offshore. Obviously on shoring is a big and popular issue right now, and this potential tax change is aligned with that.

  27. One change that I have been mulling over for a while now regards capital gains tax. It may be too blunt of a tool/change to address the actions here but it also may be that a blunt tool is all that can be used for change.
    My thought is that instead of changing or messing with the rates, as is the usual suggestion for capital gains rate changes, we change the duration. Instead of 1 year being the standard “long term gain” we change it to 3 years (potentially increasing it 5 years as well).
    If you are going to get paid in RSU’s and your income tax is paid by the company using RSU’s, then the double taxation argument against capital gains doesn’t really hold up. Of course, a larger portion of society gets hit with duration changes than just those involved in share buybacks, but how much larger? Is the trade off worth it? It would require tinkering with a portion of the tax code that, once allowed to be tinkered with, could open a pandora’s box of changes.
    Increasing the negative incentive of income tax rates for management to hold their shares longer and actually have to live with the stock market consequences of their actions instead of receiving shares, waiting a year and then selling them off at a preferred rate. It wouldn’t address all of the shenanigans but I do think it would address some.

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