Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

October 2013

Franklin Roosevelt’s New Deal may have rescued capitalism from an earlier generation of capitalists, but who or what will save it from our present-day captains of industry and finance? Some members of our Great Recession-era corporate elite share with their Great Depression-era forebears a shameless sense of entitlement and an inability to resist opportunities to demonstrate their detachment from and incomprehension of the world as most people know it. Now, as in the 1930s, the behavior of some who have reaped great personal benefit from their positions at the top of the corporate hierarchy is sowing resentment over capitalism’s wealth distribution inequities, even among people who acknowledge the system’s advantages over other forms of economic organization.

Excesses that came to light at the height of the financial crisis in 2008-2009—million-dollar office remodelings, Riviera villas, and personal fortunes that survived the collapse into bankruptcy of long-standing enterprises—continue in spite of the glare of publicity. A notable recent example involves the head of a major U.S. bank who accepted a sizable bonus payment despite the fact that his institution incurred billions of dollars in losses and fines on his watch. When asked about the bonus at a congressional hearing, his response was “It’s up to the Board.” Another executive, this time at a European company, caused an uproar when, after only three years on the job, he received $25 million for simply selling the company to a former employer—$1 million for each $1 billion in equity market value lost during his tenure, critics pointed out.

The ultimate offence to the sensibilities of anyone except members of the unreconstructed managerial class came from the chief executive of a bailed-out insurance company who compared attacks on the corporate “bonus culture” to the lynchings of African-Americans in the American South decades ago. Comparing the injured self-pride of a whining, privileged elite to the murder of innocent individuals brought a well-deserved harsh response and hasty apology from the whiner in question. Our own preference would be for this particular tone-deaf executive to take his bonus, retire to his Elysium, and not be heard from again. However, while that would clear the air of one annoyance, it would not solve the problem of a system that spawns more of his ilk on a continuous basis.

It is not that we are anti-capitalist, quite the opposite, in fact. The compensation practices and attitudinal issues noted above not only give capitalism a bad name, but are also self-defeating and potentially costly to the extent that they increase support for more restrictive regulation of business, as we see in the financial sector. Moreover, our defender of the bonus culture either misunderstands the critique, or attempts to obfuscate the issue. It is not the big cash payoffs per se that are a problem; it is the too-frequent absence of a clear link between these vast payments and job performance that rankles. Make no mistake about it—the awards are vast. The average American taxpayer earns roughly $2 million over the course of a lifetime. It has not been unheard of for a payoff equaling 100 times average lifetime earnings to be granted for failure.

Perhaps we are too idealistic. We believe that under a well-functioning, competitive capitalism such as that envisioned by Adam Smith, these excesses would be far less likely. Instead, what we have is greatly removed from the competitive ideal—a kind of crony corporatism whose out-of-control practices not only invite unwanted attention and counterproductive regulatory intervention, they effectively short-circuit capitalism’s own powerful and relentless self-regulatory mechanisms, a key one being “creative destruction.” Creative destruction—the cost of failure—is, as one financial writer succinctly put it, “capitalism’s way of ensuring that capital no longer flows to businesses that cannot put it to good use.” It is largely responsible for capitalism’s successes, and also for the opprobrium it engenders among those who suffer its ill effects through lost employment and livelihoods. The people who run businesses need to fear suffering the same fate. They should be no more insulated from the downside of creative destruction than are the business owners—the shareholders of public companies—who are subject to the risk of irretrievable loss. A system that rewards short-term results, or even failure, does just that.

We have long advocated that corporate leaders be exposed to partnership-type risks under which their rewards would be accumulated over time, tied to the long-term health of the business, and only be accessible well after their departure or retirement from the enterprise. We are under no illusion that this sort of reform will take place anytime soon owing to the almost certain political and legal roadblocks that opponents would employ. Additionally, we are skeptical that more direct interventions into corporate governance—such as regulating compensation—would work; such steps can be evaded, as they have been in the past. In addition, what criteria should be used to guide “appropriate” compensation? It would be far better to foster a genuinely open and competitive market for management services and shine light on a process now dominated by self-interested consultants. Along those lines, the SEC’s proposal to publicize relative compensation levels within companies is a step in the right direction, as are efforts by some in fund management to pressure corporate boards into adopting long-term incentives and rewards for executives (one hopes these policies also apply to the fund managers themselves). It is to be hoped that unleashed market forces will be given a chance to operate, since it is clear that not even shaming works for champions of the bonus culture.

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During times when most investors are making money, not too many care about the take-home pay of pampered executives. This is one of those times. In fact, with the exception of some hedge funds, gold bugs, and short-sellers, most Americans directly or indirectly through retirement plans have benefitted from a remarkable 20% rise in average equity prices so far this year. Continuing the rebound from 2009, market indexes have set new records, at least on a non-inflation-adjusted basis. Fixed-income activity continues to show noteworthy strength as well, as September’s record $49 billion bond sale by a single issuer—double the previous record set earlier this year—attests.

Contributing to the market gains are central bank policies, which were reinforced by the Federal Reserve’s unexpected announcement after its September meeting that “quantitative easing” operations would continue unabated. Rises in security prices are one mechanism by which monetary policy feeds through to the “real” economy. A “wealth effect” encourages spending, thereby stimulating demand. That there appears to be a disconnect between market action and recent economic performance is likely a timing issue; central bank actions work with a lag, and the normal gap between policy measures and business activity has been exacerbated by the worst economic contraction in 80 years, a downturn that weakened banks and damaged individuals’ incomes and balance sheets.

Given the severity of the retrenchment, it would take a while to recover even under normal circumstances, and current conditions are far from normal. Appalling governmental incompetence and its impact on fiscal policy at the Federal level has already put a damper on consumer behavior and business investment spending. A lengthening government shutdown and threatening debt default would create unstable conditions, especially if the latter should come to pass. The immediate future, it would seem, holds some potential excitement in store. Long-term the U.S. has the advantage of tremendous wealth and economic stability, but a default resulting from a political impasse would call into question the country’s ability to marshal those resources to meet its obligations, upending a 225-year history of reliable debt payment.

As investors we must always deal with the world’s vicissitudes on a macro, micro, and issuer level. The current circumstances, while seemingly intractable, are no worse that others we have faced and certainly not as dire as past emergencies. As the business media constantly remind us, we may have to deal with increased market “volatility”—as if that were a risk. For us, simple fluctuations in security prices, especially when they are of significant magnitude, mean opportunity, as history has shown time and again. If such expectations indeed come to pass, we plan to act accordingly.

 

Dennis Butler, MBA, CFA