Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

April 2002

Corporate accounting scams, compromised Wall Street analysts, rising interest rates, a host of international challenges—with all of this flypaper hanging about, you would think that market participants would be inclined to lie low for a while. Nonetheless the U.S. equity markets continued to evidence an undying faith in stocks in the first period of the year. Although the major averages were little changed through the end of March, prices in the broader universe of stocks generally rose, with many issues reaching new high price levels. The reason for this phenomenon is clear: the big names having the greatest impact on the capitalization-weighted indexes are not doing as well as most stocks. This presents an interesting contrast to the situation early in 2000 when a mania focusing on the big, popular stocks (especially technology) was driving the averages to new highs, while, almost unnoticed, most stocks were declining. At that time we wrote: “Money was being sucked out of virtually every other market segment. In some cases, individual issues reached valuations more depressed than they had been in the past decade—among them leading companies in their industries. This is the process by which the public markets create opportunities that the observant and the prepared can use to profitable advantage.” The “observant and the prepared,” who, incidentally, did not did not look so smart in early 2000 because they refused to follow speculation to its inevitable technology-led doom, have been profiting since from the advantage that their adherence to investment values permitted. Careful investors are not inclined to gloat, however. No one foresaw the ferocity of the downturn that has been visited upon speculators in the ensuing two years, or the favorable environment that has generally rewarded patience. Come what may, true investment unswervingly follows its own course and logic, limiting by measurement that which to speculators appears boundless through hope.

Speculation has not confined itself to the stock market in recent times; indeed, rolling bubbles seem to be occurring across the financial landscape. Some are derived from the stock market—mutual funds, for example. The Wall Street Journal recently pointed out that the number of stock funds has quadrupled since 1991 to 4800, with assets rising to $3.3 trillion from $405 billion during the period. As a result, the fund business appears to have gotten ahead of itself: with more individual funds than stocks traded on the New York Stock Exchange, nearly 50% of funds have fewer assets than required to make them economically viable (no wonder fund fees are rising). The same article also revealed how mutual funds are losing some of their already thinly-stretched managerial talent to the rapidly-growing hedge fund community—another bubble in the making. Hedge funds—private, lightly-regulated investing partnerships limited to the very well-heeled—did fine when they were obscure and their audience limited. Now that nearly everyone who can afford to lose money is getting into these things, it is hard to see how this now popular “alternative” type of investment vehicle will generate the superior returns newcomers are expecting. A vast new supply of capital, chasing both limited trading opportunities and talent to identify them, does not seem particularly auspicious to us.

Judging by the number of calls we have been getting from salespeople hawking bonds, fixed income is looking like an overinflated area as well. Bonds hardly seem a fitting object of speculative desire, but anything that works during a period of financial turmoil becomes fodder for profit-seeking hucksters, and bonds have worked quite well. So well, in fact, that issuance of new debt continues at a record pace, even after a booming 2001. Finally, residential real estate, so far impervious to shocks, seems long overdue for some sort of set back. Aside from certain areas of California near Silicon Valley, the real estate market scoots right along. Low interest rates have helped to maintain the “affordability” of property, nevertheless we find it hard to conceive of home prices rising 10% annually indefinitely.

Ownership and Responsibility

To gain perspective on the current controversy that surrounds Enron but encompasses many other corporations and their reporting policies, we look to an influential work that appeared in the early 1930s. Adolf Berle and Gardiner Means, in The Modern Corporation and Private Property, described how control of corporations had come to be placed in a managerial class while their ownership had become diffuse. Previously, a small group—a founding family or partners— both owned and controlled enterprises; therefore, those with the greatest interest in the business also made the decisions. As businesses grew this arrangement evolved into one where professional managers with little ownership made decisions, and those who owned the shares constituted a large, anonymous and passive group lacking hands-on experience with their company’s operations. The change had a crucial impact on corporate governance: managers often had interests inimical to those of owners, such as the desire to create great industrial empires, fancy perks and high salaries, while at the same time possessing the ability to fill the Board of Directors (which is supposed to watch after shareholders’ interests) with friends sympathetic to the executives. Owners, on the other hand, were (or should have been) more interested in profitability and efficiency, yet it was difficult for them to organize and speak with one voice, and most tended to defer to management anyway.

The institutionalization of stock ownership over the last half-century has both transformed and exacerbated the problems caused by the ownership/management dichotomy. Stock ownership has once again become concentrated in a few hands—at least relatively speaking—as pension, mutual fund and other large players have come to own larger blocks of corporate stock, while the relative importance of the individual holder has declined. But the emergence of fewer and larger holders has not re-created the level of interest and motivation once held by small groups of founders. Today’s owners are certainly well-informed and motivated, but institutions are distracted from the task of corporate oversight by their own imperatives, which have indirectly contributed to encouraging the kinds of inappropriate behaviors that have come to light during the past several months.

Foremost among institutionalized investment’s imperatives is the need to produce good relative investment results in the face of incessant competition from other asset management firms for a finite number of client accounts. Since the 1950s and 60s saw the emergence of a so-called “cult of performance,” the focus has been increasingly on short-term returns. The pressure from clients and other institutions to perform is tremendous and livelihood-threatening to money managers, who, in turn, subject corporations and managements to a similar third degree with each passing quarterly financial reporting period. Thus, pressure to produce short term results is built into the system and produces an environment that can be openly hostile and intolerant of even the slightest disappointment.

Such circumstances create perverse incentives and there should be no surprise that corporations and their managers have responded in turn. At a time when the management mantra, “increasing shareholder value,” has become de rigeur, executives are under intense pressure to issue quarter after quarter of positive news in order to maintain share prices and keep their large shareholders happy. Some initiatives, such as those which cut costs and increase efficiency, have included positive steps to improve the bottom line and benefit shareholders. Other activities have not been so beneficial to shareholders’ long-term interests. Ill-advised share repurchases at high prices are one example, especially when they are financed with debt. Last fall some of the airlines stumbled on this problem, only to be bailed out by the federal government. As we are now discovering, rigged accounting sometimes played a role in helping to boost reported earnings and share prices. Other borderline activities such as channel-stuffing—encouraging vendors to accept more of your products so you can report increased sales—has hurt the credibility of a number of companies and severely damaged Sunbeam Corporation.

Perhaps the most controversial tool employed to “align” managerial interests with those of shareholders has been stock options—a form of compensation granted to executives that permits them to purchase company shares at a fixed “strike price” for a period of time. Options can be extraordinarily valuable to the recipient if the share price gains during the holding period of the option—hence, they are the source of a whole new set of perverse incentives for managements to think short term. It seems to us that at least some of the accounting and other tricks that have been reported in the more notorious cases were designed to boost reported earnings and get the stock price up so executives could cash in their options. Whether they actually work to “improve shareholder value” is a subject of heated debate. Some view the grants as nothing more than corporate giveaways since, unlike shareholders, executives receiving options do not have to put up their own capital, nor do they lose money if the stock price declines. Proponents typically argue that options are a good way for start-up companies to attract talent. We suspect that if options do align mangers’ interests with those of shareholders, it is likely to be the interests of temporary holders—short-term stock traders—as opposed to those who view themselves as long-term business owners.

It will be interesting to see what the outcome of the intense scrutiny of corporate accounting and executive behavior is—this time. Boom periods always tend to be associated with lax standards, loose morals and a get-rich-fast mentality. Yes, the bilking of shareholders has a long and colorful history and such practices are unlikely to find an end with new reforms and regulations, as human greed and gullibility will never be legislated away. Diligence on the part of investors is the best protection in the long run. Yet, as long as a stock’s price keeps rising, even that line of defense can be compromised. As we saw in the Enron case, many very smart people were snookered into thinking they were dealing with a real, profitable business. As long as Enron’s stock price rose it was a “must own” security for those playing the institutional performance game (it was an important component of the indexes against which performance is compared). This points to the root problem: as long as these contradictory incentives are built into the system, all shareholders, directly or indirectly, must bear at least some responsibility for the bad corporate behavior that seems to occur with disappointing frequency.

 

Dennis Butler, MBA, CFA