Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

April 2009

The great financial market collapse of 2008-2009 has erased over eleven trillion dollars of wealth from the financial statements of millions of shareholders and challenged precepts that have underpinned America’s form of capitalism for decades. At their lowest point in early March, the stock market averages were down 25% in 2009 alone, bringing the declines since the peak in October 2007 to over 50%, the sharpest drop since 1929-1932. A year for the record books after only three months, 2009 has included the worst January on record and the biggest decline for a February since 1933. A quarter-end runup in stock prices leading to the best four-week string of gains for the Dow Jones Industrial Average since 1933 served to raise spirits a bit, but the year’s first period remained the worst for stocks since 1939, and it continued a string of losing quarters now numbering six. What will the remainder of the year bring? Anything is possible and stock markets have a way of confounding the expectations of even the most experienced observers. As valuations remain well within the range of experience for the last thirty years, further declines would not be surprising or extraordinary. But those trillions in losses are balanced by trillions of dollars in cash sitting in money market funds. Any hint that the current financial distress is easing could prompt the owners of those dollars to shift a large portion of them into stocks, creating the potential for huge market rallies. This may even turn out to be a year of record percentage gains. While the very idea of big stock gains may seem outlandish at present, recall that two years ago few could have imagined a market and economic collapse of the extent we are now experiencing.

While investors and speculators ponder their moves in response to risks and opportunities in securities, policy-makers around the globe must wrestle with the immediate real-world challenges of the economic crisis, as well as create structures to limit the destructive force of future upheavals, if not prevent them. In devising such policies, we believe it is important not to lose sight of underlying causes, which included a vast misallocation of capital, especially to the housing market. Tax incentives and low interest rates gave initial impetus to an over-investment craze, but then the markets themselves took over. According to “finance theory” the financial markets are supposed to allocate capital to its most efficient use, but in reality, things operate differently. We forget that “free markets” are assemblages of human beings who are subject to the emotions and unrealistic expectations to which participants sometimes fall victim.

What happened in real estate is exactly that. Property had enjoyed such a long string of nominal (not adjusted for inflation) increases in value that by about 2005 many people had come to believe they would never lose money in property ownership. (A few with long memories or who had read old books knew that at one time real estate was considered a wasting asset, but most lacked that perspective). The returns on investment produced by real estate were also believed to be less variable than those of other investment assets and according to the modern, statistically-oriented investment profession, that meant real estate was less risky. Abundant cheap credit and these widely-held views about the benefits of property investment led to a torrent of capital poured into a witches’ brew of speculation. Unfortunately, one statistic was either overlooked or intentionally ignored: prices had risen so far and fast that valuations by almost any measure were off the historical charts. New financial gadgets (such as new types of mortgages targeting people who could not afford traditional loans) funneled even more capital into the sector at prices that simply were not sustainable. Hence the collapse.

The rescue and regulatory plans being contemplated and enacted are attempting to deal with an unprecedented and dangerous situation. Gone at least for now is the notion that markets can take care of themselves and that self-interest will rein-in business risk-taking. While we generally agree with the measures under way to alleviate the impact of the economic downturn (doing less would risk a far worse calamity), we find some elements of the response to the crisis, including the bailouts of various financial institutions, to be highly distasteful, primarily because the major decision-makers who led these institutions into their present difficulty are getting away without real damage to their own wealth. For capitalism to function properly it must be possible to lose as well as gain; positive incentives have to be balanced by negative consequences. Management compensation schemes should be structured to create incentives similar to those which partners have in a partnership type of business organization: their wealth must be accumulated over time, it needs to remain in the business, and it must be at risk. Only then will managements’ interests be truly in line with those of shareholders.

So Much For Shareholder Value

The term “shareholder value” has come to have special significance in business and investment circles. For the last quarter-century American corporate executives have pointed to “increasing shareholder value” as their ultimate duty to the business owners, which also happens to be what the investment community wants to hear. Unlike most workers, however, executives require special “incentives” to carry out their duties (beyond just a good job for good pay), hence the proliferation of stock option awards, equity grants and so on, all promising to “align” management and shareholder interests. In reality these devices offered not much more than big payoffs to executives for meeting short-term goals without regard to longer-term consequences. Rather than question such practices, professional investors were motivated by their own incentives in the form of quarterly performance reviews, and there developed a cozy relationship between the two groups which encouraged the adoption of certain mutually satisfactory corporate financial operations.

Share buybacks at high prices was one such operation. Usually rationalized as “returning money to shareholders,” it had the added benefit of boosting a company’s shares, permitting managers to cash in options, and providing a performance fillip for investment funds. A second was “balance sheet efficiency.” Corporations with conservative balance sheets and little debt were considered “inefficient” because they were not utilizing their full capacity to borrow. All things being equal, more debt tends to increase return on shareholders’ equity, so borrowing improved profitability which raised earnings and ultimately stock prices, which in turn had a positive impact on stock options and investment performance. Egged on by institutional investors, companies often used buybacks and balance sheet leverage (debt) together in a potentially lethal combination which saw companies borrow money to buy in their own stock, more often than not at times when share prices were at or near highs.

There are many ways to manipulate earnings and attempt to influence the market for one’s shares, but the use of shareholder capital to repurchase shares at high prices stands out as being a particularly questionable practice. Now that stocks have cratered and it is difficult to borrow funds even for legitimate business investment purposes, it is fair to question the wisdom of policies which increased corporate financial burdens in favor of certain short-term benefits, especially in industries that are highly sensitive to the economy’s ups and downs (the airlines come immediately to mind). The long-term consequences have in some cases been catastrophic. It is not uncommon to find companies in financial distress due to debt taken on during good times, often to buy in shares when prices were high. Those companies are now having trouble repaying or refinancing that debt and many have resorted to dilutive common stock offerings at much lower prices to raise capital for operations. In the name of shareholder value, managers pursued policies which in the long run were actually destructive of value to shareholders and all other corporate constituents. The corrupting influence of these activities has become so widespread that even business leaders who are most closely identified with promoting the cult of shareholder value are now questioning the narrow focus on share price.

Adam Smith, the founder of modern economics and the idol of free-market capitalists, maintained that prudence was “of all virtues that which is most helpful to the individual.” Adam Smith never saw stock options and bonuses. While certainly helpful to some individuals, these compensation practices have incentivized shockingly imprudent behavior that has been devastating for many more. The sharp downturn in stock prices and economic performance is forcing almost everyone to be more cautious in their financial affairs. Negative investment results (stock returns are now negative going back ten years) require people to increase savings. Lack of credit and job insecurity means an increased focus on necessities and less on luxuries. Poor performance (and a great deal of negative publicity) is forcing corporations to rethink compensation policies and business strategies. Let’s hope these welcome changes are not superficial and result in greater attention to genuine, long-term shareholder value.

 

Dennis Butler, MBA, CFA