There is certainly a lot of talk about financial ‘reform’, but here are some points which I think are important for investors to keep in mind (in reverse chronological order):
I wrote the preceding paragraph early Wednesday morning, but after reading that Pitt wants a promotion and a raise, I finally decided that the guy really does have to go. That was definitely way too far over the top. It proves that the guy has incredibly poor political judgment even if he is a very capable lawyer and bureaucrat.
[UPDATED 7/23/02] 3Com (COMS) has taken a step forward towards voluntary reform and says it will no longer report pro-forma profits. Personally I have never thought the pro-forma issue was a big deal since all the GAAP numbers are still there if you need them, but this does illustrate how the market is more than capable of correcting itself without the need for government intervention. The problem with banning pro-forma earnings is that investors really do need to know what income from operations was versus balance sheet adjustments. Both forms of earnings are needed. In fact, since the charges vary wildly from quarter to quarter, strict GAAP earnings are difficult to track and forecast and make things like “consensus earnings” very difficult for FirstCall, Multex, and Zacks to tally. Trying to anticipate charges months (let alone a year) in advance is quite an infeasible task.
· [UPDATED 7/22/02] Insider trading is clearly illegal and should clearly be punished, but it is clearly much less harmful to investors than the really important stuff like fraud and lack of transparency. The SEC should investigate and prosecute insider trading and the penalty should be at least disgorgement of all profits plus a fairly heft penalty (at least 25% plus interest). ‘Profits’ needs to be calculated using the cost basis and the lowest stock price within 30 days after the ‘inside’ information became public. There could be cases where the stock didn’t fall significantly at all and the executive merely sold out of fear, but that should be punished as well. Some insider information is good news, so gains due to buying should also be punished similarly. That said, insider trading is a relatively minor corporate ‘speeding violation’, a misdemeanor. Make Martha Stewart pay up and then move on. Her case is just a side show and detracts from the truly important stuff that really affects us shareholders. And if President Bush’s stock sale back in 1990 can be proven and the SEC investigation can be restarted, make him pay up as well, but then let’s move on and leave these truly minor sideshows behind us.
· [UPDATED 7/22/02] We need some kind of Federal Retirement Insurance Fund which would give employees and retirees at least a partial payment if their company-managed retirement plan gets wiped out due to the company going bankrupt or ‘reorganizing’. This would help in situations such as Enron, WorldCom, Polaroid, and some of the steel companies which effectively abandoned their retirement plans with no recourse for the employees and retirees. Every company offering a company-sponsored retirement plan would pay an insurance premium to fund the insurance fund. This would be a federally-backed enterprise so that payment of the insurance claims would be guaranteed by the federal government if there were insufficient funds in the insurance fund. It would be a political decision whether to guarantee 50%, 75%, 90%, or even 100% of the retirement plan assets that were held in company stock. It would not cover any losses in non-company stock except where there was clear corporate malfeasance in managing the retirement plan. A committee at the insurance fund would be responsible for determining the stock price to be used to determine payment, preferably based on the last stock price before it began to underperform the S&P 500 by at least 5%. The insurance premium that the company would have to pay would be set by the insurance fund based on how far the company stock had underperformed the S&P 500 over the past 5 years. And the insurance fund would have some kind of compulsion power when the underperformance exceeds some threshold, but I’m not sure what that might be other than forcing the company to replace a fraction of the company stock with cash.
· [UPDATED 7/20/02] Pay a lot more attention to who is on the board of directors for a company. Above all others, these are the people who are in the best position to supervise the activities of corporate executives. And by all means they should be held accountable for corporate malfeasance that occurs under their ‘direction’ (they are supposed to be ‘directors’). They are the ones who are responsible for seeing that the key members of the management team have the training, experience and character to pursue shareholder interests. Responsibility starts with the board and stays with the board.
· [UPDATED 7/20/02] All of the obsessing over expensing of stock options has unfortunately taken attention away from the key issue of excess executive compensation. The bulk of options are granted to non-executive employees, so trying to squeeze opportunistic executives by trying to make options less attractive would hurt non-executives more than executives and has taken attention away from excess base compensation and executive perks. Options and stock were just mostly “play money” anyway, but paying executives anything over $150,000 and granting significant perks is cash out of the investors hide. The point of the company board offering excessive compensation packages was the belief that this was needed to attract (or retain) “star” talent who could bring a little “rocket science” to the company. We now know that much of that star (even super-star) talent and rocket science was more harmful than helpful. The board of directors should take three steps: 1) “hire from within” and promote promising managers who are more interested in building the business “organically” than through the deployment of “rocket science”, 2) the board members themselves must take a far more active role in making sure that they are setting the tone and the stage on which the CEO ‘performs’, and 3) selectively (and sparsely) use outside consultants when specific expertise is needed rather than hiring wolves to lead the flock. Consultants (especially retired executives) should be used to teach and impart wisdom and then told to move on.
· [UPDATED 7/17/02] “Just Say No” to the whole concept of a company meeting or beating or missing “the consensus” earnings forecast by 1 or 2 or 3 or even 4 pennies. A nickel should be close enough. Such fine distinctions are not only useless, but also encourage companies to try to meet those kinds of silly narrow expectations. The criterion that investors should use is “in the ballpark” or “close”. Give management a little leeway and let them focus on doing what’s right for the long term rather than rewarding or penalizing them for ridiculously absurd overly-focused short-term performance. The whole point of investing in companies is to invest in the future and saving a few pennies in the short run at the expense of the long run is clearly a bad choice.
· [UPDATED 7/17/02] Retirement plans must be removed from the control and accounting of companies. There have been numerous abuses by companies and there are current concerns about whether plans are fully funded. What is really needed is some form of privatized retirement plan that melds the piecemeal approach we have now. In any case, companies should not be able to use ‘excesses’ in retirement plans as if they were cash and employees should not be at the mercy of management. There should be strict diversification requirements. There should be some sort of federal retirement plan insurance so that bankruptcy and corporate malfeasance cannot instantly wipe out a worker’s lifetime contributions.
· [UPDATED 7/15/02] Expensing of stock options is a relatively minor peccadillo and should not be considered such a big deal. This is true even if you are comparing two companies and one does it and the other doesn’t. Worst case, it may knock a few pennies off reported earnings. What accounting can’t do is tell you the effect of options on the future prospects of the company and that’s what option grants are all about. Back during the “Internet boom”, nit-picking bears whined that options were merely a way to pay people lower salaries. That has never been what options are all about. Options are intended to incent people to put more effort into their work by giving people a larger stake in the outcome. Granted, at the executive level it may have inspired some accounting manipulation, but expensing options certainly doesn’t get rid of that problem. For technology companies, it is the options granted to mid-level managers, technical contributors, and even lower level employees that really matter and are important to build a team spirit focused on enhancing the longer-term prospects for the company. Some people talk about options as being “given” to people, but that’s nonsense since they are usually based on the value of each individual’s contribution to the enterprise. Also, options tend to vest over a number of years, so it’s difficult to calculate the “expense” for a given quarter. And finally, if they are to be considered an expense, then they should be accounted for based on the actual expense for a given quarter, which may be very small. Back to the real world, if revised accounting rules result in a dramatic hit to reported earnings far beyond the true economic impact on the company, then investors, analysts, and traders will then simply adjust the premium or discount on the stock price to reflect the fact that reported earnings don’t reflect the true value of the company. If there is no dramatic hit to reported earnings (or anything else for that matter), then why is expensing options considered to be such a bloody important reform? My view is that this was just yet another nit to be picked by bears who were over-zealously trying to paint a portrait of doom and gloom so that they could line their own pockets.
· [UPDATED 7/15/02] Should SEC Chairman Harvey Pitt resign (or be replaced)? There are people calling for his resignation, but I see this as a red herring. Everybody wants more reform and they want it sooner. Pitt certainly has dragged his feet somewhat, but not so much as to render his leadership ineffectual. Personally, I think he should go since he just doesn’t have the kind of leadership skills people want to see, but I don’t have any problem with him staying on. I call the question a red herring because the real issue is what the SEC should be legally chartered to do, not who is at the top. I’ve read a lot of stock market history and although the SEC is nominally supposed to protect investors, its practical role is to loosely ride herd over Wall Street and let market participants run as they wish as long as things don’t get too far out of hand and as long as people “follow the rules”. In some sense, the hidden goal had been to protect Wall Street from its own worst excesses rather than to protect investors. Of course, there are many problems with that model and we’re seeing the results. It was interesting that the first SEC Chairman was Joseph Kennedy, Sr., who was one of the primary stock market culprits in the 1920’s. The history of the SEC is replete with examples of how Wall Street has always had the final say on what the rules would be. Washington was not able to force the SEC on Wall Street, but rather the SEC had to patiently cajole and wait for Wall Street (the New York Stock Exchange) to agree to be regulated by the SEC. What we really need is a blue-ribbon commission to study this whole mess and to propose a comprehensive, carefully crafted set of principles for reform. Once you do that, it matters very little exactly who is at the top. That simply won’t happen with Congress, the SEC, companies, accountants, the brokerage firms, state attorneys general, consumer advocates, and boatloads of lawyers clamoring for all manner of reform. That said, ultimately the single most important piece of ‘regulation’ for the stock market is good old-fashioned “light of day”. We’re already seeing a lot of voluntary reform. Let the process work as it is for a while longer and then institutionalize the best practices.
· [UPDATED 7/15/02] Good old-fashioned “light of day” is the best regulator. And that starts with even more disclosure of a company’s accounting practices. It would be better for government to avoid ultra-detailed micro-management of accounting practices and simply require companies to disclose anything that could possibly have a material impact on how a company would be valued. There are plenty of independent security analysts who have always been more than happy to pore through the company SEC filings with a fine tooth comb looking for anything that could possibly have even the slightest negative connotation.
· [UPDATED 7/13/02] There will be quite a number of changes in the sales practices of companies as we now have a new collective view on what is acceptable as well as what must be disclosed. These may result in modest or even moderate revenue declines, but could also result in higher profit margins as well. Revenue will become a lot cleaner and clearer. Quite a bit of ‘rocket science’ accumulated over the past decade concerning things like ‘revenue recognition’ and earnings management. Much of that has already been stripped away as a result of recent revelations. There will continue to be a fair amount of rocket science, but not enough to cause major problems with investor confidence beyond the near term.
· [UPDATED 7/12/02] Management must be responsible for providing investors with guidance on revenue, earnings, profit margins, change in the balance sheet, R&D funding, and long-term (5 year) growth rate. Each number should be a range with the outer 40% of the range being the goal (with only a 50% chance of success) and the inner 60% being the commitment (with a 90% chance of meeting or exceeding). There is no need to hold management legally liable for failure to achieve guidance, as long as management always notifies investors of any changes in guidance ASAP. Also, management should disclose the seasonality of the company business (nominal sequential quarterly growth for each quarter in a typical year) and how each month is ‘loaded’ (% of quarterly sales expected in each month.)
· Additional government regulation is the least desirable approach.
· New laws from Congress are not needed, but will probably not do any significant harm.
· Transparency of corporate finance is the key ingredient. That seems to be improving already, on a voluntary basis.
· Although complete separation of investment banking and analyst ‘research’ is preferable, it is unlikely and the net result is that the only solution is for all investors to simply ignore all research from all but 100%-independent research firms. Do not ask your broker for research reports on individual stocks and give him (or her) an ear-full if then try to get you to look at them. The bottom line is that you (that’s right, you the reader) must absolutely abstain from buying or selling stock based on any non-independent research reports.
· The market is already well along in the process of ‘self-correcting’ from past indiscretions. Sure, we’re bound to run across a few more very bad apples and lots of ‘misdemeanor’ accounting indiscretions, but I think everybody has now gotten the message that the market now has a zero-tolerance policy towards anything other than squeaky-clean accounting. Sure, we’ll still have EBITDA and pro-forma reporting and a fair amount of lingering debt overload, but management now has their marching orders to disclose just about everything imaginable. All the new laws and regulations will have little additional benefit beyond the market-driven reforms that are already being put in place. It may take another couple quarters for companies to get comfortable with the new accounting regime, but we are well along towards a heightened level of financial transparency.
· Be careful not to fall for the cries of panic (“The sky is falling”) emanating from parties whose goal is to try to force the market down to profit from short-selling. There is no double dip coming. There is no depression coming. There is no deflation coming. The dollar is not going to crash. Not all company managers are crooks.
Updated: February 05, 2006 08:00:11 PM -0500
Copyright © 2002 John W. Krupansky d/b/a Base Technology