FOOL ON THE HILL
An Investment Opinion
Does the SEC Read the Fool? Bill Mann (TMF Otter)
October 20, 1999
Ah, earnings season. Now is the time when the Fools become antisocial, burrowing away to focus on conference calls, poring over earnings announcements, running spreadsheets to unlock the truth on the performance of our holdings. For the long-term investor, these earnings releases are the true gauge of portfolio performance, and the best determinant to whether our expectations of performance by our companies is being borne out.
This is also the Season of Consternation. In the recent past you will find on the Fool website various discussions about "Window Dressing" by mutual fund managers, the conflicts of interest that influence sell-side analysts' opinions, options excesses, and non-public disclosure by public companies. Now a powerful voice has weighed in on the issue, stating that a lack of integrity and transparency in the American capital markets threatens our role as the world's financial leader.
In a speech Monday before the Economic Club in New York, the Chairman of the Securities and Exchange Commission (SEC), Arthur Levitt, had some choice words for a few of The Motley Fool's favorite Wise bugaboos -- earnings manipulation by companies, non-public disclosure, and the cozy relationship between companies and analysts. I doubt seriously that The Motley Fool brought these issues into Chairman Levitt's consciousness, but I must admit that he focused upon several of the themes we've been pounding on.
Chairman Levitt announced that the SEC is seeking to propose rules that will close the gap between what information is available to people "in the know" and the rest of the investing public. But he also condemned the ethical vacuum being created by the "web of dysfunctional relationships" between sell-side analysts and the companies they cover, calling on the companies to level the playing field, to open their quarterly conference calls, post them on the Internet, and to invite the press.
Geez, is it just me, or does Chairman Levitt sound just a bit like our own Matt Richey (TMF Verve) -- renowned for his taking several companies to task for their treatment of shareholders, most recently Coca Cola (NYSE: KO) -- in his frank assessment of the chicanery that is threatening our markets?
I don't want to understate this, for in my mind a widespread crisis of confidence is one of the most dangerous long-term threats to my investment money. And I don't believe this solely because as an individual investor I am generally outside of the circle of direct access to companies. Rather, the quality of information available to investors has a much greater implication, one upon which the efficacy of the American financial market is built.
Already we see some fallout. There has been a distressing trend recently for investors to absolutely punish companies that miss estimates by as little as one penny. Even worse is when a company meets, but does not blow away, the earnings estimates, and as a result its share price is taken out back and shot. There is a certain short-term view about this type of activity that concerns me, because even the best run company is going to have some bad quarters.
But think about what is happening here. In some cases, like Intel (Nasdaq: INTC) last week or Pfizer (NYSE: PFE) back in March, billions of dollars of market cap is being erased as a result of a single quarterly report. In no way do I believe that Intel or Pfizer did anything wrong. In fact, these two companies stand out as ones that should be commended for their openness and the clarity of their financials. Rather it seems clear to me that investors are becoming so accustomed to treating analyst's estimates as nothing more than marketing material that they are beginning to see incompetence in a company that cannot, somehow, figure out how to correctly guide sell-siders to the "correct" number.
The reason I believe that we, the investment community, must demand full and open access to information is partially one of fairness, but it also has much to do with self-preservation. The United States has in recent decades been considered the safest equity market on the planet. This has much to do with our relatively successful free-market economy and the companies spawned from it. But it also has much to do with the sacrosanct nature of our security laws, the free flow of capital, and the quality of information that American corporations have to provide the public. Obviously, there are a multitude of other reasons, but I propose that these factors make the United States a much more attractive destination for investor dollars than any other market. The Federal Accounting Standards Board (FASB), for all of its flaws, has done a pretty good job in forcing companies to disclose their warts.
If the U.S. no longer represents the most open, equal market on the planet, I and other investors will have no choice, over the long run, to seek out those markets providing us more protection. And the resultant loss of liquidity caused by such capital flight would be palpable, and the damage to share prices significant. If analysts' reports and companies' earnings statements are to remain plausible, both sides are going to have to work to make their relationships with one another more open and healthy.
Chairman Levitt is exactly right that there is not much that additional laws or regulations can do if the environment surrounding corporate disclosures does not improve. He points out, for example, that a "sell" rating from an analyst is "as common as a Barbra Streisand concert." Why? Because analysts have too deep of a conflict of interest within their own companies. As one Wall Street firm expressed in a memo, "We do not make negative or controversial comments about our clients as a matter of business practice� the philosophy and practical result needs to be 'no negative comments about our clients.'"
To translate, the analysts' firms are often too concerned about the gravy train of investment banking or advisory fees to be too critical of a company. Moreover, in no way is it common practice for the firms to disclose their relationship with the company being rated. Would you look at Goldman Sachs' (NYSE: GS) "buy" rating on a company just a bit differently if you knew that Goldman had an enormous stake in the company since it had underwritten the IPO? Unfortunately this type of information is not readily available, and so people see an analyst's "Top 5" list, or her "strong buy" ratings without knowing that underlying factors may determine that this rating furthers the interests of the analyst and her company instead of investors acting upon it. Unless a statement of disclosure is included, a Foolish investor should always look at analyst reports with a healthy dose of skepticism. The analysts are drowning in conflict -- it is our duty not to reward them for it.
To close, I'd like to commend and support Chairman Levitt for the sentiment of his speech. This is an issue that is much less sexy than the "threat" of day-traders (all 5,000 of them), but far more important and wide-reaching. The basic environment in which investors can be confident in the information given to them by the companies to which they have entrusted their money is one that merits protection; it should have the tacit and active support of all Fools.
Oh, and just in case Chairman Levitt does come visit us, let me be the first to say "Fool on!"
Text of Arthur Levitt's speech, October 20, 1999