FOOL ON THE HILL

Who Failed Investors?

Bill Mann thinks the origin of the pessimism currently facing investors has less to do with the drop in the market and more with investors' fear that no one's looking out for them anymore. The cult of "increasing shareholder value" from the 1980s and 1990s morphed into something much worse: "Lie, cheat, and steal, but keep that stock price high."

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By Bill Mann (TMF Otter)
October 18, 2002

No one can point to one specific cause of distrust by investors in the U.S. markets. Pundits say trillions of investment dollars are sitting on the sidelines, but there's a bigger problem. Some of that money isn't coming back. It's not on the sidelines; it's left the stadium.

Did the drop in stock prices, the collapse of the bubble, cause this problem? Preservation of capital has a lot to do with the exodus from the market. It became overvalued in 1999, and now the market and the economy are in the process of resetting. Both will be back, but we don't know when, and the interim continues to be painful. Pessimism rules the market, and not the good kind of pessimism. This is the "I-know-I'm-about-to-get-screwed" kind of pessimism.

From Rockefeller to P.T. Barnum
The root cause of the negativity -- this lack of trust -- is a degradation of professional standards among executives, accountants, investment bankers, brokers, analysts, even regulators. Once upon a time, the role of the corporate executive was to manage a company so it fulfilled the needs of every single constituent to the best of its ability: shareholders, employees, suppliers, customers. No, I'm not describing a halcyon time when all companies were virtuous; I know that's never happened. The necessity for powerful unions beginning in the mid 1800s indicates companies lacked concern for employees' best interests, even then.

The cult of "increasing shareholder value" destroyed this balance. Actually, at its core, I couldn't agree more with the premise of this cult. The reason people invest in companies is to generate a return on their risk capital; therefore, a company must do what it can to generate profits and cash flows. In the late 1980s, the cult of shareholder value took some pretty good knocks from the Ivory Towers, as we watched the American model of capitalism buckle under the weight of the Japanese model, a more traditional stakeholder model. Critics claimed that while American companies planned for performance on a quarterly basis, Japanese companies had a decidedly superior long-term planning model, as evinced by the fact that Japan was rapidly overtaking the U.S.

All great, except it was wrong. Japanese companies, as we now know, aren't even judged on long-term capital efficiency. As a result, they destroyed wealth for extended periods of time, while giving the appearance of dynamic growth. Companies must generate a return on that capital to give investors a return. The economic growth in the 1990s proved that America's shareholder-based model was still highly relevant.

More equal than others
At the same time, something happened in the mid '90s. Along with the explosion in stock options as a percentage of corporate executive compensation, the shareholder wealth cult lost its way. Stock price became the be-all and end-all, rather than a good approximation of a corporation's ability to generate wealth. For many companies, everything was tied to share price. Basic compensation for executives, rank-and-file investment-banking relationships, debt and equity financings -- all predicated on a company's ability to keep its stock price up, not its economic performance. As a result, companies did everything they could to ensure their results looked as strong as possible.

Accountants, once called upon to make a pessimistic case for all financial audits, were compromised with rich consulting contracts. Investment bankers, having firmly taken control of many of the big brokerage houses, used their retail-investor access as a marketing tool to generate more banking fees, which tended to have more zeros than the average retail investor's annual trading revenues. Enron's massive fraud happened not because it was a rogue company, but because executives only paid attention to raising the stock price -- the worst-case scenario of an environment that rewards appearances over truthfulness.

Somewhere along the line, the shareholder value lock on companies was broken, this time by a "what's in it for me" mercenary spirit. Executive pay was tied to pushing the "outrage barrier," not the amount of economic value created. Celebrity analysts pimped garbage stocks without considering the damage inflicted upon investors. They just wanted the huge paychecks derived from investment-banking deals they helped land.

Analysts, mutual funds, big pension funds, even regulators sat in silence while ethical lapses among our corporate leaders rotted away the very foundation of the American capitalist machine. And the Jack Grubmans, the Dennis Kozlowskis, the Bernie Ebbers, the Henry Blodgets, the Al Dunlaps -- they get to keep their money. So do the investment banks, accounting firms, and law firms that chose to specialize in investor deception.

Made wealthy by doing nothing
Think about it -- for the first time in history, a fair number of the mega-rich in America got that way by running companies that failed. As a result of all the IPOs in the late '90s (when investment banks foisted hype-jobs masquerading as companies onto a public worked into a lather over the promise of stock market riches), a group of "entrepreneurs" cashed out without creating a single red cent of economic value. Of course, gullible investors deserve a great deal of blame -- no one forced them to invest. But banks' willingness to push these companies, analysts' willingness to promote them, exchanges' willingness to list them, and accountants' willingness to give them clean audits and a complete lack of oversight from regulators have conspired to undermine our faith.

I received an interesting email from a reader in New Hampshire after my latest rant about an apparent Regulation Fair Disclosure violation by Schering-Plough (NYSE: SGP). The reader noted that these violations won't stop until corporations have a direct interest in stopping them. If shareholders abandon companies with ethical problems, only then would it be in the best interest of those companies to fix shareholder issues.

I agree. I also think the negativity surrounding the stock market and malfeasance happens at a time when the mechanisms -- albeit belatedly -- are working quite well. An accounting firm, based on its bad-faith auditing of Enron, has been shut down. Several former executives face jail time. Bankruptcies, a sign that the cost of poorly allocated capital is absolute, are up. This -- all of this -- is good.

Yet, I still don't get the feeling ethics will return any time soon. The rewards for gaming the investing system in the U.S. are still too tempting, and "situational ethics" are too high. As long as the "me first" attitude continues to rule the markets, our investments are at undue risk. We can't legislate ethics.

It's interesting that most articles about good corporate governance almost reflexively quote Berkshire Hathaway (NYSE: BRK.A) Chairman Warren Buffett, as if it were part of the template. Even people with whom Buffett shares no values, other than perhaps "air is good," liberally quote him as if he were some sort of talisman. Two things about him are noteworthy: 1) His inordinate success as an investor and business manager, and 2) His rock-solid moral and ethical grounding. But Warren Buffett is incredible for another reason: His moral grounding is exceptional in the realm of corporate America.

Where are the next Warren Buffetts, the people who don't take as much money as they can, just because they can? I know they exist, and when the market finally rewards the ability to create long-term wealth for investors over fooling the masses, I'll know the great experiment of American capitalism is healthy.

Fool on!
Bill Mann, TMFOtter on the Fool Message Boards

Bill Mann is the managing editor of The Motley Fool Select, where you can find his best Foolish stock ideas that you won't find anywhere else. Bill owns shares of Berkshire Hathaway. The Motley Fool has a disclosure policy.