Fool on the Hill
Serious Thoughts About Bill's Media Article

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By miscfool
July 11, 2001

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Bill (TMFOtter),

Well done! I can just imagine your mindset when you wrote your Media Disparages the Individual Investor article! The funny part is that while you normally are quite direct, I believe you pulled your punches and avoided "calling us to arms" to protect ourselves as individual investors. Let me explain.

But before I begin, a small dig at CodeFool. CodeFool decided to take you and the Fool to task for having some sort of vendetta against Cramer because Cramer has accused the Fool (i.e., Dave and Tom) of being lousy stock pickers. Not that it is needed, but please allow me to come to your and its defense in this point.

CodeFool asks: What exactly does Cramer have to do with Individual Investor? Cramer runs the and

Efficient. You asked the question, then answered it! Cramer's world obviously touches the individual investor. Bill's comments refer to Cramer's Reg FD discussion with First Call's Joe Cooper, not Cramer's comments about analysts. Bill also writes about an article published on (hello Cramer!) by a fund manager who claimed that Reg FD was increasing volatility and implying that this was hurting individual investors. CodeFool, the issue is not Cramer per se, but of laying the blame for something (volatility) at the feet of Reg FD and then claiming that volatility, hence Reg FD, was a bad thing.

Bill's observation is: The insinuation here is that individual investors are ill-served when the market has to take the shocks of information coming out all at once rather than being filtered.

And THAT is the central observation! Not whether or not Dave and Tom have the right idea with the Foolish Four or the Rule Makers and Breakers. Not whether buy and hold is a religion, with reformers now preaching buy to hold. Simply, that our getting the information at the same time as the Wise is a good thing.

And it is a good thing. Bill correctly observes that preferential disclosure let institutional investors dump stocks early in the face of bad news and so generate greater returns than could individual investors who faced depressed prices when they finally learned the bad news; similarly, institutions bought into good news early and gathered better returns than the individual investors who could only buy in at inflated prices by the time they learn of the positive news. Small wonder that, given this pre-Reg FD situation, the odds of better returns were stacked in favor of the investment industry when compared to the "hapless" individual investor!

BTW CodeFool, Cramer's impressive 25% yearly returns were mostly accumulated during this preferential treatment time; let us see how his next ten years will pan out now that Reg FD says that he has to legally learn information at the same time as the rest of us. If he keeps a 25% return rate, then maybe you should outline his strategies for us here on the Fool ;->

Back to volatility. Bill says so eloquently later on: Who gives a rip if the declines happen quickly or like Chinese water torture? I'd rather know why, wouldn't you? Prior to Reg FD, oftentimes we didn't know until way after the fact. By then the damage was done.

Again, volatility is not a bad thing if it helps everyone have a level playing field in which to generate returns! Stocks that become oversold are a buying opportunity, and stocks that inflate too much are a short-seller's dream. If anything, the volatility opens up more chances to make money for those who really understand their companies/industries -- just ask Warren B. But if you want to invest, you had best know the rules.

And this is where the Fool comes in! For me, the Fool's value is not in the mechanical investment strategies. It is in the constant reminder that *I* can manage my money well if I take the time to learn as much as possible about the companies I invest in. And gives me an unparalleled forum in which to meet like minded people for a good price ;-), to hear about the high cost of mutual funds that often yield sub-par returns, to hear debated different valuation strategies, and to understand in the bull-bear debates that no one really knows the future but we all do the best we can after studying out the facts. In this alone, Dave and Tom have done more to advance financial literacy on this continent than most of the "wise" pontificators. The Fool may not be perfect (and has admitted as much recently), but the Fool's framework of fun and education has provided me with a great launching pad for all my future investment decisions.

Bill, you were right when you claimed that there is much greater evidence that failure of analysts to disclose their conflicts of interest on companies they cover is a much greater threat to investor dollars than any volatility caused by Reg FD.

As you said, Reg FD finally forced publicly traded corporations to treat all investors as company owners with the inherent right to receive relevant company information at the same time. Score one for the individual investor. And the threat you identify would be addressed by fact that the NASD proposed a rule requiring analysts to do clearly state when their companies own more than 5% of a security being discussed, as well as whether they have received compensation from the security issuer for investment banking services over the previous 12 months. If adopted, it would be another great step forward. Sadly, that it is taking official rules and regulations to get people to act ethically is a damning statement of the institutional investment and banking industries as a whole.

No, Bill, I do not think it silly that the analysts need to be told by the NASD how to act. I think it is sad. Worse, I think there is another problem for investors that you did not mention that is easily as serious as the analysts hiding their potential conflicts of interest, and that is the pernicious and excessive use of stock options. This is the explosive Yang to the analysts' conflict of interest's poisonous Yin.

We have not yet had to fully pay for the use of stock options. Stock options are going to end up hurting all investors by hiding compensation expenses, by huge opportunity costs as shares are sold to insiders for less than the market will pay, by inviting companies to use debt to buy back shares, by artificially lowering P/E ratios, etc. The reasons have been detailed in previous articles here at the Fool, by Warren B., by Forbes and The Economist, etc. When these options are finally accounted for, it will be the largest transfer of wealth from shareholders (us) to corporate officers and employees ever. Can you say ouch?

I am afraid we are too caught up in the glare of the stock market's opportunity to see the serious corrosion in the plumbing that may threaten to blow the whole thing apart or at least to seriously injure quite a number of us if it somehow lets go in a spectacular fashion. We somehow marvel at the financial markets -- we see them as the pinnacle of the free-enterprise system, as the engine that drives the economy. And in many ways, they are. But we fail to see that it has often taken disaster to bring about any push for better regulation of this essential tool of the free market.

It took the crash of 1929 to bring about the creation of the SEC a few years later. In the early 90's, the Financial Accountings Standards Board (FASB) tried to get companies to account for options, but ran into fierce opposition from Silicon Valley companies; it was a way for them to finance their growth cheaply and "invisibly." IT firms may have taken the most advantage of options -- in just one case, Microsoft showed a profit of $4.5 billion in 1998, and had options been properly accounted for, it would have shown a loss of $17.8 billion! (Smithers & Co. calculation, as quoted in The Economist 2001-01-27, p.16) Anyone else starting to get worried out there?

And it is not just hi-tech firms that are using options, at least for senior directors. William Mercer found that 93% of 350 companies rewarded senior directors with stock options, as opposed with only 62% in 1992 (The Economist, ibid). [As an aside, does anyone else find it perverse we must bribe corporate executives with options to ensure that their interests are aligned with those of the very same company that is paying their base salary in the first place?]

Are we going to need a major crash for us to learn that stock option funny accounting is seriously eroding shareholder value? I hope not, but I am not confident that we are immune from this scenario. Right now, boards everywhere are scrambling to re-price options that have gone underwater. Why? Everyone expects the economy to pick up over the next year or two, and options last up to five or ten years. If your firm has re-priced options and then the market picks up again, when these options are exercised, external shareholders are going to see their positions diluted and the company will lose out on the money they could have collected had they issued the shares to market at full price, having transferred it, minus the option price, to employees/directors. Non-optioned shareholders will be left holding a diluted position of a poorer company, as the company will receive less money for its optioned shares than it would have had they been sold on the open market.

Reg FD was a nice departure from this "disaster first, reform later" mold, but it took the guts and plenty of energy from the SEC Chair to bring it to pass in the face of bitter opposition. And the end of the pooling of interests method of accounting is also to be cheered. But we individual investors have much to do if we are to ensure that the playing field is improved further. And we cannot count on any other shareholder groups to help -- for example, mutual funds have refrained from using their massive shareholder clout to help curb the obscenely high compensation being paid out to many CEOs right now, even though it would be in their interest to do so.

Analysts will fight the disclosure rules; corporations and their option holders will fight the much-needed changes to properly account for the true costs of their precious options. They have seen that positive change can happen (positive for us that is, negative for them), so they will push hard against any changes that negatively affect them. They may even propose "self-policing, voluntary" standards and other non-solutions. Do not be dissuaded. Be vigilant, push hard for your voice to be heard, and perhaps we will sing the victory song of a solvent retirement together one day.

Aux armes, Fools!


PS: Thanks for the original article Bill. It is *always* a pleasure to read your contributions. Anyone want to start a "Bill in 2004" campaign? ;->