Thursday, July 17, 2008

Idle Shareholders

"How can we have these levels of fiction in financials after Sarbanes-Oxley? How do people get away with this? How do they live with themselves?" - Jim Cramer getting emotional about the mortgage investment insurance industry 8/5/07

Readers note: I apologize in advance for the length of this one. A lot of background is necessary in order to fully deliver the punch line. Bear with me. It's important.

The mass-market emergence of Mutual Funds democratized equities. Suddenly everyone was in the market. This influx of funds automatically pushed up prices of just about every equity. Over time, the continued influx of dollars was largely counterbalanced by a tidal wave of new equity issuance which continues to this day.

The results? We have the biggest, deepest, most liquid equity markets on the planet. They're far more resilient than they were a few decades ago. A huge percentage of Americans experience the wealth creation of owning a little slice piece of American ingenuity, yet their downside risk is limited by the portfolio effects of the funds.

Super-duper, but not without negative side-effects.

Let's roll back the clock to the heady days of industrialization 100 years ago. Back then, and for the first half of the 20th century, it was quite common for a corporation's stock to be held by a few powerful shareholders. Nutty Howard Hughes held nearly all the stock of Hughes Aircraft, TWA, and other firms. John D.Rockefeller and his descendants owned the majority of Standard Oil. HJ Heinz owned and ran the eponymous company. These people's lives, reputations, and fortunes were inexorably inter-twined with the companies they owned. As such, if something started to smell funny at any of these concerns, the primary owner had a very clear interest in stepping in to set it straight.

Fast forward to today. In many industrializing nations, that ownership structure still predominates, but here in the US, financial engineering (especially funds) and competition-driven conglomeration have torn this cozy relationship apart. Who's GE's biggest shareholder? It changes frequently, but all the top 5 are funds, none of which owns more than 10% of the company. Same thing at Google, Heinz, and most others you can think of.

These funds are run by a fund manager who's sole goal is to maximize his own compensation. He (or she) typically gets his (or her) Scooby Snacks by maximizing the per-share market value of the fund, usually measured comparatively (when his fund's share price grows faster than some standard index like the S&P 500). If, on the other hand, the fund has a bad quarter or two, it's a piece of cake for investors to switch their money to another fund. If too many people leave the fund, it gets closed and the FM is likely out of a job for a long while. Who wants to hire a loser?

Each fund has rules, but generally, for the above reasons, the FM has a strong incentive to move in and out of stocks rapidly based on the latest news, forecasts and earnings reports, lest he end up holding the bag (of a stock in meltdown due to some headline). Buy-and-hold is a tough proposition. Patience is in very short supply. FMs just can't afford to stop watching every market twitch and rumor long enough to really partner with, police, or even deeply understand companies they own.

A whole sea of Wall Street analysts make a comfy living supposedly "getting inside the heads" of companies and then reporting out their insights and secrets. I say supposedly because they, like the FMs really only have one interest: near-term stock price movements ... and only one avenue of predicting them: Quarterly Earnings. Earnings. Earnings!

Here's a hint for them: earnings are not the end-all, be-all indicator of a company's health and prospects.

Of course, there are still some family-run businesses that aren't subject to this. There are some value-investors (Buffet comes to mind) who believe in extremely long investment horizons. There are activist investors and private equity houses which take an (often overbearingly) active role in management. There are so-called "responsible" funds. But beneath the clamor of these is a vast ocean of shareholder indifference.

Yesteryear's shareholders were often active members of the board of directors. These guys insisted on voting on any significant business decision. They were tightwads always; clubby when possible; ballsy when needed; patient in the face of adversity.

By contrast, today's impatient FMs don't even sit on the board, nor do the owners of the fund's shares. Instead, they vote with their feet (by selling) ... or not at all.

Granted, every one of today's S&P 500 companies is a lot more complex than the biggest company was 50 years ago. A member of the board of directors today would have to be extremely experienced in the industry, highly astute, and have no other preoccupations in his life in order to be as deeply informed and involved in the decision-making as people were "back in the day." This just doesn't happen. Board members suffer from info overload just as you and I do. Most have corporate ADHD as a result. Few, if any see fit to invest in a staff of analysts who could keep them informed enough to be deeply involved.

Even if an issue is put to a shareholder vote, the common shareholder (either direct or via mutual fund) has no idea what's going on and thus votes randomly ... or more often, doesn't vote at all, in effect deferring to the execs. Moreover, most modern CEOs insist on a privileged seat on the board, total control of the "messaging" to the board, as well as broad-ranging control over the business.

What's wrong with that, you may ask. Execs are all Harvard-educated, Mensa members who have no need to sleep ... right? Who better to make decisions for the company? Doesn't every army need a strong general? Well, a modern exec can anticipate spending less than 5 years at any single job or company. In that time, he has to milk out every cent of compensation he can, because there's a decent chance something ugly will happen to the company on his watch. The analysts will wail. The fund managers will flee. The share price will tank. The exec will lose his job. Once that happens, his future job prospects are shaky at best. Even if he retains his job, he'll be in for a tough road fighting for the uncertain future of a company that's on the ropes. Often his best financial and career move is to step off that painfully slow local train in favor of an approaching express. Moreover, these days you have to be a salesman of eternal optimism to qualify for the job. In that context, preventing said unlikely but nasty event seems to be unworthy of a CEO's time. (P.S. these dudes are lightening rods for corporate ADHD. I ran across a good podcast on the subject here).

Clearly, the interests of the execs are not perfectly aligned with those of the company. The interests of the shareholders are not perfectly aligned with those of the company. Even the employees are not in it for life. Something goes wrong? Everyone jumps ship.

Perfect capitalism theory might argue that this is better. Schumpeter's creative destruction ensures that capital naturally flees a sinking ship in search of maximum returns elsewhere, ensuring that dysfunctional enterprises wither away.

Then there's the reality: Since the execs play fox, hen, farmer, hunter, butcher, chef, and diner, there are no checks or balances. In short, they run amok with remarkable frequency. This isn't to suggest that all execs are fraudsters (well, some are) or even that they're grossly incompetent (well, some are) and only hold on to their job through political connections (well, some do). No, what it means is that they are just as human and infallible as the rest of us. They generally respond to the incentive structure they face ... and sometimes they just respond irrationally. Absent a strong incentive to care about the long-term success of the company, they don't bother to.

As a result you have a culture of negligence in nearly every public company in the country. Books get cooked. Decision-making gets farmed out to lawyers (often with no business acumen). Long-term problems go untended to and fester. Capital projects go underfunded or interminably postponed. Opportunities pass unexploited. Short-sighted incentives create unanticipatedly adverse results. People end up wasting a ton of time playing political games and mis-communicating. Good employees are not properly developed but rather are promoted to their level of incompetence and fall victim to the Peter principle.

You get the picture: companies never buckle down and deal with their tough, long-term issues. Everyone from employee to CEO to Board to investor to competitor to banker to media, even to politician sees the problems and the impending consequences, but nobody seems to have the power or muster (read: incentive) to avert disaster.

The endgame is that once-titans like MCI and Bear Stearns implode when we least expect it. The execs jump out the nearest window with their golden parachutes on. Employees get canned. Those absentee FMs and mutual fund investors (like you and me) unlucky to have been holding the stock when the music stopped ... they get burned.

Meanwhile, the mass-irritainment talking heads whip up public fervor; the politicians talk and try (but fail) to legislate the problem away (like SOX); the public gets a bad taste for corporate America; the whole economy is dragged down by a million tiny inefficiencies.

On the bright side, American corporations have ample opportunity to grow more productive and resilient by remedying these ills. Could someone figure out a better way to run these businesses, it could spark the next virtuous cycle of equity gains and investor confidence.

And there's the challenge. Any ideas? Stay tuned for mine!

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