Corporate America

So Mr. Skilling got sentenced this week. Strange that this should happen the week that the Dow hits a record high. That remanded me of this piece which I wrote 4.5 years ago about Enron and Wall Street.

Enron and Beyond - What Went Wrong?

Something went wrong with Enron. An underlying question should be: was this an isolated case or an indication that something is wrong with our economic system?

One reality is that we live in a very capitalistic system. Our economic resources and means of production are entrusted to corporations. For the most part, this has worked well. The most basic answer as to what went wrong at Enron is that the folks who ran the company forgot whom they were working for. The shareholders own corporations and management should be working to allocated the resources of the company to maximize something. That something - dividends perhaps - should benefit shareholders. The problem, I think, is that corporate management has lost sight of what it was supposed to be maximizing.

I see four problems:

1) not enough attention is paid to the bottom line. The definition of "the bottom line" used to be clear - the bottom line was dividends. Everything else was just a light.

2) an unhealthy alliance has come into existence between Wall Street and corporate America.

3) shareholding is highly diluted. This may be the result of conglomeration, mutual funds or some more general notion of sharing the risk. The result is that few companies have individual stockholders with "clout".

4) corporate officers compensation is too often tied to having a great year.

1) The Bottom Line

When I was a kid (no, this was not before The Great Depression, people used to talk about dividends. The values of stocks were measured by the quaint notion that they were somehow related to the dividends check that you got each quarter. Folks help equities in order to get their share of the (post-tax) profits.

Several things started to undermine dividends as the method of ultimate evaluation. As Greenspan pointed out part of the problem was that share repurchases became more popular in the 1980's. Presumably, this was preferred because it lowered shareholders tax liability. An unintended consequence was that dividends, now obscured, fell from a typical 6% to something more like 1%.

With dividend disappearing it became natural for Wall Street to concentrate on earnings as "the" preferred method of evaluation. The rub is that while dividends have an exact value "earnings" are subject to interpretation.

In a simple world pretax profit would equal cash receipts less out of pocket cash costs. In the complex, real world of corporate American a significant part of pretax profit results from the change in the value of balance sheet items. Balance sheet items should reflect the future flow of income but there are two problems here: 1) for even a noble soul, future income can be difficult to forecast and 2) for the scoundrel the obfuscation of future income affords limitless opportunity to juice the balance sheet.

Measuring the present value of an asset based on its future income can be a problem. Related to the mortgage business is the valuation of mortgage-backed securities. Their value must be based on the anticipation of future income and that income can get truncated when rates fall and refinancing occurs. Thus, the problem with evaluation the present value of assets is that it is based on an ability to predict the future.

In Enron's case it was not merely a case of mis-evaluating future cash flow. They hid losses and debt in "partnerships". The movie "Enron: the Smartest Guys in the Room" points to the problem Enron had as "marking to market" its assets. The producers/writers missed the point. "Marking to market" is a perfectly legitimate accounting method. It means evaluating your assets at their present market value, not what you paid for them. Enron was nor marking to market. It was marking to some contrived dream view of value. It was doing this for the exclusive purpose of deluding Wall Street about its balance sheet.

2) Wall Street

Wall Street has had an unnaturally high upward bias on estimating earnings. Note the following fact: if one looked at the three- to five- year earnings forecasts growth of all of the S&P 500 companies as compiled from the projections of securities analysts from 1985 to 2001 (Thompson Financial's I/B/E/S estimates) they averaged 12% a year. Actual growth was more like 7%. If these guys were Las Vegas odds-makers their employers would be out of business.

One may infer that firms that sell securities have a bias toward analysts with "rose-colored glasses". In fact, it is not merely Wall Street but also the media that has an upward bias. When you listen to TV or the radio upward movement in equities prices is good news. Downward movement is bad news. To be sure, there is positive socioeconomic value in increased equity values but analysts should be objective. Period.

It may be too idealistic but it would also make economic sense if investors starting putting a premium on the accuracy of analysts' forecasts.

3) Shareholder Dilution

Recently (remember this is a piece form 4.6 years ago) there has been a lot of attention paid to the HP/Compaq merger. Take note of the clout that Walter Hewlett had. He owned enough stock that he could create a stir This is rare in corporate America today. As a practical matter, business are no longer controlled by the owners but by the CEO. The CEO chooses the Board of Directors who tend to support his business strategy and, generally, formulates accounting practices and chooses an outside audit firm that will go along with those practices.

This has served us well but there has been too little objective analysis by Wall Street of the practices of CEO's and their auditing firms. The same folks who are providing the analysis are in the business of selling the securities of the firms they are analyzing. In fact, what may exist is a vicious cycle. CEO, CFO and analysts sit down. CEO and CFO do their pitch. Analysts like it and sell it to the public. The CEO/CFO have to figure out how to deliver what was promised and come up with some "creative" accounting practice to make up the difference.

Part of shareholder dilution is related to the fact that there are more people in the market than ever before. Stocks used to be held as investments. Now they are traded furiously and speculatively. A consequence is volatility. There are more nuts in the market and their bad investment decisions cause volatility.

4) The Pack-it-into-one-big-year-effect

In its simplest form the notion here is that it is not beneficial to allow CEO/CFO's to benefit by getting large bonuses as a result of front-loading the future value of contracts with the purpose of creating one great-looking year and a large bonus.

The solutions are clear: we need objective audits and we need objective securities analysis by Wall Streeters who are not working for the same firms that are pitching the securities. This objective auditing and analysis must point out the cases where corporations may be fudging future cash flows for the benefit of a few officers.

The purpose of corporations must be reconfirmed. They exist to serve a public good by controlling the nation's assets and to produce a real profit (dividend) for the folks whom they really work for - the shareholders.

More recently we have had scandals regarding backdating of options. Corporate America must understand that they work for the shareholders. What must be reaffirmed is that the Board if Directors works for the shareholders and the CEO works for the Board of Directors. The shareholders must assure that the Board is looking out for them.

The HP story in a sense appears more comic than anything else. But I have an HP computer at home. I have not really seen anyone discuss this to any extent but it is most discomforting to know that the company which made my computer felt that planting software in peoples' computers to find out who is talking about the company does not exactly induce me to ever buy another HP computer. In my opinion, that was really dumb of them.

 

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Dick Lepre

Comments

[Michael]

Corporate America seems like such a poor choice to be stewards of our future given their track record this past decade. What then is the next best choice of investment if one wants a decent shot at making their money grow enough to allow for retirement before age 70? Real estate seems a poor substitute with the way people are saying property is overvalued in many places. International stock market perhaps? Love a few good alternative places to put my money, it just seems more and more like big business and our own government are not looking out for the public's best interests.

[Peter Westre]

In general you make good points. I think that one area that needs to be rexamined is the emphasis on returns to the shareholders without appropriate rewards and increases in compensation to the employees who make it possible for the corporation to make a profit. Placing the emphasis on rewards to shareholders increases inequity within society at the risk of loss of social stability.