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The Battle For The Soul of Capitalism - Part XXIV

A New Kind of Capitalism

The change from traditional owners’ capitalism to the new managers’ capitalism is at the heart of what went wrong in corporate America. It was reflected in the stock market bubble and the subsequent market burst, during which at least $2 trillion of wealth was transferred from public investors to corporate insiders, entrepreneurs, and financial intermediaries. Largely through stock options, executive compensation reached extraordinary levels, despite the production of corporate profits that were in fact, measured by the growth of our economy, less than ordinary. Managed earnings was an important engine of the system, and its goal, at least implicitly, was to raise corporate stock prices whether or not increases in intrinsic corporate values were achieved. It is that pathological mutation in capitalism that largely explains what went wrong. Explaining why it went wrong is the province of the next chapter.

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The Battle For The Soul of Capitalism - Part XXIII

Future Pension Fund Returns

Nowhere is the fiction of managed earnings more apparent than in the assumptions of future returns made by corporate pension funds. Over the past decade the yield on the ten-year U.S. Treasury bond has plummeted from 7.9 percent to 4.2 percent—a drop of 45 percent— and the prospective investment return on stocks (dividend yield plus assumed 5 percent earnings growth) has fallen by 15 percent, to 6.8 percent. For a typical pension portfolio (60percent stocks, 40percent bonds), the expected market return would be 5.8percent. Yet in 2004, the average corporate pension fund assumed a future annual return of 8.6 percent, 35 percent higher. To make a bad situation worse, neither return takes into account investment costs, nor leaves a reserve against the unexpected. The fact is that pension funds should probably be counting on future annual long-term returns, net ofinvestment costs, ofsomething like 5 percent per year. (I cover this subject in greater depth in chapter five.)

Manipulating pension returns has played a major role in enabling corporations to manage their earnings, for in few other places on the corporate books are unbridled estimates of assets and liabilities so easy to adjust. Yet, it is only in recent years that pension projections have become the stuff of scandal—“pension deficit disorder,” using the inspired phrase of Morgan Stanley strategist Henry H. McVey—and the Securities and Exchange Commission (SEC) is investigating the issue. We shall learn much more about how corporations—in league with their highly paid actuarial con- sultants—have managed earnings by managing their pension assumptions.

Changing pension assumptions can make an astonishing difference in corporate earnings. Consider this example:

In 2001, Verizon Communications reported a net income of $389 million and awarded its executives bonuses based on that amount. Net income would have been negative, however, had the company not included $1.8 billion of pension income. Thus, Verizon was able to use pension earnings to convert net income to profits, giving the firm cover to provide managers with higher bonuses. It gets worse. It turns out that Verizon’s pension funds did not generate anyreal income in 2001; they had negative investment returns, losing $3.1billion in value. How, then, could Verizon report income of $1.8billion from its pension assets? The company merely increased its projection of future returns on pension assets to 9.25percent, a move allowed under the accounting rules then in effect. Thus, the $1.8billion in pension income used to move Verizon into the black did not even reflect actual returns generated by the pension funds. The pension income was simply the result of a change in the accounting assumptions. This certainly did not create any value for the firm or its shareholders.

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The Battle For The Soul of Capitalism - Part XXII

Managed Earnings

Hand in hand with the excesses of CEO compensation came “managed earnings” as a major contributor to the stock market boom. Sleight-of-hand financial engineering produced quarterly profits that were viewed by investors as predictable and recurring. The result: handsome rewards to those projecting unprecedented levels of future earnings growth, and then, with the skill of the alchemist, delivering the results they had forecast.

During the 1990s, the idea of corporations providing quarterly earnings guidance took hold and quickly was followed by earnings management. “Exceeded expectations,” or “met expectations” (or, heaven forbid, “failed to meet expectations”) became the jargon of corporate America’s financial reporting. Market participants anxiously awaited each company’s quarterly announcement, quickly comparing it with the earlier “guidance.” What was ultimately revealed, however, is what we always knew to be true: relying on the accrual accounting that is the basis for corporate financial statements is an act of faith, no more, no less. As the eminent economist Peter Bernstein has written: “The financial statement records as revenues money not yet received. It excludes from expenses money actually paid out if spent on assets expected to produce revenues in the future.” And when earnings guidance is given, there seem to have been few limits on the earliest possible recognition of revenues and the latest possible recognition of expenses. On some occasions, fraud was involved.

A 2004 study by Thomson Financial found that since 1998 companies have missed their analysts’ expectations only 16 percent of the time. The remaining 84 percent of the time they at least met expectations—23 percent exactly, another 22 percent by an additional one penny per share, and 39 percent by more than one penny—remarkable predictability, during good times and bad times alike, in complicated businesses with many lines of endeavor. It was, of course, “too good to be true.”

For such performance defies common sense. Thoughtful investors know that while business growth may follow rough trend lines, quarterly surprises are inevitable. Accounting results that show otherwise are nonsense. Although it seems absurd that a company that misses its guidance by a mere penny can see its market capitalization promptly plummet by several billions of dollars, in a certain way the logic is unexceptionable: if, with all that financial pushing and pulling and stretching, the company nonetheless falls short of its guidance, it is only a matter of time before the chickens come home to roost in the form of a major negative surprise.

Such surprises, it turns out, can be measured. At least some overaggressive accounting is often uncovered later by federal and state regulators, requiring the kinds of earnings restatements catalogued in Box 1.3. In total, some 1,570 public companies restated their earnings from 2000 to 2004, seven times the 218 companies that restated their earnings from 1990 to 1994. While many corporate executives have already been paid huge bonuses based on those engineered earnings, I have not heard of a single instance in which their bonuses have been recalculated and the overpayments returned to the stockholders.

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The Battle For The Soul of Capitalism - Part XXI

Extraordinary Compensation for Ordinary Performance

The record is clear that investors have a big stake in executive compensation. A study by Morgan Stanley’s former chief strategist Steve Galbraith found that “one way [for CEOs] to rake in the dough has been to preside over a company with an underfunded pension plan, large layoffs, and mediocre stock performance.” (While Mr. Galbraith does not argue causality, more extensive studies may well make such a case.) Analyzing the 500 companies in the S&P Index, he found that the six companies whose CEOs made more than $50 million in 2002 provided average annualized returns in 2002–3 of minus 40 percent, compared to minus 3 percent for the remaining companies in the Index.

Galbraith argues that “the root appeal of capitalism revolves around extraordinary reward potential for extraordinary performance, [but] what is less understandable are extraordinary compensation packages handed out for ordinary performance.” Thus, despite wildly errant growth projections, these seemingly failed executives (or terrible forecasters) were rewarded with increases that took their average annual compensation to new heights—an amazing failure of prudent governance by corporate directors. Paraphrasing Churchill, never has so much been paid by so many to so few for so little.

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The Battle For The Soul of Capitalism - Part XX

Managers’ Capitalism in the Driver’s Seat

Clearly, owners’ capitalism had been superseded by managers’ capitalism, and managers’ capitalism has created great distortions in our business world and our society alike. Our imperial chief executives, with all their fame, their jet planes, their perquisites, their pension plans, their club dues, their Park Avenue apartments, appear to have forgotten that they are employees of the corporation’s owners. The owners seem to have forgotten it, too. But executive character has not gone unnoticed. CEOs are now close to the bottom of the barrel in public trust. One survey showed that while 75 percent of the general public trust shopkeepers, 73 percent trust the military, and 60 percent trust doctors, only 25 percent trust corporate executives—slightly above the 23 percent that trust used-car dealers.

These self-styled lions of capitalism, often so powerful, charismatic, and demanding that they earned the title “imperial” CEOs, typically drew compensation that suggested that they alone controlled the fates of their companies. As silly as this claim is, more than a few were willing contributors to this fantasy, too often arrogant, greedy, and vainglorious, convinced that “they did it all by themselves” and are worth every penny they were paid.

But while so many business managers took the credit (and the cash) for themselves, it was our expanding national economy and our booming stock market that made them look good. So long as their own wealth was growing, investors accepted uncritically the idea that the high rewards generated in CEO compensation were well deserved.

The reality was far different: While our CEOs created enormous wealth for themselves, far beyond what our thriving economy delivered, they had failed to create extra wealth for their shareowners. And when the bubble burst and the stock market values melted away, these operators had long since sold hundreds of billions of dollars worth of their own stock to the public (and even to their own companies), leaving the new owners holding the bag.

Executive pay is out of control because compensation committees aren’t doing their job. But the consultants are doing theirs. They are paid by management to advise management how much management should be paid. Small wonder that in 2000, for example, we observed awards for achievement for CEOs running from as high as $92 million, to $125 million, to $151 million, and to, believe it or not, $872 million. For a single individual in a single year! These numbers, of course, find their way into the great compensation database, which in turn ratchets up when awards for 2001 are considered, moving formerly average awards into below average territory. And so the compensation norms rise again. It is truly a sick system, all the more difficult to cure since “everyone is doing it,” and the process has the superficial appearance of being rational.

Managers’ capitalism, then, is more than just aprovocative idea. It carries a high cost to corporate owners that can be measured. A study by two professors from Harvard Law School and Cornell University recently found that the compensation of the five highest-paid executives in each of the 1,500 companies included in the Standard & Poor’s 500, Mid-Cap 400, and Small-Cap 600 indexes during 1993–2003 alone was in excess of $300 billion. What is more, despite the fact that the reported corporate earnings grew at a puny 1.9 percent nominal annual rate during the period they examined, the share of corporate profits consumed by these executives not only rose, but more than doubled—from 4.8 percent of profits in 1993–95 to 10.3 percent in 2001–3. A long time ago, even as staunch a conservative as former president Herbert Hoover said, “You know, the only trouble with capitalism is capitalists. They’re too darn greedy.” Just imagine what he’d say today.

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The Battle For The Soul of Capitalism - Part XIX

Box 1.3 Bad Apples or Bad Barrel? Phase I

Corporate America Restates Its Earnings

While the miscreants of corporate America are often dismissed as a few “bad apples,” the abuses of the barrel of capitalism have been pervasive. The corporations listed below, many with market capitalizations of $100 billion or more, have restated earnings or been involved in settlements with the Securities and Exchange Commission (without admitting or denying guilt). Their aggregate market value, measured at their individual highs, totaled some $3 trillion, an enormous part of the giant barrel of corporate capitalism.

Adelphia
American International Group
Avon
Boeing
Bristol-Myers Squibb
Cendant
Ceridian
Citibank
Coca-Cola
Computer Associates
Conseco
Critical Path
Dynegy
Enron
Fannie Mae
Fleming Companies
Freddie Mac
Gateway
GemStar—TV Guide
International
General Electric
Global Crossing
Halliburton
Hanover Compressor
HBO McKesson Robbins
HealthSouth
Homestore
Household International
Informix
Interpublic
Kimberly Clark
Kmart
Kodak
Krispy Kreme
Legato Systems
Lernout & Hauspie
Lucent Technologies
Marsh McClennan
MBIA
Merrill Lynch
MGIC
Micro Strategy
Microsoft
Network Associates
Oxford Health Plans
Peregrine Systems
PNC Financial Services
Qwest Communications
Raytheon Corporation
Reliant Resources/Energy
Rite Aid
Royal Dutch/Shell
Safety Kleen Corp
Silicon Graphics
Spiegel
Sunbeam
Symbol Technologies
The Shell Transport Co.
Time Warner
Trump Hotels & Casino Resorts
Tyco
Warnaco Group
Waste Management
WorldCom

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The Battle For The Soul of Capitalism - Part XVIII

Bad Apples

Striking as they do at the heart of our capitalistic system, the corporate scandals of the recent era were unpleasant to witness. But even as “it’s an ill wind that blows no good,” when the bright spotlight of public attention shines on major scandals, it also illuminates all the nibbling that has taken place around the edges of proper ethical practice. Were it not for the scandals, untoward practices may have persisted indefinitely. Because they call attention to a corporate barrel that itself is in need of considerable repair, we owe a certain perverse kind of debt to the fallen idols of capitalism, “bad apples” like these:

• Kenneth Lay, Jeffrey Skilling, and Andrew Fastow presided over the collapse of Enron, revealing a panoply of financial engineering that quickly turned to fraud. Enron’s bankruptcy also turned the spotlight on the profound failings of a blue-chip board, the co-opting of its accounting firm (which also provided Enron with consulting services), and the active participation of its bankers in deals of dubious validity. Market value of Enron at pre-scandal high: $65billion. Final market value: zero.
• Bernard Ebbers, CEO of the bankrupt WorldCom (later MCI), gained his position in the hall of shame when the firm cooked the books, resulting in an $11 billion accounting scandal. To avoid selling his own shares to meet margin calls, he had borrowed a stunning $40 8million, which WorldCom’s board guaranteed. (The Sarbanes-Oxley Act now bans corporate loans to executives.) Market value of WorldCom at pre-scandal high: $165 billion. Final market value: zero.
• William Esrey and Ronald LeMay of Sprint gained the spotlight with their receipt of $287million in option compensation, paid to reward them for a merger (with the aforesaid WorldCom, of all choices) that in fact was never consummated. Their subsequent attempt to dodge taxes through an allegedly illegal tax shelter also raised the issue of collusion by the firm’s independent auditor in the setting of executive compensation. Market value of Sprint at pre-scandal high: $58 billion. Market value in early 2005: $32 billion.
• Dennis Kozlowski, the CEO of Tyco, gained his first unwelcome attention with a clumsy attempt to illegally evade state sales taxes on $13 million of art purchases, quickly followed by disclosure of the $2 million Roman-theme party given in Sardinia for his wife’s birthday. The fete included the now-famous ice statue of Michelangelo’s David exuding, as it were, vodka. But the spotlight on those events quickly illuminated a classic case of a manager’s confusing the shareholders’ money with his own, as he allegedly looted Tyco and its shareholders of $600million. Market value of Tyco at pre-scandal high: $117 billion. Market value in early 2005: $68 billion.
• Jack Welch of General Electric gained an equally unwelcome spotlight for his extramarital peccadilloes. His divorce proceedings illuminated the “stealth” compensation typically awarded to retired chief executives but rarely disclosed. While his total compensation as GE’s CEO surely approached $1billion, his lavish retirement benefits, valued by one commentator at $2 million per year, included a New York apartment with daily flower deliveries and wine, and unlimited use of a company jet. He also was awarded a generous retirement stipend of $734,000...per month. Nonetheless, he seems to have little to spare, given that his charitable giving came to just $614per month.* Market value of GE at 2000 high, $600 billion. Market value in early 2005: $379 billion.
• Steve Case of AOL. In an extraordinary example of the delusions of grandeur that characterized the information age, the news of the marriage of the “new economy” AOL and the “old economy” Time Warner as 2000 began sent the price of Time Warner soaring to a then-all-time high of $90per share. But AOL’s revenues began to tumble almost immediately. Barely two years after the merger was announced, the firm reported losses totaling $98billion. In the heady days before the bubble burst, Case, the founder of AOL (and the chairman of the merged company) sold nearly one-half billion dollars worth of his shares, mostly at boom-level prices. The stock value declined to a low of $9.64. Market value of AOL at pre-scandal high: $226 billion. Combined market value of Time Warner and AOL at merger, $240 billion. Market value in early 2005: $82 billion.
• Richard Grasso, chairman of the New York Stock Exchange, made news with the disclosure in 2004 of the staggeringly large compensation package ($187.5million) bestowed on him by those he regulated. The spotlight also illuminated the salutary (if not explosive) effects of disclosure, the Big Board’s flawed system of governance, and the near-monopoly it maintains for its member firms and specialists, who operate each day with bountiful inside information about the buying power of, and selling pressure from, investors who intend to engage in trades. Value of seat on the New York Stock Exchange at 1999 high, $2.65 million. Value in early 2005, $975,000.

There are many other “bad apples” whom I might as easily have mentioned, but these seven examples should be enough to make the point that the scandals ofthe recent era have brought into sharp relief the painfully broad and baneful impact of managers’ capitalism, and the financial shenanigans that it fomented.

The problem goes far beyond the few renegades I have listed as bad apples. The traditional nature of capitalism has been distorted, and today’s version is riddled with problems reflected in serious manipulation of financial statements. Indeed, since the market crash, some 1,570 publicly owned firms have restated their earlier financial statements, including some of our largest global corporations, such as Royal Dutch/Shell, the giant oil company, Schering-Plough, Qwest, Bristol-Meyers Squibb, Xerox, and Halliburton. (See Box 1.3.)

*While the Good Book says “judge not, lest ye be judged,” the tight-fisted charitable giving of such fabulously wealthy executives appalls me. Another example is Sam Waksal, imprisoned for his crimes at ImClone. He earned $134 million in 1999–2001 and gave but $157,451 to charity, implicitly telling the world, “1⁄10 of 1 percent for the greater good, 99.9 percent for me.”

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Posted by Todd S. at 1:52 PM

The Battle For The Soul of Capitalism - Part XVII

Box 1.2 Executive “Perks”

Since what is publicly disclosed as CEO compensation excludes the host of perquisites they receive to augment their lavish lifestyles, their compensation is actually understated. Even the list below does not exhaust the remarkable benefits paid to senior management. General Electric, for example, pays 9.5to 14percent interest on salary deferrals.

• Use of company aircraft for personal travel. The cost of this most popular perk can easily run in the hundreds of thousands of dollars per executive per year. (In 2003, personal flights valued at $304,527 were paid by Citigroup for just one of its officers, executive committee chairman Robert E. Rubin, whose other pay came to $16.2million.)
• Payment of taxes on personal travel benefits. A substantial extra perquisite, essentially doubling both the benefit to the executive and the cost to the shareholders.
• Lending money to executives, then forgiving the loan. While such loans are no longer legal, forgiveness of earlier loans can go on indefinitely. Home Depot lent $10 million to new CEO Robert Nardelli in 2000, and each year forgives one-fifth of it and the attendant interest, as well as pays the taxes on both, as “an incentive for him to stay with the company.”
• Providing “amenities.” Private boxes at sporting events, entertainment, luxury apartments, country club dues, home security systems, and so on, available only to the highest paid executives.
• Payments to terminated executives. As it has been said, “corporate America takes care of its own,” but never more generously than the $140 million awarded to Michael Ovitz for his fourteen months of work at Walt Disney before being fired.
• Stepped-up retirement benefits. Generous termination bonuses and massive step-ups in pension benefits are often paid to executives when they retire, and thus slip through the reporting screen.
• Charitable contributions by corporations to the favorite causes of senior executives, which may even give credit to the CEO for his generosity.

In his detailed study of executive perquisites and personal aircraft usage, David Yermak of New York University suggests that the typical CEO fails to “recognize boundaries between the company’s assets and his own.” However, Yermak also finds that perks are a useful, if inverse, diagnostic tool for investors—the higher the perquisites, the greater the likelihood the company will perform badly.

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Posted by Todd S. at 1:34 PM

The Battle For The Soul of Capitalism - Part XVI

Burgeoning Executive Compensation

The recent era, however, defied the long-run reality. When the S&P 500 Index rose from 130 in March 1981 to 1,527 in March of 2000, the return on investor capital, excluding dividends, was 13.8 percent per year. Earnings growth amounted to 6.2 percent annually, less than half of the return, with the remainder the result of a rise in the price-earnings ratio from eight times to thirty-two times. That increase alone accounted for 1,100 points of the 1,400-point gain, or 7.6 percent per year. If one were to attribute even a 5 percent corporate cost of capital as a threshold for a stock option grant—a return a company might have earned merely by placing all of its assets in a bank certificate of deposit—corporate management could claim responsibility for an extra return of only 1.2 percent per year. Yet when the Index reached 1,527, a stock option for ten thousand shares at $130 at the outset would have placed a cool $14 million on the executive’s plate at its conclusion. Nice work if you can get it!

With huge option grants to corporate managers and overstated earnings, all the while disregarding the cost of these options as an expense, total executive compensation went through the roof. In 1980, the compensation of the average chief executive officer was forty-two times that of the average worker; by the year 2004, the ratio had soared to 280 times that of the average worker (down from an astonishing 531 times at the peak in 2000). Over the past quarter-century,[...], CEO compensation measured in current dollars rose nearly sixteen times over, while the compensation of the average worker slightly more than doubled. Measured in real (1980) dollars, however, the compensation ofthe average worker rose just 0.3 percent per year, barely enough to maintain his or her standard of living. Yet CEO compensation rose at a rate of 8.5 percent annually, increasing by more than seven times in real terms during the period.

The rationale was that these executives had “created wealth” for their shareholders. But were CEOs actually creating value commensurate with this huge increase in compensation? Certainly the average CEO was not. During that twenty-four-year period, corporations had projected their earnings growth at an average annual rate of 11-1⁄2 percent. But they actually delivered growth of 6 percent per year—only half of their goal, and even less than the 6.2 percent nominal growth rate of the economy. In real terms, profits grew at an annual rate of just 2.9 percent, compared to 3.1 percent for our nation’s economy, as represented by the Gross Domestic Product. How that somewhat dispiriting lag can drive average CEO compensation to a cool $9.8million in 2004is one of the great anomalies of the age. If CEOs have failed to create value, there must be another explanation for such compensation. One can only wonder what it might be.

What is more, the staggering sums paid to CEOs are understated. The figures include only what is publicly disclosed as CEO compensation, and since our CEOs receive a host of perquisites to augment their lavish lifestyles, the reality is considerably higher. These “perks” are often undisclosed and excluded from the “total compensation” reported for officers in the proxy statement. Even the list in Box 1.2 does not exhaust the undisclosed special benefits extended to executives, such as bargain interest rates on their loans and high interest rates on their deferred compensation.

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The Battle For The Soul of Capitalism - Part XV

The Flaws of Stock Options

Even if executives were required to hold most of their stock for an extended period, however, the fixed-price stock option is fundamentally flawed as a method of aligning the interest ofownership and management:

• They are not adjusted for the cost of capital, providing a free ride even for executives who produce only humdrum returns.*
• They do not take into account dividends, so there is a perverse incentive to avoid paying dividends.
• Stock options reward the absolute performance of a stock rather than its performance relative to peers or to a stock market index.

As a result of these conceptual flaws, executive compensation takes on the appearance of a lottery, creating unworthy centimillionaires in bull markets and eliminating rewards even for worthy performers in bear markets. By making the incorrect presumption that stock price, and stock price alone, is the measure of executive performance, we produced undeserving executive celebrities and overlooked those who incrementally and consistently added real value to their corporations.

These problems were well known, and simple solutions to the executive compensation morass were readily available. Restricted stock, in which executives are awarded shares of the company and required to hold them to earn their rewards, were one obvious alternative. Companies also could have raised the option price each year or linked the stock performance with the performance of the overall market, or with a peer group. But such sensible programs were almost never used. Why? Because those alternative schemes would have required corporations to count the cost as an expense. This recognition of compensation expenses would have reduced the earnings that they were trying to drive ever upward. Largely because their costs were conspicuous by their absence on companies’ expense statements, fixed-price options became the universal standard. Rather than consider compensation plans that made sense for the business, the self-imposed constraint of expense avoidance framed the discussion of executive pay.

As the compensation consultants are wont to say, these stock options are “free.” That singular, simple anomaly bears much of the responsibility for the staggering increase in these payments over the years. But stock prices are inherently flawed as a means ofcompensation. Uncritically, we came to accept stock prices as a measure ofexecutive prowess and success, ignoring the fact that short-term fluctuations in stock prices are based only tangentially on the level ofcorporate earnings (even earnings that are accurately stated). Rather, short-term prices are driven by speculation, reflected in how many dollars investors are willing to pay for each dollar of earnings on any given day. But in the long run, as I will show in chapter five, virtually 100 percent of the return on stocks is determined by dividend yield and earnings growth.

*The cost of corporate capital is generally described as the risk-free interest rate plus an equity premium. In early 2005, approximately 4-1/4 percent on the U.S. Treasury ten-year note, plus, say, 3 percent. Total cost of capital, 7-1⁄4 percent.

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The Battle For The Soul of Capitalism - Part XIV

The Spark That Lit the Fire

It should hardly surprise us that one of the chief protagonists that sparked the fire that led to the rapid escalation in stock prices was executive compensation, closely linked with its fellow protagonist, managed earnings. Executive compensation, made manifest in the fixed-price stock option, rewarded executives for raising the price of their company’s stock rather than for increasing their company’s intrinsic value. (I discuss the issue of price versus value in greater depth in chapter five.) When that is what investors measure, in effect, that is what managers manage.

Executives don’t need to be told what to do: achieve strong, steady earnings growth and tell Wall Street about it. Set “guidance” targets with public pronouncements ofyour expectations, and then meet your targets—and do it consistently, without fail. First, do it the old-fashioned way, by increasing volumes, cutting costs, raising productivity, embracing technology, and developing new products and services. Then, when making it and doing it isn’t enough, meet your goals by counting it, pushing accounting principles to their very edge. And when that isn’t enough, cheat. As we now know, too many firms did exactly that.

The stated rationale for fixed-price stock options is that they “link the interests of management with the interest of shareholders.” This oft-repeated and widely accepted bromide turns out to be false. Managers don’t hold the shares they acquire. They sell them, and promptly. Academic studies indicate that nearly all stock options are exercised as soon as they vest, and the stock is, in turn, sold immediately. Indeed, the term cashless exercise—in which the firm purchases the stock for the executive, sells it, and pays the difference to the executive when the proceeds of the sale are delivered—became commonplace. (Happily, the practice is no longer legal.) We rewarded our executives not for the reality of creating long-term economic value but for pumping up the perception of short-term stock market prices. The fact is that executives had created wealth for themselves, but not for their shareowners. Long before the stock market values melted away, executives had made a timely exodus from the market by selling much of their stock.*

*One caveat: Since executives have substantial human and economic capital tied up in their firms and some diversification is warranted, I recognize that moderate portions of their holdings may be sold from time to time. But they should retain holdings that are a substantial portion of their total compensation and wealth.

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The Battle For The Soul of Capitalism - Part XIII

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The Battle For The Soul of Capitalism - Part XII

The Vicious Circle

The market boom and bust were based not only on the delusions of the day but on a mutation from virtuous to vicious circle—a failure of character, a triumph of hubris and greed over honesty and integrity in corporate America. It’s facile to ascribe the wrongdoing of the era to just a few bad apples, and it’s true that only a tiny minority of our business and financial leaders has been implicated in criminal behavior. But I believe that the barrel itself—the very structure that holds all those apples—is bad. While that may seem a harsh indictment, I believe it is a fair one.

Consider Reuters journalist Martin Howell’s list of 175 “red flags,” each of which describes a particular shortcoming in our recent business, financial, and investment practices. I’ve personally observed many of these warning flags, twenty-four of which are listed in Box 1.1. They amply illustrate that those in privileged positions, corporate managers, and money managers alike who ought to have known better, rather than accepting uncritically the financial machinations and hyperbole of the so-called New Era, should have been issuing instead stern warnings to investors.

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The Battle For The Soul of Capitalism - Part XI

Stock Market Bubbles

This massive $2 trillion-plus transfer of wealth from public investors to corporate insiders and financial intermediaries during the late bubble years was hardly without precedent. Transfers of this nature and relative dimension happen over and over again whenever speculation takes precedence over investment. But a day of reckoning always follows. As the Roman orator Cato wrote some three thousand years ago: “There must certainly be a vast Fund of Stupidity in Human Nature, else Men would not be caught as they are, a thousand times over, by the same Snare, and while they yet remember their past Misfortunes, go on to court and encourage the Causes to which they were owing, and which will again produce them.”

While each financial bubble is different, most have been associated with the abandonment of traditional financial standards. As Edward Chancellor, author of Devil Take the Hindmost: A History of Speculation, reminds us, manias reflect the worst aspects of our system: “Speculative bubbles frequently occur during periods of financial innovation and deregulation...lax regulation is another common feature...there is a tendency for business to be managed for the immediate gratification of speculators rather than the long-term interests of investors.” What is more, bubbles often take on the attributes of castles built on sand, as sound business practices erode, integrity and ethics are compromised, and financial malfeasance creeps into the system.

One danger of such bubbles is that they undermine the notion that the stock market is an appropriate investment vehicle for long-term investors. The idea that common stocks were acceptable as investments—rather than merely speculative instruments—is said to have begun in 1925 with Edgar Lawrence Smith’s Common Stocks as Long-Term Investments. Its most recent incarnation came in 1994, in Jeremy Siegel’s Stocks for the Long Run. Both books unabashedly state the case for equities and both, arguably, helped fuel the bull markets that ensued. Both books presented compelling statistical evidence that stocks were the ideal long-term investments.

Nevertheless, based on the impressive historical data on past stock returns that the books presented, the public seized on the idea that the market was somehow a risk-free venture, and that making money was inevitable. Ironically, while both books clearly emphasized the importance of long-term investing, they seemed to mute investors’ apprehensions, inadvertently creating an atmosphere of short-term speculation. Apparently ignoring the inherent risk in stocks, investors of both eras seemed to make the implicit assumption that stock market history would repeat itself. When stocks are seen as a “sure thing” and prices are bid up to unsustainable levels, great bear markets follow. And so it was in the aftermath of the publication of both books.

Yet the only certainty about the equity returns that lie ahead is their very uncertainty, a lesson that, unfortunately, too often gets lost from one generation to the next. We simply do not know what the future holds, and we must accept the self-evident fact that historic stock market returns have absolutely nothing in common with actuarial tables (a point of view that is fully discussed in chapter five). “The past is history; the future’s a mystery.”

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The Battle For The Soul of Capitalism - Part X

The Losers

If the winners raked in what we can roughly estimate as at least $2.275 trillion, who lost all that money? The losers, of course, were those who bought the stocks and who paid the intermediation costs. Most of the buying came from the great American public—sometimes directly by buying individual stocks; sometimes indirectly, through mutual funds; sometimes in their personal accounts; and frequently through the increasingly popular 401(k) thrift plans, themselves often treacherously loaded with the stock ofthe companies for which the investors themselves worked. “Greater fools?” Perhaps. Surely greed, naiveté, and the absence of common sense plagued too many stock buyers, and aggressive sellers capitalized on the popular delusions and madness of the investing crowds.

Millions of investors rushed into the stock market to buy the burgeoning number of speculative stocks—technology shares in Internet, telecommunications, and other companies—that were part of the ballyhooed “new economy.” For example, during the peak two years of the bubble, $425 billion of investor capital flowed into “new economy” mutual funds, favoring those types of speculative growth stocks; $100 billion actually flowed out of those stodgy “old economy” value funds that would provide a peaceful refuge from the storm that was to come.

Ironically, the list of losers also included those same corporations. In order to avoid the dilution in their earnings that would otherwise have resulted from their issuance of options, the very corporations that issued those billions of options at dirt-cheap prices also bought them back—but at the inflated prices of the day. The real losers, of course, were not those corporations themselves, but their own shareholders, who lost twice: first because of the dilution in their interests caused by the options issuance, and second because the purchases of their stocks depleted corporate cash. The largest 100 companies in the S&P 500Index actually bought back even more of their stocks than they issued in the form of stock option grants, while the 100 largest NASDAQ companies appear to have (wisely) bought back far smaller amounts.

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The Battle For The Soul of Capitalism - Part IX

The Winners

Consider first the winners. A large proportion ofthe shares that were sold as the bubble soared to its peak were those held by corporate executives who had acquired vast holdings of their companies’ stocks through options, and those of entrepreneurs whose companies had gone newly public as Wall Street investment banking firms underwrote huge volumes of initial stock offerings, many now worthless. Examining a group of executives in a mere twenty-five corporations in those categories, Fortune magazine placed sales of stock at $23 billion—nearly a billion dollars for the executives of each company.

While hard data for all stock sales by executives in publicly traded companies are not available, it seems reasonable to estimate that total sales could have reached $200 billion or more. Initial public offerings (IPOs)— largely of “new economy” companies, most of which were bereft of earnings—totaled more than $800 billion from 1995 through 2001. (An unknown, but doubtless enormous, portion of the proceeds of these sales was reinvested in stocks.) Thus, the wealth transfer to insiders and entrepreneurs who sold their stocks may well have totaled $1 trillion or more.

The other—and even bigger—recipients of the massive transfer of wealth were the financial intermediaries themselves—investment bankers and brokers who sold those high-flying stocks to their clients, and mutual fund managers who sold those speculative “new economy” funds to the public. Why were they winners? Because the investment banking, brokerage, and management fees paid by investors for their services reached staggering levels. More than a few individual investment bankers saw their annual compensation reach well into the tens ofmillions, and at least a half dozen owners of fund management companies accumulated personal wealth in the billion-dollar range, including one family whose wealth is said to be at the $20 billion level. During 1997–2002 alone, the total revenues paid by investors to investment banking and brokerage firms exceeded $1 trillion, and payments to mutual funds exceeded $275 billion.

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The Battle For The Soul of Capitalism - Part VIII

The Great Bear Market

As Sir Isaac Newton warned us, for every action there is an equal and opposite reaction, and the reaction to the stock market boom and the mismanagement of so many of our corporations inevitably followed. The reaction to the Great Bull Market, of course, was the Great Bear Market, one that held us in its throes for two and a half years and from which we still feel the residual effects. From its high in March 2000 to its low in October 2002, the market lost fully one-half of its value, making it, with the Great Crash of 1929–33, one of the two largest drops of
the entire century.

That combination of percentages—a market that rose 100 percent, then tumbled 50 percent—produces a net gain ofzero. Even with the subsequent 50 percent recovery from the low through early 2005, stock prices remained more than 20 percent below the peak, about where they were in 1998. Nonetheless, taking dividends into account, investors who stayed the course during this seven-year period are far better off on balance than those who rushed in later to ride the wave of euphoria, only to experience heavy losses.

In a sense, the Wired forecast was right on the mark. We we removing into a New Era. But, so far at least, the New Era has been the diametrical opposite of its bullish predictions. Rather than a long boom in the stock market, we’ve seen a short bust. Rather than the end of war, the United States is now engaged in three wars, in Iraq, in Afghanistan, and on terrorism. The growth rate in information technology has slowed dramatically. Employment has increased only marginally, and the abatement of poverty is nowhere in view. Rather than the sustained economic growth that Wired anticipated, we’ve had a recession, from which our economy is recovering only fitfully. And, corporate malfeasance has shaken the confidence of investors to the point that the very nature of modern-day capitalism is—quite properly—being challenged. Each of these challenges reverberates across the entire financial services field.

Yet even after the Great Bear Market, the return on stocks for long-term investors has been remarkable. From 1982, when the long bull market began, to early 2005, the U.S. stock market provided a compound growth rate averaging 13 percent per year. Through the miracle of compounding, those who owned stocks in 1982 and still hold them today had multiplied
their capital more than 16 timesover. So for all ofthe stock market’s breathtaking ups and downs, long-term owners who bought and held common stocks have been well compensated for the risks they assumed. For such investors, the coming of the bubble and then its going—the boom and then the bust—simply did not matter. Unfortunately, for far too many others, it was devastating to their wealth.

All that has transpired could be sparingly acknowledged if it weren’t for the fact that there were winners and losers during the mania—and lots of both. Simply put, the winners were those who sold their stocks in the throes of the halcyon era that is now history; and our financial intermediaries,
who prospered beyond the dreams of avarice. The losers were those who bought stocks, and those who paid the high intermediation costs that are part and parcel of participating in the stock market.

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The Battle For The Soul of Capitalism: Part VII

The Happy Conspiracy

The financial markets of the late 1990s seemed to accept the Wired thesis; if not in its entirety, surely in its spirit and its direction. From the start of 1997 to its high point in March 2000, the stock market doubled, valued at stratospheric multiples of earnings, dividends, and book values literally never seen before. The Great Bull Market fed on itself, a mania driven by the idea that we were in a New Era. Bolstered by that euphoria, our system of market capitalism—as all systems sometimes do—experienced a profound failure, with a whole variety of root causes, each interacting and reinforcing the other: the notion that our corporations were trees that could grow not only to the sky but beyond; the rise of the imperial chief executive officer; the legerdemain of financial engineering in corporate reporting; the failure of our gatekeepers—the auditors, regulators, legislators, investment managers, and boards of directors—who forgot to whom they owed their loyalty; the change in our financial institutions from being stock owners to being stock traders; the promotional hyperbole of Wall Street; the willingness of professional securities analysts to put aside their skepticism; the frenzied excitement of the media; and, of course, the eager members of the investing public, reveling in the easy wealth that seemed like a cornucopia. It was this happy conspiracy among virtually all interested parties that drove business standards down even as it drove stock prices up. The victory of investors, insiders, and investment operators during the Great Bull Market had a thousand fathers.

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The Battle For The Soul of Capitalism- Part VI

The Long Boom

As the culmination of this change in the nature of capitalism drew near, the critical factors that affect the markets also were changing. Only recently, as 1999 was about to roll into 2000, the Y2K issue—an acronym now almost lost in the dustbin of history—was the major challenge of the day. Our nation’s systems experts prevailed, and our computers clicked into the year 2000, and then, a year later, into the twenty-first century. A new century, billed as a new era of growth for our global economy, had begun. The spirit of the coming age was summarized in a 1997 article entitled, of all things, “The Long Boom.” Wired magazine, the hottest publication geared to the “new economy” fantasy, headlined its lead story: “We’re Facing Twenty-Five Years of Prosperity, Freedom, and a Better Environment for the Whole World. You Got a Problem with That?” Who could possibly have a problem with that? Indeed, the readers of Wired must have salivated as they anticipated, in the article’s words, “the beginnings of a global boom on a scale never experienced before...a pe- riod of sustained growth that could eventually double the world’s economy every dozen years and bring increasing prosperity for billions of people on the planet...growth that will do much to solve seemingly intractable problems like poverty, and ease tensions throughout the world, all without blowing the lid off the environment.”

That wildly bullish thesis was based on the indisputable triumph of the United States as sole superpower, the end of major wars, waves of new technology, soaring productivity, an expanding global marketplace, and corporate restructuring—“a virtuous circle...driven by an open society in an integrated world.” In all, a “radically optimistic meme."

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The Battle For The Soul of Capitalism - Part V

A Pathological Mutation

The system worked. Or at least it did work. And then, late in the twentieth century, something went wrong. The system changed; one more aberration in the long course of capitalism. While each of its earlier failures was followed by safeguards put in place as defenses against future abuses, none of them contemplated the next step of scandal that perhaps almost inevitably would follow. What went wrong this time, as William Pfaff described it, was “a pathological mutation in capitalism.” The classic system— owners’ capitalism—had been based on a dedication to serving the interests of the corporation’s owners in maximizing the return on their capital investment. But a new system developed—managers' capitalism—in which, Pfaff wrote, “the corporation came to be run to profit its managers, in complicity if not conspiracy with accountants and the managers of other corporations.” Why did it happen? “Because the markets had so diffused corporate ownership that no responsible owner exists. This is morally unacceptable, but also a corruption of capitalism itself.”

The age of managers’ capitalism has had dire consequences for our notion of some sort of fairness in American society, and is a major cause of the increase in the gap between America’s rich and poor, between haves and have-nots. In the mid-1970s, for example, the wealthiest 1 percent of Americans owned about 18 percent ofthe nation’s financial wealth. By the close of the twentieth century, the share owned by the top 1 percent had soared to 40percent, the highest share in the nation’s history, with the possible exception of the estimated 45 percent share reached around the turn of the previous century, the age of the Robber Barons—John D. Rockefeller, E. H. Harriman, Jay Gould, et al. Such concentration, most citizens would agree, is antithetical to the long-term stability of our society. Of course these inequalities won’t be easily remedied by a return to owner’s capitalism, for the issues are deeper and more complex than that. But I caution that a society that tolerates such differences in income and wealth is a society that faces long-term disruption.

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The Battle For The Soul of Capitalism - Part IV

The Birth of Plenty

The flourishing of capitalism was central to the soaring prosperity that became the hallmark of the modern era. During the past two extraordinary centuries, the global economy has experienced increasing productivity and economic growth at rates never witnessed before in all human history. According to the brilliant investor, philosopher, and neurologist William J. Bernstein, author of The Birth of Plenty: How the Prosperity ofthe Modern World Was Created:

[From] about A.D.1000...the improvement in human well-being was of a sort so slow and unreliable that it was not noticeable during the average person’s twenty-five-year [italics added] life span. Then, not long after 1820, prosperity began flowing in an ever-increasing torrent. With each successive generation, the life of the son became observably more comfortable, informed, and predictable than that of the father...[the result] of the four essential ingredients that are necessary for igniting and sustaining economic growth and human progress:

• Property rights—creators must have proper incentives to create, which go hand in hand with civil liberties.
• Scientific rationalism—innovators must possess the proper intellectual tools in order to innovate, and must be able to do so without fear of retribution.
• Capital markets—entrepreneurs must have access to sufficient capital to pursue their visions.
• Transportation/communication—society must be able to rapidly and efficiently move information and finished products.

It was only at the birth of modern capitalism in the early nineteenth century that all four of these elements began to flourish in concert. While the forces that drive economic growth are complex to evaluate, and often contested in academic circles, there was a timely convergence of human and physical capital, supported by a network of modern systems: legal, financial, commercial, educational, governmental, and the like. In any event, two centuries ago the world’s standard of living began inexorably to improve, and the modern world was born.

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The Battle For The Soul of Capitalism - Part III

Capitalism—The Virtuous Circle

Capitalism, Webster’s Third International Dictionarytells us, is “an economic system based on corporate ownership ofcapital goods, with investment determined by private decision, and with prices, production, and the distribution of goods and services determined mainly in a free market.” Importantly, I would add, it is “a system founded on honesty, decency, and trust,” for these attributes too have been clearly established in its modern history.

During the eighteenth and nineteenth centuries, as the world moved from its agrarian roots toward an industrial society, capitalism began to flourish. Local communities became part of national and, later, international commerce; trading expanded; and large accumulations of capital were required to build the factories, develop the transportation systems, and fund the banks on which the new economy would depend. Surprising as it may seem today, according to an article by James Surowiecki in Forbes, the Quakers were at the heart of this development.

In the 1700s and early 1800s, Quakers dominated the British economy, probably because their legendary simplicity and thrift endowed them with the capital to invest. They owned more than half of the country’s ironworks and played key roles in banking, consumer goods, and transatlantic trading. Their emphasis on reliability, absolute honesty, and rigorous record-keeping infused them with trust as they dealt with one another, and other observant merchants came to see that being trustworthy went hand in hand with business success. Self-interest demanded virtue.

This coincidence of virtue and value, of course, is exactly what the great Scottish economist and philosopher Adam Smith expected. In The Wealth of Nations in 1776, he famously wrote, “The uniform and uninterrupted effort to better his condition, the principle from which [both] public and private opulence is originally derived, is frequently powerful enough to maintain the natural progress of things toward improvement. ...Each individual neither intends to promote the public interest, nor knows how much he is promoting it...[but] by directing his industry in such a matter as its produce may be of the greatest value, he is led by an invisible hand to promote an end which was no part of his intention.”

And so it was to be, the Forbes essay continued, that “the evolution of capitalism has been in the direction of more trust and transparency and less [purely] self-serving behavior; not coincidentally, this evolution has brought with it greater productivity and economic growth. . . . Not because capitalists are naturally good people, [but] because the benefits of trust—of being trusting and of being trustworthy—are potentially immense, and because a successful market system teaches people to recognize those benefits...a virtuous cycle in which an everyday level of trustworthiness breeds an everyday level of trust.”

Said differently, capitalism requires a structure and a value system that people believe in and can depend on. We do not need a Pollyannaish faith in the goodwill of mankind, but we do need the confidence that promises and commitments, once made, will be kept. We also need assurances that the system as a whole does not unduly benefit some at the expense of others. It is these elements that led capitalism to flourish.

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The Battle For The Soul of Capitalism - Part II

Chapter 1 - What Went Wrong in Corporate America?

"A Pathological Mutation"

The great stock market bubble of 1997–2000, and the great crash that inevitably followed, are poignant reminders of the periodic but random aberrations described in Charles MacKay’s 1885 epic history of speculation, Extraordinary Popular Delusions and the Madness of Crowds. Each burst of madness, of course, is different, but each yields similar adverse consequences. The most recent episode witnessed the culmination of an era in which our business corporations and our financial institutions, working in tacit harmony, corrupted the traditional nature of capitalism, shattering both confidence in the markets and the accumulated wealth of countless American families. Something went profoundly wrong, fundamentally and pervasively, in corporate America.

At the root of the problem, in the broadest sense, was a societal change aptly described by these words from the teacher Joseph Campbell: “In medieval times, as you approached the city, your eye was taken by the Cathedral. Today, it’s the towers of commerce. It’s business, business, business.” We had become what Campbell called a “bottom-line society.” But our society came to measure the wrong bottom line: form over substance, prestige over virtue, money over achievement, charisma over character, the ephemeral over the enduring, even mammon over God.

Joseph Campbell’s analogy proved to be ominous. On September 11, 2001, we witnessed the total destruction of the proudest towers of American commerce, the twin towers ofNew York’s World Trade Center. While that tragic event reawakened the nation to many ofour social values, it was too late to deter our financial system from its ruinous course. In the aftermath, the stock market continued its downward trajectory. When the plunge ended, the aggregate market value ofAmerica’s corporations had dropped by a stunning 50 percent, the worst stock market crash since 1929–33. The value of U.S. stocks collapsed from $17 trillion to $9 trillion, before some $4 trillion of this paper wealth was recovered in the ensuing market rebound. New symbols of commerce arose from the ashes: no longer the proud towers ofcommerce, but beleaguered captains of industry. Too many of our business leaders were transmogrified from mighty lions of corporate success to self-serving and untrustworthy operators, with several doing “perp walks” for the television cameras.

Our bottom-line society has a good bit to answer for. As the United Kingdom’s chief rabbi Jonathan Sacks put it: “When everything that matters can be bought and sold, when commitments can be broken because they are no longer to our advantage, when shopping becomes salvation and advertising slogans become our litany, when our worth is measured by how much we earn and spend, then the market is destroying the very virtues on which in the long run it depends.”

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The Battle For The Soul of Capitalism - Part I

The following is chapter one to John Bogle's The Soul of Capitialism.

From the back cover:

There is no one better qualified to tell us about the failures of the American financial system and the grotesque abuses that have taken place in recent years than John Bogle, who as founder and former chief executive of the Vanguard mutual funds group has seen firsthand the innermost workings of the financial industry. A zealous advocate for the small investor for more than fifty years, Bogle has championed the restoration of integrity in industry practices. As an astute observer and commentator, he knows that a trustworthy business and financial complex is essential to America’s continuing leadership in the world and to social and economic progress at home.

This book tells not just a story about what went wrong but, more important, the story of why we lost our way and of how we can right our course. Bogle argues for a return to a governance structure in which owners’ capital that has been put at risk is used in their interests rather than in the interests of corporate and financial managers. Given that ownership is now consolidated in the hands of relatively few large mutual and pension funds, the specific reforms Bogle details in this book are essential as well as practical. Every investor, analyst, Wall-Streeter, policy maker, and businessperson should read this deeply informed book.

You can read Tom Ehrenfeld's interview with John Bogle here.