Column

CRIME IN THE SUITES

Beyond ‘WorldCon,' here are the real reasons the markets are tanking

DONALD COXE July 15 2002
Column

CRIME IN THE SUITES

Beyond ‘WorldCon,' here are the real reasons the markets are tanking

DONALD COXE July 15 2002

CRIME IN THE SUITES

Beyond ‘WorldCon,' here are the real reasons the markets are tanking

Column

DONALD COXE

THE KANANASKIS G8 get-together was the first to have three kinds of bears in the press commentary. The local grizzlies and black bears were given credit (along with $300 million or so of taxpayer money) for keeping the protestors away from the dignitaries. But the big bears that got splashy coverage were of the Wall Street variety. When the announcement of the “WorldCon” accounting fraud roiled the stock market, briefly sending major U.S. indices to lower levels than Osama Air had managed, President Bush was put on the defensive. He naturally went on the offensive, promising punishment for practitioners of crime in the suites.

By the weekend, the chattering classes were buzzing that the seemingly endless supply of corporate sleazebags had put capitalism at bay. The rogues’ gallery of putative destroyers included Enron’s Ken Lay, Global Crossing’s Gary Winnick, Tyco’s Dennis Kozlowski, WorldCom’s Bernie Ebbers and, in the interests of gender equality, Martha Stewart. (Including her in that list for a mere US$227,000 of alleged insider trading was, of course, ridiculous, but it surely helped get the public’s attention focused on the message that Evil was out of control.)

Can capitalism survive the crooks?

Milton Friedman, the economist who has done more than all the rest to lay the theoretical groundwork for the capitalist revolutions launched by Margaret Thatcher and Ronald Reagan, is not apologetic. He has long believed that “the main problem of capitalism is capitalists; the main problem of socialism is socialists.” Speaking in San Francisco in the midst of the brouhaha, he ridiculed the theoretical basis that made this explosion of rapacity possible. He said there never was a tech-driven “New Economy.” In his view, “We’ve had a new economy for 200 years.”

Amid the baying for blood, that wisdom got little press coverage. Far easier to note that investors have lost more than $3 tril-

lion in the tech meltdown, and ascribe it to accounting fraud and embezzlement.

The truth is both more and less complicated. The total stock market losses from Enron, WorldCom, Global Crossing and Tyco are less than the market value decline from the falls of just Cisco, JDS Uniphase, Nortel and EMC Corp., all supposed “New Economy” firms. Nasdaq’s collapse didn’t come from fraud. It came from a mania based on a series of widely promoted fallacies:

First, that corporate profits could grow many times faster than the economy at large. (They never have and never will.)

Second, that lavish stock option programs truly aligned management’s interests with those of the stockholders at large. (They never have and never will.)

Third, that the cost of those programs should not be included in the companies’ reported earnings (even when, as in the year 2000, the profits earned by insiders through options far exceeded the total profits of the technology industry worldwide, leaving less than nothing for the suckers in the investing public).

Fourth, that a relentlessly competitive industry with almost no sustainable barriers to entry should be valued with priceearnings ratios far above the rest of the stock market. (The only major tech and telecom firm that has shown it is a true growth company is Microsoft, because it is a monopoly.)

Fifth, that the existence of a “New Economy” justified the development of new valuation systems. (“Aggressive

Yes, the accountants looked the other way. Yes, we need to send the crooks to jail. But most of the damage wasn’t done by fraud, but by folly.

accounting” became fashionable and managements were applauded for their ability to “push the envelope”; we now know that the really new component of the “New Economy” was the accounting.)

Sixth, that stable, established telephone monopolies could be transformed into “New Economy” firms based on stock options, buzzwords and hype. (Think, if you can bear the pain, of BCE, Telus, France Telecom, Deutsche Telekom.)

Seventh, that replacing dividends with stock buybacks was automatically in the stockholders’ interests. (Not if top management’s personal stock options benefit from those buy programs. Warren Buffett, a long-time fan of stock buybacks, is also a long-time foe of stock options.)

On that point, it is worth recalling Friedman’s long-held belief that companies should pay out most of their earnings in dividends, letting investors make personal decisions as to the reinvestment of those funds. Letting companies keep too much cash “in the corporate cookie jar” constitutes, he argued, too much temptation.

That insight was ridiculed during the mania. Companies overinvested in new plants, new equipment, and putting their names on new sports stadiums. They bought back billions of dollars of their companies’ shares to offset the dilution from exercise of management’s stock options. The prices paid for those shares seem ludicrous now, but no more ludicrous than the theory that justified those “investments” in the first place. Puzzle question: name one major company with a stock option program whose stock buybacks since 1998 have proved more beneficial for investors than paying those moneys out in dividends.

Yes, there has been fraud, and yes, the accountants have looked the other way. Yes, we need to send the crooks to jail. But most of the damage wasn’t done by fraud, but by folly.

What capitalism must now demonstrate is that it is truly a performance-based system: the people in Silicon Valley and Wall Street who created that Nasdaq monster should be fired—a very few for fraud, and very many for foolishness.

Milton would approve.

Donald Coxe is chairman of Harris Investment Management in Chicago and of Toronto-based Jones Heward Investments. His column appears every week. dcoxe@macleans.ca