It's rare that the Wall Street Journal's editorial page carries two completely erroneously-reasoned, ill-logical and, frankly, bone-headed pieces in the same day. But yesterday was such a day.
The two editorials to which I refer, of course, are "Are Executives Paid Too Much?" by Judith Samuelson and Lynn Stout, and "We Cannot Delay Health-Care Reform" by Senators Max Baucus and Teddy Kennedy. I'll deal with the first piece in this post, and the second in a later one.
In order to make the most focused, germane comments possible, I'll intersperse my remarks between the italicized text from Samuelson's and Stout's article.
"Our economy didn't get into this mess because executives were paid too much. Rather, they were paid too much for doing the wrong things."
This is true. I have long held, going back to the early 1990s, well over fifteen years ago, as a result of my proprietary equity research, that senior executives should be granted incentive compensation as a function of a five-year-lagged difference between their firm's total return and the S&P500 Index. Thus, Samuelson and Stout are observing nothing new whatsoever.
"In the summer of 2006, well before most economists had any inkling of the calamity that was about to unfold, the Aspen Institute brought together a diverse mix of high-level business leaders, investment bankers, governance experts, pension fund managers, and union representatives. When you put successful people with such disparate and conflicting backgrounds and loyalties together in the same room, the result can be a shouting match. But the members of the newly formed Aspen Corporate Values Strategy Group found they shared an unprecedented consensus: Short-term thinking had become endemic in business and investment, and it posed a grave threat to the U.S. economy."
I wonder what a "governance expert" is? Who is s/he? What are such a person's credentials? This seems like another one of those loony "institutes" cooked up by so-called experts on the outside, with no prior, inside experience actually doing any of that about which they opine.
Honestly, the term "Aspen Corporate Values" seems a contradiction in terms to begin with. The entire name of the group seems an amalgam of feel-good, sound-good business terms with no discernible meaning.
"This collective myopia had many causes. One cause, the Aspen Group concluded, was the demands of the very shareholders who are now suffering most from the stock market's collapse. It is extremely difficult for an outside investor to gauge whether a company is making sound, long-term investments by training employees, improving customer service, or developing promising new products. By comparison, it's easy to see whether the stock price went up today. As a result, institutional and individual investors alike became preoccupied with quarterly earnings forecasts and short-term share price changes, and were quick to challenge the management of any bank or corporation that failed to "maximize shareholder value."
The authors are wrong in their basic contentions, as expressed in this paragraph.
It is precisely the company's total return that is the sum total and expression of whether the company is "making sound, long-term investments by training employees, improving customer service, or developing promising new products," as such activities add comparative value for that enterprise.
To denigrate the maximization of shareholder value per se is wrong. Short-term maximization, yes. Again, I wrote about this in a Directorship piece over fifteen years ago. But long term, consistently superior total returns is the hallmark of corporate success. Samuelson and Stout mention this basic, simple and rather obvious concept nowhere in their piece.
"Meanwhile, inside the firm, executives were being encouraged to adopt a similarly short-term focus through the widespread use of stock options. The value of a stock option depends entirely on the market price of the company's stock on the date the option is exercised. As a result, managers were incentivized to focus their efforts not on planning for the long term, but instead on making sure that share price was as high as possible on their option exercise date (usually only a year or two in the future), through whatever means possible.
Executives eager to maximize the value of stock options began adopting massive stock-buyback programs that drained much-needed capital out of firms; jumping into risky "proprietary trading" strategies with credit default swaps and other derivatives; cutting payroll and research-and-development budgets; and even resorting to outright accounting fraud, as Enron's options-fueled and stock-price obsessed executives did."
The authors mix too many examples from vastly differing sectors, and attempt to give the impression all are alike. They are not. Rather than provide credible evidence, the authors simply advertise their lack of understanding of business.
And, for the record, next time, ladies, use the correct, pre-existing English language term, "incented," rather than the made-up, goofy-sounding "incentivized."
Did "massive stock-buyback programs" drain "much-needed capital out of firms?" Perhaps not. When managers believe that their firm's equity is undervalued, it is a reasonable use of resources to buy some of that equity back, then reissue it when investors realize the intrinsically higher value later on. Of course, if an inept management is, in fact, destroying value, then buying back stock hastens the proper result- withdrawal of capital from an ailing firm.
Samuelson and Stout miss this fact entirely, railing instead at any withdrawal of capital from any enterprise. In effect, the authors of the editorial seem to claim omniscience, implying that any cost-cutting of R&D budgets, staff, or mitigation of risk with reasonable employment of hedges via derivatives, are wrong on their face.
The business world is not that simple, but, evidently, Samuelson and Stout are, in their own mindset.
"The system was perfectly designed to produce the results we have now. To get different results, we need a different system.
To get business back on track, the Aspen Group concluded, it is essential to focus on not just one but three strategies: designing new corporate performance metrics, changing the nature of investor communications, and reforming compensation structures.
Starting with metrics, we need new ways to measure long-run corporate performance, rather than simply relying on stock price. In terms of investor communications, companies need to ensure corporate officers and directors communicate with shareholders not about next quarter's expected profits, but about next year's and even next decade's."
The authors begin this passage correctly. A change is required, and it is the change about which I wrote for my Directorship article over a decade ago. It's simple and requires no new measures, just the extension of the measurement of existing ones over more years, and subtracting the free ride of the S&P500's effect on corporate total return over five-year periods, in arrears.
The idea that any corporate officer can speak with clarity and credibility concerning expected profits over a year in the future is ludicrous. A decade? What are these women smoking? The only thing that would arise from such practices is frivolous shareholder lawsuits.
Oh, wait. I get it. Lynn Stout is a professor of corporate and securities law at UCLA. Makes sense. Demand that business executives make more litigation-producing earnings forecasts. Great business for law school grads, eh?
Only a lawyer out of touch with real business could write that and believe it has any relationship to the modern, fast-paced world of global business. Company fortunes can change in just a few years, due to competitive actions half a world away.
"Finally, and perhaps most importantly, companies must change the ways they reward not only CEOs and midlevel executives, but also institutional portfolio managers at hedge funds, mutual funds, and pension funds. Executives and managers should be rewarded for the actions and decisions within their control, not general market movements. Incentive-based pay should be based on long-term metrics, not one year's profits. Top executives who receive equity-based compensation should be prohibited from using derivatives and other hedging techniques to offload the risk that goes along with equity compensation, and instead be required to continue holding a significant portion of their equity for a period beyond their tenure."
Huh? You're going to forbid an executive from hedging stock options? I seriously doubt that is legal. And, anyway, all that will happen is that they will find a way, or some smart trust attorneys (wow, there are those smart lawyers again) will find it for them, to have an unrelated trust or a family relation hold the hedged position.
And how in the world can you not compensate "institutional portfolio managers at hedge funds, mutual funds and pension funds" based on their correct bets on market index movements? Not everyone invests directly in equities. Or even equity options. Some managers simply buy and sell indices and their options.
Mutual fund managers rarely, if ever, are paid incentive compensation by customers. Perhaps by the firm's managment, but not the customers directly. Hedge and pension fund managers, if they have 2/20 compensation, typically have their "20" subject to a high water mark, i.e., they can't get incentive compensation when the value of the fund declines, until the fund value rises above the prior highest value. Some funds even have escrows which hold back the 20% incentive fees for a year or more, so the manager doesn't even receive that money if short results are reversed. Samuelson and Stout once again display their naivete about that which they write so emphatically.
It's clear Samuelson and Stout aren't living in the real world of business and finance. Perhaps too much time in that Rocky Mountain air?
"So long as our metrics, disclosures and compensation systems encourage executives and institutional fund managers to look only a year or two ahead, we have to expect that that is what they'll continue to do. It's time for a long-term investment in promoting long-term business thinking."
Well, their conclusion is correct. But, as I noted in my first remarks to their opening paragraphs, this is not a new idea by a long shot. Their overall goal is fine, but their details are all wrong. And completely lacking in common sense, real world applicability, and credibility.
I wonder how this piece of bad reasoning ever made it onto the Journal's editorial pages.
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