SRI Notes

Book Recommendation

I've just finished Dan Ariely's Predictably Irrational, and recommend it to anyone who wants to learn more about behavioral economics.  Ariely is a leader in challenging conventional economic wisdom, and provides empirical evidence of many situations where conventional economic analysis doesn't work well.

I was going to write in this post about the similarities and dissimilarities between this book and Freakonomics, which we've discussed here in the past.  But, procrastination pays once again - Ariely yesterday wrote a note on this himself (read it here). 

The books are similar in many ways, but taken together they frame a multi-disciplinary debate about how far economic analysis takes us.  Behavioral economists are challenging some fundamental assumptions economists like to make about human behavior.  It seems to me they are winning some and losing some, depending on the situation being analyzed - reading both of these books will give you a good sense of whose model might be better in a given situation.

A nice summary of the rise of behavioral finance can be found at Robert Shiller's website.

The Owner vs. The Boss

Who controls the corporation?  Most economists and investors would say "the shareholders."  Even proponents of stakeholder theory agree that shareholders should have a significant say in how a firm conducts itself.  In 2005 Jean-Paul Page wrote an excellent little book entitled Corporate Governance and Value Creation for the CFA Research Institute.  It's a think piece on the role of corporations in society, written from first principles ("corporate governance begins with power") and a deep awareness of the contending schools of thought in the field.  After much deliberation Page concludes that this should be the first commandment of corporate governance: 

The ultimate power in a company must rest with its shareholders.

It's not hard to come up with an illustration for why this must be so:

Let's say you own an apartment building, and have hired a management company to run it.  You're planning to sell the building in a year or so, so you decide to only do cosmetic maintenance.  You authorize minimal repairs, but instruct the manager to put off major issues, if possible, for the next owner to deal with.  Seeing this, the management company decides to hold back a portion of the rent payments you receive and 1) gives itself a raise and 2) begins managing the property as if they, not you, were the owner.

What would you do in this situation? 

It is not an academic or hypothetical example.  It is an almost exact description of what is happening in corporate America today.  Enthused by the prospects of a sale (to private equity, perhaps), and pressured by performance-driven compensation structures, shareholders are becoming more short term-oriented than ever.  As discussed many times here, time horizons have shortened to microscopic levels - the average turnover on the New York Stock Exchange is 100%, suggesting the average investor is looking out about one-year.  Since many shares never trade (think of all that low cost-basis stock in bank trust accounts), the de facto time horizon for a given trade is even shorter than that.  People don't own stocks anymore, they rent them.

And the managers hired to run the business are increasingly treating the owners like tenants.  Let me rephrase the story I just told you:

Let's say you manage an apartment building for an absentee landlord.  Inattentive, fickle, and unsophisticated, this person is trying to sell the building for a quick profit.  You've been authorized to do only cosmetic maintenance - putting off major issues for the next owner to deal with.  After thinking it over, you decide to hold back a portion of the rent payments you receive and 1) give yourself a raise (you need to get more money up front - who knows what the next owner will think of you?) and 2) begin managing the property from a longer-term perspective (the owner may not care if the building falls down the day after the sale, but you do).

In the latest Business Week, Clayton Christensen and Scott Anthony present the clearest defense I have seen of management's perspective ("Put Investors in Their Place").  "Why," they ask, should management "pander to people who now hold shares, on average, less than 10 months?  Should managers really regard such investors, whose investment horizons are shorter than the most nearsighted of managers, as stakeholders whose value they ought to maximize?"

Well, game on.  The battle for control of the corporation is now clearly out in the open.  Large pools of equity capital, sophisticated investment banks, and leading management consultants are offering alternatives to the longstanding model of public ownership of U.S. corporations.  If that model cannot be fixed, and soon, society will face a significant loss of corporate transparency and accountability, as companies are taken private.  Christensen and Anthony point out that companies in Asia, such as Tata (India) and Li & Fung (Hong Kong) are doing exceptionally well without the help of day traders and corporate governance activists. 

Christensen and Anthony argue that this will come with social benefits.  Their script for managers reads:  "Our responsibility is to maximize the long-term value of this company.  We will therefore act in the interest of those whose interests coincide with our long-term prospects, namely employees, customers, the communities in which our employees live, and the minority of investors who plan to hold our securities for several years."

It is a noble goal.  But the choice is not a simple one.  Should social investors be prepared to sign away Page's "ultimate power" to get the social benefits (which, after all, are just a promise)?  Or is it time to start looking for a new management company?

The Man With the Iron Face

In the midst of this excellent article on the Chinese banking system, there is a pretty inspiring profile of Li Jinhua, China's Auditor-general.  There is so much interesting material hinted at in this article (e.g., a brief mention of a jailhouse interview in Las Vegas with accused embezzlers from Kaiping) I hope the authors, William Mellor and Le-Min Lim are considering writing it up as a book. 

Corporate Crime Blog

Just discovered this excellent corporate crime blog, written by two law professors.  It includes some recent commentary on KPMG, Tyco, and other cases.

The Economist on Accounting Firms

An interesting article this week questions whether the government could afford to indict one of the remaining Big Four firms.  If KPMG (which has already admitted culpability in a major tax case) were indicted and (inevitably) fired by most clients, who would replace them?  Here are two  choice quotes:

   
• "Still, most believe an indictment is unlikely... Boards would be loth to retain an indicted auditor, especially after seeing former directors of Worldcom and Enron pay millions of dollars out of their own pockets to settle investors' lawsuits stemming from accounting scandals."
   
• "Already, regulators worry that there are to few auditors for the industry to be competitive.  The Big Four dominate the audit of big, listed multinational companies because second tier firms lack the capacity and the international networks needed for the job.  In certain industries, such as oil and gas, concentration is especially acute, with only two or three auditors ruling the market."

We live in peculiar times.

Recommended

Not really a secret as it moves up the best-seller lists, but Freakonomics deserves the praise it's received. At least two chapters - one on the finances of a Chicago crack gang, the other an account of the rise and fall of the Ku Klux Klan - could be books themselves.

The praise is not unanimous.  Some economists have criticized Levitt's methods as imprecise or worse.  Salon complains that he doesn't offer solutions to the problems he identifies.  For my own part, I can't say I'm comfortable with the breathless attempts to turn him into a celebrity.  And the title is...not good.

But Levitt's work is very important to social investing. Several of his studies demonstrate that cheating pays in some professions. And he has pioneered analytical techniques (mainly of question framing) that make it possible to detect cheaters in situations you might not have expected. Social investors would do well to borrow some of those tricks.

And yes, there is a blog.  Levitt and co-author Dubner helpfully give a list of their negative reviews here.

Strong Study on Executive Pay

Jeff makes the point that when you see one of these corporate disasters, there's usually an executive pay issue lurking in the background. If I had to pick one indicator of the strength of a company's corporate governance, it would be executive pay, simply because it's where the temptation is greatest.

For many years Graef Crystal was a voice in the wilderness on this issue, but now mainstream academics are documenting some of his claims. In November Lucian Bebchuk of Harvard Law School and Jesse Fried of Boalt published a book version of their academic work on executive pay. Like Crystal, they find that levels of executive pay don't correlate with observable measures of performance. They also find a trend of rising pay as a percentage of earnings: They calculate the top five executives at the average company got pay equal to 4.8% of earnings in 1993-1995. By 2001-2003 that figure had more than doubled, to 10.3%.

They have also written a paper criticizing Raines's pay at Fannie Mae. Since Fannnie Mae is a large holding for social investors (#22 in the Domini Fund, #7 in KLD Social Select), this should be more than a passing concern.

I'm voting proxies at the moment and see plenty of resolutions on executive pay, but they usually have significant flaws. Many are overly prescriptive or punitive, others would be easily circumvented. Governance experts and social investors need a better plan for dealing with this important issue.

The Christian Science Monitor has an interesting article on this, including some commentary on Calvert's recent initiatives, here.

What We Don't Know About Enron

Maybe a lot, according to a new book by Kurt Eichenwald. He argues that Skilling and Lay may not have committed crimes, although Fastow almost certainly did. One reviewer comments:

Enron's executives made mistakes, and some committed serious crimes, but today's near-universal depiction of the company as a gang of evil crooks obscures the most important lesson of the saga: The differences between Enron and today's corporate success stories are smaller and more complex than they seem...

Eichenwald's Enron, in other words, was neither a teeming hive of crooks, nor, equally ludicrous, a convent of gentle innocents mugged by senior management thieves. Rather, it was a Petri dish designed to nourish hyper-growth, for better and for worse. In Enron's fast and loose culture, engineered by Skilling, blessed by Lay, revenue producers were deified and managers stiffed. Finance and accounting were transformed from bean-counting functions to profit centers (a terrible idea). Business development executives were paid not on value created but on contracts signed, with execution left to dull managerial types. In the 1990s, with the economy and stock-market booming, this culture allowed the company to vault from being an obscure operator of gas pipelines to a global trading powerhouse. It also created a testosterone-charged, me-first atmosphere in which mistakes, risks, and early-warning signs were trampled in a hungry stampede.

But these problems affect other companies, too, especially during a boom. So even with this potent fuel, Enron needed a catalyst to become a fireball. As Eichenwald tells it, his name was Andy Fastow...

OK, the reviewer's Henry Blodget, who brings his own...perspective...on that era. But I think the point is well-taken. Understanding exactly what happened at Enron is really important. The name has become synonymous with corporate malfeasance and anyone who ever touched the company has been tarnished (ask Paul Krugman).

But hardly anyone can tell you what really caused the collapse. Blodget correctly notes that it wasn't the executive pay or the corporate jet.

My take is that the company's senior management confused its business with its stock price - or perhaps more accurately, they made the stock price the company business. With their balance sheet massively levered to the stock, a significant correction turned into a fatal liquidity trap. Blodget says Fastow, incredibly, did not even have a debt maturity sheet. It probably would have been helpful, as things got out of hand, to know exactly how much money the company owed and when it was due.

Another interesting review of the book is here.

Corruption and Valuation

Transparency International got some media attention last week as the UN declared December 9 "Anti-Corruption Day".  The World Bank also supported this initiative. 

It turns out that Transparency's corruption measures also have investment significance.  Charles Lee and David Ng of Cornell University have done a strong study on the impact of corruption on corporate valuation.  They find that markets punish companies that operate in more corrupt countries by awarding them lower valuation ratios (Price/Book and Price/Earnings).

Socialfunds.com has a good summary of the study, which won last year's Moskowitz Prize.