Bull!

by Maggie Mahar

  45. William Gross, interview with the author. To be fair, it is worth noting that Pimco is a highly lucrative business: its “load” funds are not inexpensive. Nevertheless, the company’s advertising is, by Wall Street standards, low-key, not to mention honest, and long-term returns on Pimco’s bond funds suggest that investors were receiving value for their money.

  46. Richard Teitelbaum, “Getting the Most from Your 401 k,” Fortune, 25 December 1995, 183.

  47. Jeffrey M. Laderman, Business Week, 17 December 1993.

  48. The Washington Post, 24 June 1994, ho1.

  49. In Irrational Exuberance, Robert Shiller debunks “the widely cited ‘fact’ that in the United States there have been no 30-year periods over which bonds have outperformed stocks. The supposed fact is not really true,” Shiller writes, because as Jeremy Siegel pointed out in his book Stocks for the Long Run, stocks underperformed bonds in the period 1831 to 1861 (15). “That may seem a long time ago,” Shiller notes, “until one realizes that there are not many non-overlapping 30-year periods in U.S. stock market history: only four complete periods since 1861. Given the relatively short history of 30-year periods of stock market returns, we must recognize that there is little evidence that stocks cannot underperform in the future.”

  There are, of course, hundreds of ways of slicing and dicing “long-term” stock market returns: before inflation, after inflation, with or without dividends, over 10 years, over 20 years, since 1926, since World War II…. Financial pundits have used all of them in their search for a rule of thumb that will predict the future. In fact, there is no rule. All that can be said with certainty is that the future is unpredictable. This is why, over any 10-year period, stocks are riskier than, say, a 10-year Treasury bond that promises to pay 4.5 percent a year for 10 years, as long as the investor is willing to hold the bond until it matures.

  Shiller sums up the difference between stocks and bonds: “Stocks are residual claims on corporate cash flows, available to shareholders only after everyone else [including bond holders] has been paid. Stocks, therefore, are by their very definition, risky. Investors have also lost sight of another truth: that no one is guaranteeing that stocks will do well. There is no welfare plan for people who lose in the stock market” ( Irrational Exuberance, 195).

  50. “Equity Ownership in America, 2002” broke households down by total financial assets instead of income, the results again showed that less affluent investors came to the market later. See note 32 above, and see table “Who Owns Stocks?” Appendix, pages 463–64.

  51. For more of Cassidy’s story, see Chapter 1.

  CHAPTER 8

  1. Chanos, the short seller who exposed Enron’s bad accounting at the beginning of 2001, made the remark in a 2002 interview with the author.

  2. Shawn Tully, “What CEOs Really Make—Salaries and Compensations,” Fortune, 15 June 1992, 94.

  3. Under IRS rules, employees pay income taxes on the gain they receive when they exercise their options, while their company receives a tax deduction equal to the gain.

  4. John Byrne, “Executive Pay: The Party Ain’t Over Yet,” Business Week, 15 April 1993, 56; James Kim, “CEOs Cash in Options for Record Pay,” USA Today, 16 April 1993, 2B; Christi Harlan, “High Anxiety: Accounting Proposal Stirs Unusual Uproar in Executive Suites—FASB’s Stock-Option Plan Threatens Pay Packages: Lobbying Gets Intense—A Risk to High-Tech Firms,” The Wall Street Journal, 7 March 1994; Brian Dumaine, “A Knock-out Year for CEO Pay,” Fortune, 25 July 1994, 94.

  5. Amanda Bennett, “Executive Pay: A Little Pain and a Lot to Gain,” The Wall Street Journal, 22 April 1992, R1.

  6. Kathy M. Kristof, “Special Report: Executive Pay—The More Things Change,” The Los Angeles Times, 23 May 1993, 1.

  7. John Byrne, “The Party Ain’t Over Yet. SEC filings showed that Hirsch paid $12.25 a share for the 163,835 shares he sold in July of ’92 at $90.15 to $95.64 (for a total of $15.3 million). See Georgette Jasen, “Four Executives Display Good Timing on Stock Moves,” The Wall Street Journal, 19 August 1992, C1.

  8. See Chapter 19 on insider selling.

  9. Andy Kessler, a partner in Velocity Capital Management, made the remark in an op-ed piece that he wrote for The Wall Street Journal, “Manager’s Journal: The Upside-Down World of High-Tech,” 19 July 1999.

  10. Christi Harlan, “High Anxiety.”

  11. Christi Harlan, “High Anxiety.”

  12. Maggie Mahar, “Wall Street’s New Top Cop: Levitt Relishes Ambassadorial Duties, but Is He Tough Enough?” Barron’s, 22 November 1993, 10.

  13. Levitt was president of Shearson’s predecessor. See Scott McMurray, “At a Crossroads: Continued Survival of Amex Is Threatened as Its Listings Decline,” The Wall Street Journal, 2 July 1985.

  14. Arthur Levitt with Paula Dwyer, Take on the Street: What Wall Street and Corporate America Don’t Want You to Know (New York: Pantheon, 2002) 7.

  15. Maggie Mahar, “Wall Street’s New Top Cop.”

  16. Maggie Mahar, “Wall Street’s New Top Cop.”

  17. Arthur Levitt with Paula Dwyer, Take on the Street, 10.

  18. Arthur Levitt with Paula Dwyer, Take on the Street, 9–10.

  19. Arthur Levitt, interview with the author.

  20. Levin drew this figure from the Executive Compensation Report’s survey of 1,100 companies. The 1993 figures are included in “Broad-based Stock Options—1999 Update” (William M. Mercer, Inc., 1999).

  21. Arthur Levitt, interview with the author.

  22. At the time, Shelby was a Democrat. The following year, he would cross over to join the Republican Party.

  23. Member of Levin’s staff, interview with the author. All quotations from the hearing are drawn from a transcript of the meeting and written testimony submitted at the time of the hearing.

  24. Unfortunately, most Wall Street analysts lacked the training to competently evaluate the effect of options packages on earnings—even if they had the time and inclination. And the effect was substantial: In 2002, Bloomberg News columnist David Wilson reported that Microsoft, IBM, and Intel were among 11 members of the Dow whose fiscal 2001 net income would have been at least 10 percent lower if they had accounted for options. That group included Alcoa—which, if it had expensed options, would have had to admit that earnings were 20 percent lower than reported; American Express, 18 percent; General Motors, 38 percent; J.P. Morgan, 37 percent; Minnesota Mining & Manufacturing and Procter & Gamble, 11 percent apiece. Finally, if they had expensed options, Kodak and Hewlett-Packard would have found themselves in the red: Kodak’s option grants in 2001 would have reduced earnings by $79 million (Bloomberg News, 3 April 2002).

  25. The study Bradley referred to, showing that technology companies might have to admit that earnings were only half of what they claimed, was done by the Wyatt Company, a consulting company that focuses on human capital and financial management.

  26. Arthur Levitt with Paula Dwyer, Take on the Street, 108.

  27. Arthur Levitt, interview with the author.

  28. For examples of companies taking on debt to finance buybacks designed to offset the dilution caused by options programs, see Chapter 16 (“Fully Deluded Earnings”), which discusses the enormous losses Dell suffered after issuing call options to finance its employee stock options.

  29. As James Montier, a global strategist at Dresdner Kleinwort Wasserstein has pointed out, the fact that dividend payouts tend to cause a drop in share prices “gives management a clear incentive to reduce dividends.” (For the outside shareholder, the drop in share price is offset by the dividend, but an insider sitting on a pile of options receives no dividend.) Montier made the remark in a Q&A published in welling@weeden, 19 April 2002.

  Instead of paying dividends, many companies stepped up share buyback programs. For an executive holding options, buybacks offered two advantages: (1) the announcement of a buyback program tended to boost share prices (whether or not the company ever followed through on the repurchase schedule), b
oosting the short-term value of his option, and (2) buybacks masked the dilution caused by options grants.

  Meanwhile, management assured shareholders that they were cutting back dividends so that they could “enhance shareholder value” by plowing capital back into their companies. Often, they pointed to share repurchase programs as a better way to enhance value.

  But even later in the decade, the net effect of the much-touted share repurchase programs remained “minuscule,” Montier noted. “All of 50 basis points [one-half of one percent] was added by buybacks in 2001, for example…There was this huge myth about stock repurchases—that they had been a benefit to investors.” In fact, throughout the nineties, “In general, investors would have been substantially better off if managers had returned the cash to them, rather than investing it for them.” (For charts and a fuller description of Montier’s research, see welling@weeden, 19 April 2002, 6 [www.weedenco. com/welling/contents]).

  For the full effect of options programs on earnings, see Chapter 16 (“Fully Deluded Earnings”).

  30. Bunt’s transaction as reported in “Insider Trading,” Orlando Sentinel, 2 November 1998, 23. From January of 1998 to October of 2000, Bunt exercised the right to buy some 124,000 shares. In addition to the 25,000 shares sold in October ’98, he exercised the option to buy 15,000 shares in January of 1998 and immediately sold them at $76.69, netting a little over $50 a share. On January 23, 2002, he unloaded some 34,000 shares. By year-end, GE’s share price had fallen more than 32 percent since the date of his sales on January 23.

  31. “Over his lifetime, he [Senator Lieberman] ranked #13 among his Senate colleagues for contributions from the securities and investment industry, having collected $652,000; and has gotten more than $101,000 from the computer industry.” See “Wall Street Winners and Losers,” PublicCampaign.org, 23 July 2002.

  32. Miriam Hill, “Federal Accounting Standards Board Relies on Large Firms for Research, Advice,” The Philadelphia Inquirer, 24 February 2002.

  33. Citing the National Center for Employee Ownership and the Bureau of Labor Statistics, David Leonhardt reported these numbers as “the best estimates available” in “Corporate Conduct: Compensation: Stock Options Said Not to Be as Widespread as Backers Say,” The New York Times, 18 July 2002.

  34. Thomas Donlan, “Optional Equity,” Barron’s, 22 July 2002. See also David Leonhardt, “Corporate Conduct.”

  35. See Jennifer Reingold, “Executive Pay: The Numbers Are Staggering, but So Is the Performance of American Business. So How Closely Are They Linked?” Business Week, 19 April 1999, 72.

  36. “Internally, companies value options all the time,” according to TIAA-CREF chairman and CEO John Bigg’s testimony before the U.S. Senate Finance Committee on April 18, 2002. “I can assure you that company executives and compensation consultants routinely use the Black-Scholes model to value employee options.”

  Various economists have developed various formulas to price options; the most popular is the Black-Scholes model, developed by economists Fischer Black and Myron Scholes, who won a Nobel Prize in economics for his work on the model.

  But in its proposal, FASB did not insist that companies use the Black-Scholes model when expensing options. It left the question open for public comment. Honest men might disagree on what formula to use, but no one could honestly argue that employee stock options had no value.

  FASB did, however, insist that options be expensed when an employee receives them.

  Some observers would object: Why should a company measure the expense of an option and subtract it from profits before it is exercised? Why not wait until the executive exercises his options—at that point, the value is clear: it is the difference between the price he pays and the market price the day he exercises his options.

  But the cost to the company is the cost of the option as a substitute for other forms of employee compensation, based on its value when the employee accepts options in lieu of cash compensation. That means that the value must include the risks involved, including the risk that the option will expire before the stock rises to the strike price. For this reason, the value at the time the options are issued may be significantly less than the profit that the employee might make. Particularly in a bull market, if companies were forced to expense options based on the full profit that the executive made when he exercised the option, the expense would, in most cases, turn out to be much larger than the value of the option when it was issued—with all of the uncertainties attached to its value at that time.

  Admittedly, in the case of employee stock options, “the difficulty [of valuing them] is increased,” Buffett acknowledged, “by the fact that options given to executives are restricted in various ways.” For example, the executive cannot trade the option on the open market, and often he must wait several years before he can use the options to buy shares. “These restrictions restrict value,” Buffett noted. “But they do not eliminate it.”

  37. “A Knockout Year for CEO Pay,” Fortune, 25 July 1994.

  38. Merton Miller and Graef Crystal, “Big Bucks for Big Execs: Who Pays for the Golden Egg?” The Washington Post, 20 March 1994, cO5.

  39. Arthur Levitt, interview with the author.

  40. Arthur Levitt, interview with the author.

  41. Arthur Levitt with Paula Dwyer, Take on the Street.

  42. Business Week published a list (see below) of the CEOs’ “treasure chests” based on the market price of the shares at the end of the year. (John Byrne, “Special Report: CEO Pay: Ready for Takeoff,” Business Week, 24 April 1995, 88.)

  43. Jeffrey Taylor, “Bill Curbing Investors’ Lawsuits Wins SEC Support of ‘Safe Harbor’ Provision,” The Wall Street Journal, 17 November 1995, A2.

  44. Prepared witness testimony given by James Chanos on February 6, 2002, to the House Committee on Energy and Commerce in March of 2001. Business Week Online reported on how the Safe Harbor Act had reduced litigation: “Cases frequently take a year longer to get before a jury, and the cost of simply filing a suit has risen to more than $500,000 in some instances, plaintiffs’ attorneys say. The odds of winning have also decreased. Before the passage of the Reform Act, 12% of all cases were dismissed outright by judges. That number has increased to 28% since the law was passed.” Mike France, “This Crash Won’t Make Lawyers Rich,” 26 March 2001.

  45. Jim Chanos, interview with the author.

  46. Jeffrey Taylor, “Bill Curbing Investors’ Lawsuits Wins SEC Support of ‘Safe-Harbor’ Provision,” The Wall Street Journal, 17 November 1995, A2.

  47. Anne Kates Smith, “News You Can Use: Some Call It Securities Reform but Most Consumer Groups Think a Pending Bill Will Severely Crimp Investors’ Rights,” U.S. News & World Report, 13 November 1995, 117–18.

  48. According to LiteralPolitics.com on January 23, 2003, “Ruder made the statement to The New York Times in 1995.”

  49. Robert A. Rosenblatt and Gebe Martinez, “House Rejects Clinton Veto of Bill Restricting Fraud Lawsuits; Securities: Chamber Overrides President in 319–100 Vote,” The Los Angeles Times, 21 December 1995, 1.

  50. Robert A. Rosenblatt and Gebe Martinez, “House Rejects Clinton Veto of Bill Restricting Fraud Lawsuits.”

  51. Jeffrey Taylor, “Congress Sends Business a Christmas Gift—Veto Is Overridden on Bill Curbing Securities Lawsuits,” The Wall Street Journal, 26 December 1995, A2.

  CHAPTER 9

  1. Charles MacKay, Extraordinary Popular Delusions & the Madness of Crowds (New York: Three Rivers Press, 1980), 394. Here, MacKay describes the role of the chivalric leaders during the second, more organized, stage of the Crusades.

  2. Richard Russell’s Dow Theory Letter, 18 January 1995; 19 July 1995.

  3. To define the third phase of a bull market, Robert Rhea, the great Dow Theorist of the 1930s, wrote, “The final stage of a bull market is sometimes recognizable because people then buy stocks simply because they are going up, or because other people are buying. They consider it old-fashioned to regard earnings
or prospects.” Richard Russell’s Dow Theory Letter, 18 December 1996.

  4. The survey also revealed that many in the second-most affluent group (those with assets of $100,000 to $500,000, not including their homes) came into the market before 1990: 55 percent reported making their first purchase before the decade began, while another 25 percent bought their first stock sometime between 1990 and 1995. See “Equity Ownership: Characteristics by Household Financial Assets,” Investment Company Institute, Securities Industry Association. Gail Dudack reported on this survey in her October 2, 2002, research report.