Bermuda: Corporate Villains Were Yesterday’s Heroes
LOM Weekly Perspectives

The Worldcom shell that landed last week rattled already frayed investor nerves. Renaming it "Worldcon", the New York Times gave vent to the prevalence of cynicism among just about everybody. It is highly doubtful that we have seen the last of such fraud cases. According to the well-known cockroach theory, more instances of corporate misdemeanour are sure to turn up. Managers had a virtual free hand in the glory years, to implement all sorts of schemes to enrich themselves and to please the bevy of investors, who responded with great enthusiasm while the going was good. Compliant boards of directors, co-operative auditors, supportive analysts, obliging media, all did their part.

Currently, amidst the finger pointing and accusations, it appears that the media have got off quite lightly. Normally, they peddle a mixture of ideology, information and entertainment, in variable proportions, depending on the circumstances. In the environment of the late-nineties bubble period they played an important part in helping to puff up the balloon. Corporate leaders were praised effusively and substantive critiques were notable by their absence. However, investors were also at fault in forgetting to separate information from opinion. And, as far as the latter is concerned, of asking how well-founded it was. Many investment decisions were taken quickly, on the basis of media reports and precious little analysis.

It is hoped that investors have learnt a lesson from all this and are now armed with more critical mental weapons to filter out as much of the dubious stuff as possible. Avoiding opinion-makers and investment fashion columnists, is a wise course to take - - at any rate, if you are not a short-term trader. Being sceptical of conventional wisdom and having a contrarian turn of mind often pays off, at the very least, in avoiding the common traps that crowds fall into.

Two elemental emotions in the market are fear and greed, to which we can also add a third one: anger. By and large, investors were prepared to turn a blind eye to corporate misdemeanours if the market hadn't swooned. Now that the market is not about to levitate substantially people are looking for some retribution. So the politicians have got into the act of addressing corporate bad behaviour, and it appears that a paint job, alone, will not be enough. However, the extent of real change will be limited by the fact that investment bankers, accounting firms and corporate managers have considerably more political clout than Main Street investors.

Maximising shareholder value is supposed to be the principal goal of managers. But how this is accomplished and the extent to which the interests of employees, customers, suppliers and governments are also addressed varies over time. Changes in incentive schemes in the nineties were supposed to have aligned management objectives with those of shareholders by giving the former a stake in the performance of the company’s shares. Unfortunately, this scheme backfired by giving them the motivation to bloat the market value of common equity by any means, fair or foul. Correcting this fault will not be easy, as it requires the reformation of the system of corporate governance that will be hard to do because powerful and privileged interests are involved.

Business history has, in the past, been punctuated by periods of bad behaviour, resulting in subsequent measures of reform and ultimately the return of investor confidence. At present, a reasonable assessment is that while the equity culture is not dead it is somewhat bruised. In earlier phases, such as the 1970’s, it remained relatively dormant for a longish time because the structural environment was characterised by a number of lingering negative factors. We can look upon the current corporate travails as being part of the process of creative destruction that will eventually result in a renewed upswing. But there is no need for a prolonged bear market to ensue, as some have argued -- just an extended period of consolidation and adjustment.

Investors yearn for a short-term rally

Investor sentiment has swung about a lot this year. It has changed from the initially optimistic "Here comes the money" to "Show me the money" to "How real is the money?" Things remain pretty unstable, but after quite a bit of sell-off recently, some people are looking for a short-squeeze rally -- given the extent of short positions and the rise in volatility measures. But for the rally to be sustainable requires greater confidence in the longer-term outlook.

Institutional investors are big players in the equity market. In the halcyon days of the nineties, pension funds, endowments and life insurance companies had increased their asset allocation sharply in favour of equities. Currently, with the bond market outperforming the equity market their portfolios are probably over-weighted towards fixed income and require re-balancing in favour of equities if they wish to maintain their required allocation. This means that they should be a supporting factor on the equity buy side. Of course, if their long-term view of stocks becomes more pessimistic then they may change their strategic allocations in favour of bonds, which will mean less support for equity prices.