There’s one last factor that I want to introduce at this point. I said earlier that the complexity of the tax code does not lead directly to the excesses of the Enrons and Andersens of this world. There isa piece of that code, how- ever, that can be blamed for many of those excesses.
Simply put, in our system, dividends are taxed more heavily than cap- ital gains. The not-so-surprising result is that investors prefer to earn their returns in the form of capital gains rather than dividends. This, in turn, means that corporations do their best to pump up their stock prices. In the- ory, of course, a rising stock price can (and should) reflect a company that is increasing in value. Far too often, though, a company’s leaders are tempted to play games with their earnings in order to get stock-price increases that they have not actually “earned.”
Companies like Enron make an unhealthy transition when they play this game. They start out by playing some sort of genuine role in the economy—
producing valuable goods or services, creating value—and slowly turn into caricatures of themselves. They begin playing the “bubble game.” This tran- sition is accelerated when external circumstances go bad or the business model proves to be less robust than was anticipated. Rather than retrench- ing—or, God forbid, giving up!—they become what I call earnings- obsessed.
I should distinguish here between earnings-focused and earnings- obsessed. During the dot-com craze, the more conservative voices in the investment community—the Warren Buffett types—persisted in asking an embarrassing question: Exactly how and when are these high-flying com- panies going to make money? As it turned out, the answer in many cases was “never.” The survivors in the dot-com universe (the Amazons and eBays) accepted their responsibility to make a buck. They became earnings- focused, and this was a good thing—for themselves and for their investors.
Earnings-obsessed is different—in fact, it is almost the opposite. Earn- ings-obsessedmeans manipulating the reportingof value rather than cre- ating value. In many cases, it works—but only for a while. Enron’s executives had the heady experience of having their stock price double in 6 weeks. “The Street” loved them. Somewhere along the line, they started believing their own propaganda. They believed that they had discovered a money machine—capitalizing subsidiaries or pseudosubsidiaries on call options on the price of their stock—and that henceforth the sky was the limit.
So yes, Enron (aided and abetted by Andersen) soiled its own nest through its earnings obsession. However, let’s go back to the beginning of this section. Can’t you make a strong case that we, the investors of the world, have to share some of the blame? If we investors make it clear that we are no longer interested in dividends, why wouldn’t corporations tilt toward
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pumping up the stock price? Keep in mind that executive stock options—
another subject to which I will return later—push in the same direction. The shareholders would rather see their portfolio value soar than be paid healthy dividends, management reasons, and if we go in that direction, we person- ally get richer.
It’s a system with no checks and balances—at least until the bubble pops. And like it or not, we investors are accomplices to that system.
LESSONS FOR INVESTORS
The “appropriate” role of the accounting firm is undergoing a rapid evolution—toward the past.The auditor is supposed to pro- vide independent assessments of a company’s finances. The audi- tor is notsupposed to help pick strategies or structure deals. The recent trend of accounting firms unloading their consulting arms reflects the collective realization that having an accounting firm propose a course of action (consulting) and then passing judgment on the outcome of that course of action (accounting) is riddled with potential conflicts of interest.
The development of a merged and exotic culture between a high-flying company and its accounting firm is almost always a bad thing.This is hard for the individual investor to pick up on, of course, but there are sometimes clues pointing to excessive cozi- ness.
It is increasingly difficult to assign values to assets.Some of the time-honored valuation techniques, such as marking to market, sim- ply do not work well in many contemporary circumstances. The accelerating pace of change, the increasing technology component of many products and services, the difficulty of assessing the future value of an innovation—all make the task of valuation far more dif- ficult.
Beware the disconnect between value and valuation.Maybe the price-earnings ratio is, indeed, old-fashioned and out of touch for today’s markets—or maybe it is not.
Regulation and legislation, although well intentioned, can lead to damaging distortions. For example, taxing dividends more heavily than capital gains provides a huge incentive for “bubble thinking.”
Investors share some of the blame.To the extent that we ignore dividends—a boring but accurate measure of a company’s value- creation abilities—in favor of stock-price appreciation, we may be forcing corporate America into bubble thinking.
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Capitalism 101
At the beginning of this book I implied that we would sometimes go slowly in order to go fast. This is one of those cases. In this chapter I want to get some fundamentals in place as a foundation for later discussions. If the ter- ritory I cover is already familiar to you, feel free to move on.
The territory of this chapter is capitalism—specifically, capitalism as a system of investing money in enterprises. As you will see, a seemingly sim- ple process can become complex quickly.