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of all guest columns written by Dennis C. Butler, CFA
Having money at risk �focuses the mind,� so given their newly acquired stake in the automotive industry, U.S. taxpayers may be interested to learn that the General Motors Corporation was one of the few major enterprises to remain profitable during the Great Depression of the 1930s � quite a feat for any company during that dark period, and one which stands in stark contrast to the record of today�s GM, which has trouble making money even in boom times. How did the decline in this great company�s fortunes come about? One could with some justification point to labor contracts, high costs, poor designs, and so on, but clearly a fundamental cause has been the failure � despite stock options and all the other accouterments of high office in corporate America � to properly align the interests of management with those of the shareholders. As a result, GM management walked away with tens if not hundreds of millions of dollars in bonuses and option gains over the decades, while the value of the owners� stake in the company steadily declined for sixty years. If stock options don�t do the job, what will? Peter Drucker provides us with a clue. The late management guru once said that one of the reasons the Germans lost World War I was because too few of their generals were killed. (Top military leaders were kept a safe distance away from the actual battlefield and hence did not suffer from the consequences of their decisions). Business owners � shareholders � must cope with the risk of losing money. If management feared the loss of their own wealth, perhaps their minds would be more focused on creating and protecting it in the enterprises they oversee.
Today�s managerial and investment fraternity would do well to review the biography of one of GM�s early executives for sobering insights into the risks their predecessors faced in the days before big severance packages. The colorful history of William Crapo Durant, one of the original founders of General Motors, stands in stark contrast to the careers of today�s industrial and financial leaders. Following his ouster from that company in 1920, Durant went on to become one of the great stock market operators of the Roaring Twenties and at one time amassed a fortune of about $100 million (a lot of money in those days). He was no more successful than his counterparts of 2008 in escaping the market crash of his day, which hit his interests hard. After losing much of his remaining fortune in other automotive ventures in the 1930s, he spent his final days washing dishes at a diner somewhere in New Jersey (he owned the eating establishment, but eventually lost that, too, and died a pauper at age 85) � quite a comedown for one of the early masters of the universe. Such is capitalism � you undertake a venture and win or lose. The one-way compensation schemes that prevail in the modern business world short circuit capitalism�s built-in risk-control mechanism. The fear of the possibility of abject failure is necessary, especially when other people�s money is involved.
We could also point to the example of another auto company, American Motors, in the 1950s. When George Romney took over the leadership of that troubled company in 1954, he immediately cut executive salaries and perks, purchased company shares in the open market on an equal footing with other investors, and turned a failing company around.
It is a little unfair to pick on the automakers, since various bailout operations have turned the government into a virtual taxpayer mutual fund focused largely on financial companies. Finance grew rapidly during the last 25 years, becoming a large part of the U.S. economy and stock market in the process. Boom conditions drove rich rewards and it is here where we find compensation schemes run amok, as the top few investment banks alone handed out tens of billions of dollars in bonuses in recent years. Aided and abetted by investment institutions seeking even the slightest yield advantage, the creative dynamism and risk-taking of Wall Street is now well-known to taxpayers, since the Street is now ground zero of the financial crisis. The lure of fees for churning out ever more complex instruments whose risks were little understood was irresistible. Not being contingent on the ultimate outcomes of those risks, a large portion of those fees left the banks in the form of bonuses, never to return. Even now, after writeoffs approaching a trillion dollars, bankruptcies, and bailouts, some folks still don�t get it: one executive had to be shamed into foregoing a $10 million bonus, after his firm had received $15 billion in taxpayer funds to shore up a balance sheet damaged by previous management decision-making.
With the average stock fund down 40% last year, it was hardly surprising to learn that customers removed $320 billion from mutual funds in 2008. Navigating through such a hazardous period proved a daunting task, indeed. The vaunted hedge funds, which would allegedly do well for their well-heeled clientele in any market environment, fell short, prompting many �financially sophisticated� investors to demand their money back, only to find the gates slammed shut on withdrawals. Even some well-known mutual fund managers who had enjoyed extended runs of market-beating results lost 50% and more. International markets fell between 40% and 60%, reversing the sharp gains of prior years. Only a few assets, including U.S. treasuries, produced positive results in 2008. On only two prior occasions, in 1931 and 1907, had U.S. stocks suffered greater declines. This year was clearly one for the history books.
As they look back on this period the historians writing those books may very well describe it in terms such as �overpaid,� �overpaid-for,� and �over-leveraged.� Compensation schemes permitting �entrepreneurial rewards for bureaucratic outcomes� permitted managements of corporations, hedge and mutual funds to walk away with stock option and bonus awards based on short-term accomplishments. The perverse incentives built into such systems led to undue risk-taking with shareholder and client funds that could only pay off under ideal conditions. Home buyers, fund managers, and private equity outfits paid too much for homes, businesses, and securities which they did not understand. It is not much of an exaggeration to view this as a very open (in contrast to the Madoff business) form of �Ponzi Scheme� (buyers assumed they would be able to sell on to someone else at a profit) which came to a screeching halt when the liquidity on which it depended disappeared. Finally, a lot of that �ocean of liquidity,� which coursed so freely through the international financial system just a year or two ago, turns out to have been borrowed money. Now those debts are being recalled.
Selling on the massive scale we saw late in 2008 produces lots of cash, much of which found its way into treasury bills and money funds. A panicky retreat from risk actually resulted in negative yields for some short-term treasuries (in effect, paying the government to keep your money under its mattress). In spite of meager yields, money funds pulled in $422 billion last year. Not having learned their lesson in real estate and derivative securities, buyers of government paper now appear determined to ignore another bubble inflating in these �safe� securities. In an environment of trillion-dollar government deficits for the foreseeable future, which is bound to result in record debt issuance, it seems unlikely to us that purchasers of 10-year treasury bonds yielding little more than 2% will make money unless the positions are held to maturity. But few treasury bonds are held that long � as in any Ponzi scheme, gains have to come from the next purchaser.
In the classic 1950 science-fiction film, The Day The Earth Stood Still, an overwhelming external force threatening their destruction finally convinced earthlings to subdue their violent tendencies. In the face of daunting external threats to their financial security in the form of falling home prices, a stock market collapse, job losses, and rising prices, Americans have paid down some of their debt for the first time since 1952. Debt had reached record levels during the last decade; the pressures have obviously become too much to bear.
Capitalist theory tells us that by pursuing our own individual economic interests we at the same time promote the good of the broader economy. After their lengthy infatuation with borrowing for current consumption and funding affluent lifestyles, Americans are finding it is in their interest to �get out from under� a pile of debt. Nevertheless, some economists have suggested that a trend toward parsimony and thrift would be damaging, robbing the economy of growth and jobs at a difficult time � the �paradox of thrift,� as this situation is called. In an ironic twist, capitalists are now telling us that it is not in the collective interest for individuals to act according to their own best interests anymore. We are also being told that declines in the prices of overpriced goods � housing for instance � is bad, because lower prices have a depressing effect.
Something is truly amiss if spending beyond our means is what is required to keep the economy going at an acceptable pace! Unfortunately, this is a state of affairs that has been a long time in the making and which will take more than stimulus packages and interest rate cuts to fix. Consumer credit (fueled in recent years by those rising real estate values) has grown along with the consumer-based economy for the last 80 or 90 years. During that period credit went from being a useful �bridge� to a level of dependency which now threatens us with loss of financial flexibility. Apparently things have reached a tipping point where it is no longer feasible to take on additional burdens. Furthermore, one of the assets on which so much credit is based � housing � needs to decline in value due to the fact that real estate prices were over inflated. Americans now have a taste of what it means to embrace indebtedness on speculation that asset prices will continue to rise. Balance needs to be restored through higher savings and less spending. This may not bode well for the broader economy�s immediate prospects, but it is the way out of our financial bind and, eventually, it will promote the common good.
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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html. "Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: [email protected]
URL: http://www.businessforum.com/cscc.html
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