Don’t blame the scandals
After the string of corporate scandals in the US, the public is blaming the destruction of trillions of dollars of “shareholder value” on the malfeasance of top management. This is misguided.
In fact, the frauds serve to conceal the economic readjustment which inevitably follows periods of great innovation. Joseph Schumpeter observed that booms occur at times when “swarms” of entrepreneurs simultaneously attempt to apply some new innovation. He claimed that both the profits in the boom and losses in the ensuing depression were “essential elements in the mechanism of economic development.”
This process can be likened to evolution in nature. The information revolution created what biologists would call a new “adaptive zone” for businesses to operate in. Many companies which sought to enter this new space have found that either their business models were ill-adapted or that there were too many competitors. In an uncertain world, “the struggle for existence,” doomed many new entrants to failure.
Corruption is not the cause of the current crisis for such companies. It simply accompanies their failure. After all, had the demand for broadband technology been as great as many expected a couple of years ago, then the infamous trio-Enron, Global Crossing and WorldCom-would all be thriving today and their former bosses would still be hailed as heroes, rather than villains, of the business world.
In the long run, irrational investors should lose money and have no influence on share prices or the allocation of capital. That, at least, is what financial theory dictates. During stock market bubbles and their aftermath, however, there are opportunities for fools to become rich at the expense of the wise. In a paper titled “Feedback and the Success of Irrational Investors,” three American finance professors, David Hirshleifer, Avanidhar Subrahmanyam and Sheridan Titman, sketch a model in which the prospects of a company improve after its share price has been driven up by irrational speculators, so causing its intrinsic value to rise.
This process works in several ways. For instance, potential customers and suppliers may be more willing to do business with a company whose share price is soaring. Likewise, potential employees may be attracted to the company (particularly when enticed with stock options) and the providers of capital may be more forthcoming with funds. In addition, some companies benefit from the so-called “network effect,” when the value of their business increases exponentially with the number of customers they attract. Irrational traders help such companies grow more quickly and establish a competitive advantage, thus justifying post facto the premium their shares formerly received.
These forces can combine to earn irrational investors higher returns than their more rational counterparts. They help explain the success of certain internet businesses-such as online auctioneer eBay or the internet service provider America Online, which used its overvalued shares to purchase media giant Time Warner in 2000 (according to analysts, the value of AOL’s original business within the merged entity is now close to zero). Yet they were clearly not sufficient to ensure the survival of most dotcom enterprises.
More relevant in the bear market of today is the danger that the irrational pessimism of investors could actually be undermining the intrinsic value of some companies. Bill Gross, the managing director of Pimco, the world’s largest bond investor, maintains that hedge funds are aggressively selling short the bonds of particular companies in the hope of driving down their prices. The credit-ratings agencies, stung by their failure to anticipate the collapse of Enron, are responding by downgrading such bonds to junk status after they have fallen in price. This provokes certain classes of bondholders-such as insurance companies-to sell, thereby causing bond prices to fall even further.
Such practices appear to be affecting the stability of some telecoms companies on both sides of the Atlantic. In the current climate, the viability of a telecoms company is judged by the size of the discount on its bonds to their par value. Following the discovery of a massive accounting fraud, WorldCom’s bonds have been trading recently at 15 cents in the dollar, which gives the business a total capitalisation of less than $4 billion. Considering that WorldCom has total sales of around $35 billion, the value of the bonds appear to be absurdly cheap.
This ignores the fact that businesses which are troubled with debt are in danger of losing customers. More than 150,000 customers recently fled British cable company ntl while it was undergoing a financial restructuring. The same problem is starting to afflict WorldCom. Meanwhile, robust telecoms companies, such as Cable & Wireless, are advertising to lure customers away from their stricken competitors.
Just as the self-fulfilling prophecies of irrationally exuberant speculators reached a limit in the spring of 2000, so the pessimism of today has gone too far. Warren Buffett, the world’s most successful investor and a famous technophobe, has recently made an investment in a solvent telecoms company which is intending to buy assets from its distressed competitors. Carl Icahn, the US financier and former corporate raider, has also said that he is buying up chunks of WorldCom’s debt.