The stock market has been particularly fragrant over the last week or so.
The delicate odor of an election now two weeks past its sell by date has combined with the increasing stench from an economic boom dead three years, whose putrefaction had previously been masked by increasing applications of the cheap perfume of a fiat currency. However, the greatest stink-bomb so far has come in the area of the New Economy, where each week sees significant new bankruptcies and stock values in many cases are down 90 percent from their highs. Even bulls now admit that the New Economy hype a year ago may have been something of a bubble, for a bear, the question poses itself: was it just an innocent bubble, or was there a substantial element of fraud involved?
To get the caveat out of the way first. Yes, the Internet has changed our lives, and the change has by no means finished. But the change has not revolutionized our existence, except in the modestly important field of access to pure information. James J. Cramer, of TheStreet.com, on one of his less optimistic days, described the Internet as an “interesting new wholesaler, with a nice sideline in pornography.”
It’s a little more than that, but much of its value simply substitutes for other sectors of the economy (for example it’s unlikely Amazon.com increases global book sales much in the long run, but it certainly pressurizes the sales and profits of bricks and mortar book retailers.) Even bulls, licking their wounds, admit that the valuations of late 1999 were grossly overstated.
Indeed, with so many Internet bankruptcies, and many more stocks trading at less than 10 percent of their peak values, it is quite clear that the peak valuation of the New Economy was at least five times overstated. If 20 percent of the New Economy’s peak value was real, therefore, the other 80 percent was bubble or fraud, and the question is, which?
The distinction between bubble and fraud has always been a difficult one to draw, with borderline cases being particularly awkward. To some extent, it rests on the question of intention. If the seller of stock at inflated prices in an IPO genuinely believes there to be a plausible case that the value of the stock is justified, then the high price is a bubble caused by investor enthusiasm. If on the other hand, the seller of stock believes the price to be unjustified, particularly if he has material information that is denied to the buyer, then there is an a priori case that fraud is committed. In the latter case, the seller of stock is in the same position as the mafia-related “bucket-shops” of the 1980’s, which lured unsuspecting dentists to their financial doom through touting worthless penny stocks. The principals of First Jersey Securities went to jail; it is thus reasonable that the principals of an Internet IPO, if fraudulent, should also do time.
Sorting out whether a bubble was fraudulent has perplexed regulators since the first true stock market bubble, the South Sea Bubble of 1720. In that case, the South Sea Company itself was not, by modern standards, fraudulent, it had a genuinely profitable business, operating a trading monopoly with Spanish South America, and the scheme which started the bubble, to exchange the British national debt for South Sea stock at a premium was arguably sound — indeed, it bore a strong resemblance in principle to Governor Bush’s plan to privatize Social Security. Other companies floated at the time, touted as the “project of great value, its nature to be announced later,” were clearly fraudulent.
Then there were some intermediate cases, such as Puckle’s Machine Gun, designed to fire round bullets at Christians and square bullets at Turks. Whether that was bubble (no hails of square bullets met the Janissaries during the 18th century, so it was at best that) or fraud depends on the state of Puckle’s invention. If he had a working model, or even good drawings, then it was simply a high-tech investment that didn’t work out. If on the other hand, Puckle’s Machine Gun was no more than a gleam in the eye, then it was a “concept” stock, charitably defined, and the issue was probably fraudulent.
In 1720, the authorities took a robust view. When the bubble collapsed, they presumed that fraud must have been involved somewhere, even though they couldn’t put their finger on it, so they imprisoned the South Sea Company directors and confiscated their property, thus setting back British entrepreneurship by a century. In the modern financial markets, we must be more careful.
In my view, there are two areas of the New Economy boom where fraud would seem to have occurred; the flotation of companies at valuations which could never have been justified by their prospects, and the deception of investors by unfair earnings figures based on unacceptable accounting practices.
For an example of the first, take Pets.com, which “went for long walkies” on Election Night. Pets.com went public on February 9, 2000, in an offering led by Merrill Lynch and Bear Stearns, and thereby raised $82.5 million for just over 25 percent of the company. Now the pet supplies market, while representing $23 billion in sales in 1997, is fragmented; the largest company in the market, Ralston-Purina, has a market capitalization of only $7.8 billion. Pets.com itself had sales of $0.6 million and expenses of $16.4 million in the quarter prior to flotation; in the quarter then in progress (which management presumably knew something about) it had gross margin of minus $4.9 million and net loss of $39.2 million. Thus it was clearly going to run out of cash about when it did, less than three quarters after the IPO.
It is almost inconceivable that the management of Pets.com believed they could build a nationwide pet supplies distribution operation for $80 million, or that the market was large enough to justify a larger expenditure. After all, most pet supplies are low value items; you are simply not going to get rich by FedEx-ing tins of cat food across the U.S. Pets.com was thus at best Puckle’s Machine Gun, and in reality bore more resemblance to the “project of great value, its nature to be announced later.” Yet it was underwritten by two of Wall Street’s most eminent houses, and I am sure it was by no means the worst such IPO.
The second potential fraud, unacceptable accounting, is a problem that has grown much worse throughout the market, not just in the New Economy area. For example, it would in my view have been inconceivable 20 years ago that a company of Daimler-Benz’s stature would have reported a $2.9 billion profit from a stock swap as operating earnings, as it did last week. The SEC indeed addressed this problem last week, by forcing disclosure of accountants’ consulting ties with their clients, but this is far from solving the problem of deteriorating accounting quality.
The most egregious fraudulent representation in the New Economy, and in much of the old economy, relates to management stock options. Such options have existed for many years, but before the 1990’s they related to an insignificant portion of large companies’ capitalization, and were small in value in relation to the earnings of most large companies. With the growth in “incentive compensation” in the 1990’s, this is no longer the case; as I will demonstrate below, the value of stock option grants to management can in many cases wipe out the reported earnings of the company concerned.
The Financial Accounting Standards Board attempted to address this problem in 1994, mandating companies to recognize the cost of options grants using the Black-Scholes options valuation model. However, justified objections to the validity and reliability of this model combined with intense industry opposition to produce a final FASB 123 which pretended that multi-year stock options at market price have no value. Consequently, companies, particularly in the New Economy, have resorted increasingly to rewarding both top and middle level executives with stock options rather than salary, thus diluting the interest of stockholders while reporting as costs only the relatively low cash salaries paid.
To see how this works, take Cisco, the archetype of the New Economy. In the year to July 2000 Cisco reported net income of $2.668 billion, or $0.36 per fully diluted share, up 24 percent from the prior year. However, in the same year, employees exercised options on 176 million shares, at a weighted average exercise price of $5.75 per share. New options were granted on 295 million shares, at a weighted average price of $52.10 per share.
Making the rough assumption that the market price when new options were granted was the same as that when old options were exercised, we can calculate the net transfer of wealth to employees from 1999-2000’s option exercises under the Cisco share option scheme, as $52.10 minus $5.75 per share, or $46.35 per option exercised. Multiply by 176 million options exercised, and you get a total wealth transfer from stockholders to employees, entirely outside Cisco’s income statement, of $8.158 billion.
I see no difference from the stockholders’ point of view between paying employees via stock options or paying them in cash; either method removes wealth from the stockholders. If Cisco did not give stock options, they would have to pay employees much more to keep them; the stock options are merely a form of executive compensation, a very expensive one in Cisco’s case. Taking this into account, instead of a net income of $2.668 billion in 1999-2000, Cisco stockholders actually suffered a net loss after stock option exercises of $5.49 billion. Repeating this arithmetic for previous years demonstrates that Cisco has not made a true profit in any year since at least 1996.
Thus Cisco’s entire market capitalization, currently around $360 billion, is based on earnings that are in real terms consistently negative, but are not clearly reported as such. To me, that smells like fraud.
I would thus argue from the two examples above that the preponderant reason for at least 80 percent of the outrageous peak New Economy stock market valuations was not innocent bubble, but fraud.
Once the oncoming recession, and the stock market decline, have hit with full force, the American people will no doubt want revenge for their losses, as they have done in the past. At that time, it seems likely that legal evidence for the trial and imprisonment of some of the major New Economy figures will be readily available.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.