I have come to believe that just as are other consumer items, stocks need to be more closely regulated to protect the public.
Even in the greatest bull market of our times, the average investor in mutual funds was reported to have barely made money. Why? Because he/she tended to chase performance, thus guaranteeing purchase as the smart, early money was exiting after the upside had been achieved.
In the go-go late '90s, a national mania was created by the financial community and its enablers in business, the media and government that sucked vast numbers of America into believing that they too could be Bernard Baruch or Warren Buffett.
The whole mantra of "stocks for the long run", even as propounded by such honorable men as John Bogle, who built up the Vanguard Funds, clearly depends on the valuation of stocks when the long run begins. Beyond that, the future is unknowable. All we can say is that common stocks in the U.S. have, over many years, provided X return, but that achieving those returns was not necessarily easy for an individual person, and that individuals must be aware that they should not rely upon past history to predict the future. For example, they should be told that the very data that indicate that stocks have outperformed cash and bonds for the past hundred years (say) may logically suggest that they will underperform the same alternative asset classes for the next hundred years.
All consumer items are subject to some sort of prudential regulation. Even when a physician prescribes a medication, the patient is provided a list of potential side effects. And the prescriber has no financial interest in whether the patient takes any medicine, or which one is given. (Quite different from the selling of financial products!) Even so, patients are by law given information about the downside of the medicine.
Yet when the average investor purchases a mutual fund, all he or she tends to see is a bland warning that it may lose value and that the cost of running the fund is a certain amount. For the millions of investors who buy/trade their own individual stocks, there is no necessary disclosure of the facts of what they are buying. I propose that the boom-bust cycle of the stock market is of such importance both to individuals and to society at large (given the importance of public companies to the economy) that greater disclosure is required. Here are some modest proposals:
1. When a stock that has significant institutional ownership is purchased by an individual, the individual should be informed that large investment organizations that can be expected to have greater knowledge of the value of the company, greater sophistication and greater financial ability to withstand moves down in the price of the stock may either be selling the stock to the individual or are currently unwilling to pay a higher price; in other words, presumably "better" investors have declined to value the stock at the current time at any higher price than the individual is proposing to pay. Further disclosure (where appropriate to the stock) should be made that in addition, sophisticated people are actually paying significant interest and other costs to bet that the stock price will actually decline, and that these individuals can be assumed to have engaged in sophisticated analysis of the Company's financial position and business prospects, and have not only decided not to own the stock but to take on the potentially unlimited risk of borrowing it and selling it without even owning it, in the hope of profiting by buying it back at a cheaper price.
2. The individual must be shown financial data for the company before being allowed to buy the stock. This data should include dividend history and asset value with AND without intangibles and goodwill. Earnings data are insufficient for a variety of reasons. Data on an individual stock could for example have warnings such as the following:
A. If you purchase this stock, you may never receive any income from it. The stock may become worthless for any of a number of reasons.
B. In addition, you have the ability today to purchase a U.S. Government bond that will pay you (prevailing interest rate) for (1, 5, 10 years, for example) and that will return you the face value of the bond in (# of years). You are thus forgoing that guaranteed income and return of principal when you purchase this stock.
C. Management and the board of directors of the company own X% of the stock. In general, the less stock those controlling the company earn, the less their interests are aligned with those of stockholders.
D. Management's interests in the stock may be different from those of stockholders, no matter what % of the company's stock it owns. For example, executive compensation may be high enough to materially affect the profitability of the Company. Substantial amounts of stock options or restricted stock may be granted that would diminish your current ownership of the Company, even if the Company succeeds.
E. Management owns options in the company at X% above/below the current market value. To the extent that the options are exercisable above the current stock price, management may take extra risks in an attempt to increase the stock above that price. These risks may be disproportionate to the chance of success and thus may be adverse to the interests of stockholders. To the extent that management owns options below the current market price, it may fail to take prudent risks to increase the stock price.
F. Even if the stock market as a whole rises, the price of the stock you are purchasing may decline or fail to rise.
G. (If applicable): The company in which you have expressed an interest in purchasing stock also has bonds available for purchase. The current price at which you may be able to purchase a bond of the company is approximately X, which would provide a yield to maturity of Y. A company's bonds may be sound investments even if the stock price of the company goes down.
H. The aggregate market value of the company you may purchase stock in is X. The Company reports that its financial value is Y based on Generally Accepted Accounting Procedures, of which Y' is in net cash and the rest is in more difficult-to-value assets. Thus, by purchasing this security, you are expecting that over time, the company will earn at least Z money (X-Y). In addition, financial professionals adjust upward the value of Z by a variable amount that takes into account such factors as the amount of money that their money could earn in safer places such as a Government bond, bank deposits, corporate bonds, and the like.
I. If a broker has recommended the purchase of this stock to you, he/she will earn income from it and will earn income again if you sell it. The broker therefore has a greater financial interest in you purchasing a stock that you are likely to sell at some point than one that you will never sell. The broker therefore has an inherent, unavoidable interest in you purchasing a stock that is more suited for trading than for long-term investing.
One can go on, but you get the point. In addition, mutual funds and closed end stock funds could be required to disclose the average ratios of price to net cash, price to book value, price to earnings of their stock holdings.
I suspect that if such disclosures were mandated, people would be less willing to part with their money in the "market" in general or individual stocks in particular. This could impart a salutary influence on the valuation of stocks and thus help prevent bubbles. By doing so, these actions would in fact tend to lead to stocks once again being good investments for the long run.
Ferdinand Pecora led the investigation of the U.S. Senate Committee on Banking and Currency in 1933-34 (the "Pecora Commission"). In 1939, he published the book, "Wall Street Under Oath". This is the first paragraph of his "Author's Preface" followed by snippets:
"Under the surface of the governmental regulation of the securities market, the same forces that produced the riotous speculative excesses of the "wild bull market" of 1929 still give evidences of their existence and influence. Though repressed for the present, it cannot be doubted that, given a suitable opportunity, they would spring back to pernicious activity."
" . . . Wall Street . . . looks forward to the day when it shall, as it hopes, resume the reins of its former power."
"The public, however, is sometimes forgetful. As its memory of the unhappy market collapse of 1929 becomes blurred, it may lend at least one ear to the voices of The Street subtly pleading for a return "to the good old times." Forgotten, perhaps, by some are the shattering revelations of the Senate Committee's investigations, forgotten the practices and ethics that The Street followed and defended when its own sway was undisputed in the good old days."
As I stated in my prior post, "Where is Jurassic Park When You Need It?", we need another Pecora Commission to deal with the abuses of the financial system of the past decade.
Copyright (C) Long Lake LLC 2009