A case of trust discount?
By Farhan Mahmood
Some 85 million Americans own shares in the 2,700 companies that trade on the New York Stock Exchange, and almost all have lost large sums of money in recent years, many because of outright fraud. Some analysts opine that investors will not be returning to the stock market until there is concrete evidence that Corporate America is clearly not running a cynical scheme to defraud the ordinary shareholder.

There is no doubt that the bankruptcies of Enron and Global Crossing appear to have done serious damage to financial markets. The collapse of the Houston-based energy giant has created doubt about corporate financial reporting in markets around the world as jittery investors continue to wonder whether other companies are using the same accounting tricks to keep debt and other bad financial news off their books. Accounting frauds at Ahold and HealthSouth are recent additions to the notorious list.

What must be done to restore the shattered faith of disillusioned investors? Is the answer stricter regulation? More aggressive prosecution of wrongdoers? Structural changes to corporate governance practices? An increased focus by companies on personal and corporate ethics? A saner approach to executive compensation? Or is it simply a matter of allowing time to heal the wounds? The solution involves all of the above, in various measure

 

The triple influence

Investors may have hoped the end to the conflict in Iraq would inspire a de'tente between stock market bulls and bears but the two camps seem as divided starting off the second quarter of 2003 as they were in the first. Many remain skeptical about the quality of earnings being reported by Corporate America. Uncertainty continues to overhang stock markets, particularly as US officials issue warnings to Syria's leaders. Investors remain concerned about what lies ahead, whether it is the issue of credibility of a corporate balance sheet or the volatile geopolitical situation.

Recently, Richard Grasso, chief executive officer of the New York Stock Exchange, said that US markets are labouring under the triple influence of a war discount, a terrorism discount and a trust discount. He thinks that the third influence is the one that is most damaging. Even if the war and terrorism discounts fade over time, the issue of "trust discount" will not. It must be seriously addressed and resolved by the regulators and business community.

According to Mr. Grasso, the best way to restore public faith is with more aggressive prosecution of wrongdoers. In particular, he feels that executives involved in wrongdoing should not be able to walk away with their wealth and have it sheltered by state laws that protect certain personal assets from seizure. "People who inflict this kind of pain should lose everything."

Although Mr. Grasso believes the tide is turning, and that investors are still willing to put their money in stocks, the state of markets paints a different picture. New York State Comptroller Alan Hevesi, who oversees the second-largest state pension fund in the United States with about US$100 billion of assets under management, believes investor confidence has not hit bottom even yet. "Investors don't trust yet. The damage that's been done is extraordinary," he says. According to Mr. Hevesi, more regulatory changes -- including even tougher guidelines for auditors, and rules allowing shareholders to more easily sue corporate advisers such as lawyers and accountants -- are still needed. The damage that has been done cannot be overstated. "Thousands of people were defrauded, and many lost their life savings. There have been billions in lost value. It's not enough to say there were a few rotten apples," continues Mr. Hevesi

 

Where did it go wrong?

To understand the impact of events such as the bankruptcy of Enron on the evolution of capital markets over the longer term as well as enforce the type of regulation that may prevent such disasters, one needs to look back at history. The 1980s and 1990s were years of enormous expansion for global financial markets as well as for structural and technological changes. The capital markets have participated remarkably well in mobilising capital resources and responding to the challenges and increased competition resulting from these changes.

Starting in 1982, the United States witnessed a rapid increase in the pace and volume of company mergers and acquisitions, new issues of debt and equity securities, trading volumes, and market capitalisation. At the same time, financial markets were being deregulated in the United States as well as around the world, and new technologies were being introduced. In the early 1990s, Europe was also experiencing a boom in mergers and acquisitions in preparation for the introduction of a single currency and the disappearance of trade barriers within the European Union in 1999.

This environment provided both opportunities and challenges for investment firms. The stock market plunge of October 1987 was followed by another market slump in 1990. Criminal charges against Drexel Burnham caused the junk bond market to collapse, and insider-trading scandals increased regulatory oversight in the early 1990s. Misconduct in financial reporting, pension fund management, and trading in derivatives produced class action litigation and further regulatory scrutiny. The Glass-Steagall Act was finally repealed, increasing competition by allowing commercial banks to engage in investment banking and investment banks to engage in commercial banking. Bond markets became increasingly volatile in the 1990s. Globalisation presented new opportunities and risks, as evidenced by the Russian default in 1998 that forced Long-Term Capital Management into insolvency.

Some analysts feel that former US president Bill Clinton should have done more to champion legislative reforms that were defeated in the 1990s, including a failed effort by former Securities and Exchange Commission chairman Arthur Levitt to introduce strict rules preventing auditors from also doing extensive consulting work for their clients. (Mr. Levitt was forced to retreat after Congress and Republican Senator Phil Gramm threatened to cut the SEC's budget if it didn't back down from the proposal.)

Recently, Eliot Spitzer, New York State's crusading Attorney General, warned of looming prosecutions against research analysts over bogus stock recommendations, the final stage in his plan to clean up Wall Street. Mr. Spitzer, who oversaw a US$1.4 billion settlement in December 2002 with 10 of the largest brokerage firms on Wall Street, acknowledged that many investors remained skeptical that justice has been served when few individuals have faced prosecution, few have had to give up ill-gotten profits, and few have even been required to admit wrongdoing when settling cases. Last week, Frank Quattrone became the first Wall Street player to face criminal charges stemming from the sweeping US investigation into industry excesses during the recent stock market bubble.

Emerging markets: a potential beneficiary

Mounting concerns among fund managers about the quality of US corporate earnings is spurring new interest in emerging markets. If the quality of earnings is not guaranteed in the US, why not invest in the emerging markets where the quality isn't guaranteed but stocks are cheap? But while emerging markets provide an increasingly important investment opportunity for global institutional investors, many potential investors remain hesitant to participate. However, with the war in Iraq winding down, the tone of emerging markets has brightened somewhat. The significant improvement in investor sentiment toward emerging markets is particularly notable.

However, institutional funds are still reluctant to flow into these markets in a big way. Their reluctance is often due to a lack of understanding of the markets on the part of fund managers, restricted access to research, minimal corporate information, risks associated with yet under-developed market economies and the need for liquidity. One of the biggest barriers to investing in emerging nations is the variable quality of basic information in many markets. This is a time when regulators and stock exchanges in these countries can seize the opportunity and enhance their credibility and profile with investors through greater transparency, improved quality and frequency of reporting.

 

Phase of the healing period

With many of its initial regulatory reforms now taking effect, the United States may be entering an interim healing period as regulatory changes are phased in and their success is weighed. The disillusionment in the markets is profound and meaningful reform is needed in all areas. The blunt message stock markets appear to be sending out is that it is a weak and dangerous strategy to wait for investors to leap back into the markets on blind faith.

Investors continue to be cautious on the post-war global economy with the IMF in its latest World Economic Outlook arguing that the ongoing unwinding of the stock market bubble, risks of a bubble in housing, financial imbalances globally and current account deficits continue to present substantial risks. In addition the uncertain effects of the SARS epidemic in Asia and the threat of the US being sucked into a longer term occupation of Iraq are also weighing on the outlook for investors going forward.

European and US stock markets continue to remain weak. The mid-March euphoria, reflected in the sharp gains in major stock indices in the days leading up to the start of operation "Iraqi Freedom" seems to have abated considerably. Once again, focus has shifted back to economic fundamentals. The economic statistics coming out of both the US and Europe remain weak with most economists continuing to downgrade their forecasts for global GDP growth. The recent decline in payroll employment and a high unemployment rate signify that the US economy is still operating with considerable slack. A prolonged winter and higher-than-anticipated oil prices remain a drag on recovery.

 

A crisis of confidence

Following the debacles of Enron, WorldCom and now Ahold, a crisis of confidence prevails in the financial system, perhaps more so in the US compared to Europe. For many years, earnings numbers and assets were inflated by companies through financial reporting gimmicks. These included aggressive revenue recognition, exploitation of off-balance sheet entities, "channel stuffing" and under-funding of pension liabilities. Unfortunately, many observers feel that the investment community has not seen the last of such gimmicks.

Some analysts feel that the root of the accounting problem is that stock market bubbles tend to reward aggressive accounting as it inflates earnings. Earnings management, or rather mismanagement, results when companies exploit the flexibility in accounting principles that allows financial reporting to keep pace with innovations in the economic and business environment. Companies select accounting options that obscure management's decisions rather than shed light on them.

The investment community must do its due diligence and not get carried away by lofty prices and the greed that accompanies it. It is expected to place much emphasis and weight on the fundamentals driving corporate earnings. Once liquidity starts flowing back into stocks to tilt the balance in favour of riskier investments, US and European stock markets will begin to reverse the negative returns seen over the last three years. Till the time such balance is achieved, equity risk premium will remain high and stock markets may well remain in flux.

By some measures, the US market could still be considered expensive, despite the sharp drop from its peak three years ago. What lies ahead? It is all a question of placing confidence in the data and information supporting the valuation of stocks. Valuation is a matter of judgement and, among other variables, is based on the quality and soundness of corporate financial statements. It is hoped that with the recent and on-going crackdown on Wall Street, analysts would now be more careful and will exercise caution when commenting on "Earnings Quality" and making investment recommendations.

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