Posted by on October 14, 2015

The Wall Street Journal has recently run a lengthy, front-page article entitled “How Some Investors Get Special Access to Companies.”  This is the type of article that should make the blood boil.

The article describes private meetings between large investors and the management of publicly traded companies.  Although the content of these meetings are regulated by the SEC under a “Fair Disclosure” regulation (Regulation FD), it is very clear that they are anything but fair to the investors who don’t participate.  In theory, under Regulation FD, companies are not allowed to disclose privately any “information that might be reasonably expected to affect the price of a stock or bond.”  In practise, they clearly do.

The article gives a number of quotes that indicate the benefit that investors derive from these meetings: “You can pick up clues if you are looking people in the eyes” and “(meetings) can have value even if management isn’t saying anything new, because investors can gauge their tone and confidence level.”  It also cites academic research that shows that investors with access are able to generate higher returns.  Finally, there is the greatest proof of all: Greenwich Associates, an investment advisory firm, estimates that investors pay about $1.4 billion a year to brokers for arranging this access.  This is not for the social aspects of the meetings.

This is wrong on a whole series of levels.  The first is that it would be easy to reduce greatly this unfairness.  I have had an exchange with Matt Levine, who is one of the sharper commentators at BloombergView, on this subject after he wrote a piece entitled “Sometimes Companies Meet With Their Owners.”  Matt’s argument is that, basically, large investors have always had unfair advantages over small ones and, as the title explains, it is sometimes necessary for management to speak directly to large shareholders.  So, life is unfair.

All true.  But why can’t the company be forced to publish a transcript of these meetings or, even better, distribute a video recording? [1] And why can’t the direct participants be forbidden to trade, or to pass the information to someone whom they reasonably think may trade on it, for a period of, say, 24 to 48 hours after the private meeting to make sure that the transcript or video has been widely disseminated?  This would still allow the companies to carry out the necessary meetings with shareholders but would greatly reduce the scope for privileged information to be passed.

This would probably not reveal all forms of non-verbal communication that take place, but it is still better than what we currently have; we should never allow perfection to be the enemy of the good.  The trading blackout would also make both the company and the shareholders think twice before having private meetings, which would be a useful discipline.  The article points out that the senior management of General Electric, for example, held 70 private meetings with analysts and investors in 2014; the number swells to over 400 when other executives are considered.

But there is an even stronger argument for shining a bright light on these meetings.[2]  It is very clear that companies use these meetings to reward favored investors and brokers – the latter of whom collect the estimated $1.4 billion in extra fees paid for access.  And who are the favored investors?  It’s the ones who don’t rock the boat when it comes to things like management compensation or corporate governance.  And the favored brokers are the ones who provide flattering stock analysis and recommendations, including recommendations on things like management compensation and corporate governance.

In other words, access to private information is a form of bribery used by corporate managements to assure that shareholders and brokers are suitably compliant.  Commentators and regulators often complain that shareholders fail to exercise the control over management that you would expect from owners.  When management is left with tools like these to reward and punish shareholders, is this really so surprising?

Opponents of this change will doubtlessly argue that it will have a “chilling” effect on information flows and will result in share prices not continuously reflecting all available information.  This is true.  But, frankly, I think that we have made a fetish of minute-to-minute market liquidity and information flows.  The reality is that this only matters to short-term investors.  Companies do not make investment decisions on the basis of where their shares are trading on a given day.  And if a persistent difference between the fair value of a stock and its market price emerges, then this is simply an incentive for management to find an effective way to communicate with the market to eliminate this difference.  But they can do this publicly and not through granting informational morsels to their friends.

Emerging Markets

“It’s tough to make predictions, especially about the future.”  These are the words of Yogi Berra, who has sadly died since my last blog posting.

With this in mind, I will go out on a limb and make the following prediction: The most likely source of the next financial crisis is US dollar debt in emerging markets.   Not government debt, since most emerging market governments learned their lesson back in 1997 and have taken on limited foreign currency debt.  But the private sector is a different matter, as this Bloomberg article makes clear.

The scariest thing about this article is that many of the countries with the biggest foreign currency debts (Brazil, Turkey, Indonesia) are the same counties whose currencies are in free fall.  Some of these countries are major exporters of commodities, often selling in dollars, which will limit their exposure to local currency weakness; in fact, this is why they thought it was safe to take on so much foreign currency debt in the first place.  But of course commodities are also being routed, so there is little comfort here.

So far, there have only been limited defaults.  But there is always an illusion at the beginning of any credit crunch.  Defaults mostly materialize when it comes time to refinance, which remains possible, even for dodgy credits, so long at the money keeps flowing.  There is a circularity in all credit markets: lenders point to a low level of defaults to justify continued investment, but the low level of default results from the continued availability of refinancing money.  Like all circularities, this one can easily come to an abrupt end.

Prescription Drugs

Since my earlier blog about “Bad Medicine,” I have been following the prescription drug story more closely.  This includes reading up on Hillary Clinton’s suggestions for remedying the problem, some of which actually make sense (such as freeing up drug importation and prohibiting anti-competitive payments to keep generics off the market), while others are predictably insane (such as the requirement that companies spend a certain percentage of their revenue on R&D).

But the item that that has really caught my eye is the apparent prohibition on Medicare from negotiating drug prices with suppliers.  This is embedded in the 2003 legislation that enacted Medicare Part D, which extended coverage of prescription drugs.  (This extension of Medicare, along with the Iraq war, is one of the budget-busting legacies of “Dubya,” which reminds us that Obama is not the only disastrous President we have had lately.)

Now, there may be nuances to this prohibition about which I am unaware, but it appears to say that Medicare must simply accept the quoted prices for all drugs.  This is a big deal since Medicare accounts for 29% of all prescription drug purchases in the USA.  If this is the case, then the government has created a free-money machine for predators such as Martin Shkreli or the company Valeant.  All they have to do is identify drugs with a significant Medicare clientele and then they are free to charge whatever they want.

Could our legislators really be this stupid?  Or corrupt?

Unions

It is sometimes suggested that one of the cures for wage stagnation and growing inequality is to bring back the unions.  Here are some reminders from Europe of exactly what that would mean.

Jeremy Corbyn, the new leader of the UK’s Labour Party, is committed to nuclear disarmament.  He therefore wanted to discuss the renewal of the Trident nuclear submarine program, which carries the ballistic missiles that comprise the UK’s nuclear deterrent, at the recent Labour Party conference.  And which, incidentally, is projected to cost £20 billion.  However, he was overruled by the public sector unions that supported his recent election.  Their reason?  I quote from Len McCluskey, the leader of the largest of these unions:

“Everyone would love the whole world to get rid of nuclear weapons – we understand the moral arguments and cost arguments in these days of austerity.  However, the most important thing for us is to protect jobs.  In the absence of any credible alternative to protect jobs and high skills, we will vote against any anti-Trident resolution.”

There you have it, folks.  This is the type of far-sighted and non-parochial thinking that people like Jeremy Corbyn, Hilary Clinton and Bernie Sanders want to empower.  Although I can’t find the number of “high skills” jobs Unite hopes to protect, but since we are talking about £20 billion here, I have to believe that this will set a new record for the most expensive jobs program in history.

Meanwhile, over in France, we had the spectacle of senior executives from Air France being figuratively ripped to shreds while union members chanted “naked, naked.”  The location was a meeting of the workers’ counsel called to discuss 2,900 layoffs at this perpetually loss-making company.  This follows previous acts of aggression by workers in France, including last year’s “bossnapping” of two Goodyear executives who were held prisoner for more than 24 hours, after which their tormentors suffered no legal consequences.

Left-wing politicians the world around, including in France, have rightfully bemoaned the lack of prosecutions for financial crimes.  Let’s see how many of these professional hypocrites call for jail terms for the union members responsible for this assault.

(Flash update:  The WSJ reports that the French police have detained six men in connection with the Air France assault, after the airline and its executives filed complaints.  But from initial detention to a prison sentence is a long and twisting road.)

The Model Minority

The Economist has run a lengthy article about Asian-Americans.  It begins with a description of Michael Wang, who had a perfect score in his college entrance (ACT) exams, who was ranked second academically out of 1,002 students at his high school, who was part of a chorus that performed at Barack Obama’s inauguration, who came in third place in a national piano championship, who was in the top 150 in a national mathematics competition, and who was in several national debating-competition finals.  Michael was rejected by six out of the seven Ivy League schools to which he applied.  Like many other members of this “model minority,” he is no longer willing to take this quietly.

Asian-Americans have suffered systematic discrimination, including as recently as World War II when 120,000 Japanese Americans were interned in camps as potential “fifth columnists” while no similar actions were taken against Americans of German or Italian ancestry.  The article points out that the worst single incident of lynching in American history was actually directed against Chinese immigrants, when 17 were murdered in 1871.  Yet, as anyone who has walked the campuses of MIT, Caltech, Harvard or Stanford, or any other top-flight university, can attest, Asian-Americans are massively represented (44% of the recent incoming class at Caltech, which is routinely rated the number one school in the world).  This is despite explicit discrimination which means that, as estimated by two Princeton academics, Asian-Americans need a Scholastic Aptitude Test (“SAT”) score about 140 points higher than a white candidate in order to be admitted to a private university, whereas African-Americans can have a result that is 310 points lower in order gain the same result.  And two University of Michigan researchers have produced a study which shows the difference is down to nothing more than hard work: they followed 6,000 white and Asian children from toddler through school.  They found small differences in initial cognitive abilities and the socio-economic status of parents, but sizable gaps in effort that eventually produce large differences in academic results.

After years of avoiding the issue, the Supreme Court has agreed to hear the case of Abigail Fisher versus the University of Texas in its next session.  Ms Fisher, who is white, is suing UT over its affirmative action policies which she claims unfairly denied her a position.  Her suit is backed by an amicus curiae brief submitted on behalf of 117 Asian-American organisations.  This follows a lawsuit by a group of Asian students against Harvard and the University of North Carolina.  Here is the gist of Harvard’s defence in this suit:

“…a class that is diverse on multiple dimensions, including on race, transforms the educational experience of students from every background and prepares our graduates for an increasingly pluralistic world…”

I suppose that this argument could be used to support the admission of almost anyone, including a few utter imbeciles since they too are part of our “pluralistic world,” although I think that Harvard restricts this policy to its professorial staff.  But more importantly, what is the message that this sends for both over- and under-achieving students?  What does it teach our young about the relative merits of individual hard work versus political machinations?  And, from a strictly economic perspective, what are the implications of this for American success when we deliberately hinder investment in our most promising human capital?

I have previously quoted Supreme Court Chief Justice Roberts on this subject: “The way to stop discrimination on the basis of race is to stop discrimination on the basis of race.”  Let’s hope that he follows through in the Abigail Fisher case and that Justice Kennedy joins him, since we can reliable expect that the “Gang of Four” (Justices Ginsburg, Breyer, Sotomayer and Kagan) will march in lock step to whatever nonsense Obama’s Department of Justice puts forth in defence of this indefensible practise.

Thomas Sowell

We haven’t heard much from Thomas Sowell lately, but here is a feature article, appropriately entitled “The March of Foolish Things,” in The Wall Street Journal about him which proves that age has not dulled his common sense or willingness to speak unpopular truths.  It is worth a read.

Interest Rates and Savings

Shortly after I speculated that the Fed’s zero interest rate policy (“ZIRP”) might be, contrary to expectations, depressing consumption rather than stimulating it, Bloomberg has run an article entitled “A Core Tenet of How Central Bank Stimulus Supports Growth Doesn’t Fit the Data, According to Deutsche Bank.”  The article describes some recent research by DB’s chief global strategist, Bankim Chadha.  The study finds that, once the “wealth effect” is held constant, there is a strong negative correlation between the savings rate and the level of real interest rates. In plain English, this means that the lower the level of interest rates (adjusted for inflation), the higher the level of savings as households try to make up for weak investment returns by putting more money in the piggy bank.  Makes sense.

GOP Tax Plans and Carried Interest

There has been a proliferation of tax plans out of the GOP candidates.  Messrs Rubio, Rand, Bush and Santorum have come out with detailed tax plans.  Even The Donald, whose usual policy description is just “something great,” has provided a written proposal.  These plans vary considerably, but they all have one thing in common: they will eliminate, either explicitly or implicitly, the tax break enjoyed by “carried interest” payments.  This is long overdue.

For those who don’t know about “carried interest,” I will briefly explain.  This is an incentive fee paid to managers of funds out of the profits they generate on their investments.  The fee is usually about 20% of the profits, subject to various tests and performance thresholds.  For years, this has been treated as investment earnings and not employment compensation, which means that a large portion of it qualifies for capital gains treatment.  Rates of taxation on long-term capital gains being much lower than ordinary income, this means that the managers of these funds pay lower tax rates than mere mortals.  This is a major source of the very low taxes paid by Mitt Romney when he was at Bain Capital.[3]

The United Kingdom is the only other country that grants a similar benefit to carried interest.   This means that it would be very easy for the US and the UK to simultaneously curtail this tax break, without the risk of either losing business.  This should be done.

Roger Barris, Weybridge

I WISH THAT I HAD SAID THAT…

“Most of the Muslims leave their homelands to escape poverty, repression and humiliation at the hands of their own dictators.  Unfortunately, when they move to Europe they try to implement the same values they are escaping from.  And this is something I just can’t understand,” by Dr Ali Alyami, a native of Saudi Arabia who has been a US citizen for four decades and who is a sometimes adviser to the US government on the Middle East

“Mr. Trump is a loud-mouth vulgarian appealing to quieter vulgarians,” by Bret Stephens, commenting in The Wall Street Journal

“…a slow-motion collision between two garbage trucks…,” by Scott McNealy, the CEO of Sun Microsystems, describing the merger between Hewlett-Packard and Compaq Computer, the capstone transaction of Carly Fiorina’s less-than-stellar career at HP

“…since America loves Pope Francis, and Hillary Clinton needs a boost, she should start wearing a two-foot hat, and call herself the other leader who gave up having sex for power,”  comedian Bill Maher on how Hillary Clinton can ride Pope Francis’ coattails

 

[1] We would have to come up with analogous restrictions for stock analysts, which is another conduit for companies to disclose private information to friends.  This is a bit trickier, but it can still be done.  The article points out that there is one major research firm, Morningstar Inc., that holds no private meetings as a matter of principle.  It would also be good to force the stock analysts to do their job instead of just relying on winks and nods from friendly investor relations people.

[2] Thanks to my friend Jim Clemence for pointing this argument out to me.

[3] Romney always struck me as a bizarre candidate for attack by the Left on this score. Although he paid a very low tax rate, as a deeply religious Mormon, Romney also practiced “tithing” and routinely gave at least 10% of his income to the church or other charities.  If you look at this as another form of tax, his combined rate was not unreasonable.  Someone like Steve Schwarzman from Blackstone would have been a much more appropriate target, particularly after Schwarzman compared an earlier attempt to eliminate this totally unjustifiable tax break to Hitler’s invasion of Poland.

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