This is the fourth article in a series about Post-Modern Security Analysis.

The analysis of corporate governance

The term “corporate governance” came into vogue in the 1990s and now dominates discussion of ethics and morality in investment markets.

For five essays on “corporate governance” on this site, go here.

Often, the pretense of “good corporate governance” has served to shield ethically-challenged management from critical scrutiny by ordinary investors — an exercise in hypocrisy.

However, the corporate governance movement has come up with one important concept: stakeholders. The view that a corporation has many different “stakeholders”, with different interests, is essential to Post-Modern Security Analysis.

Management still talk about “looking out for shareholder interests”, but the influence of other stakeholders can hardly be ignored, especially the stakes of various governments, labor unions, franchise owners, administrators of off-balance sheet assets, license holders, creditors, employees, trading counter-parties, out-sourced suppliers, down-stream customers, banks, and, last but not least, management itself.

The analysis of corporate governance and of the relative importance of various stakeholders should be the first step in Post Modern Security Analysis.

Determining the relative importance of various stakeholders

Investment securities are a combination of contractual agreements and legal requirements merged with expectations of customary behavior. Normal and reasonable expectations of the benefits and risks of a specific investment opportunity vary among the stakeholders in each case.

For example, fifty years ago, common stockholders expected that most profits would be distributed to them in the form of dividends and that hired management would be content to provide faithful service for a fixed salary and occasional modest bonus.

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I   make a habit of reading the Harvard Business Review to check on the current degree of moral ambiguity being washed into the brains of future business leaders at America’s leading MBA factory.

The September 2006 issue of the Harvard Business Review featured a lead article, “Ten Ways to Create Shareholder Value”, by Alfred Rappaport, Professor Emeritus at Northwestern Univerity’s Kellog Graduate School of Management.

Professor Rappaport also authored the best seller, “Creating Shareholder Value: A Guide for Managers and Investors”.

In the Harvard Business Review article, Professor Rappaport says,

“Value-conscious companies repurchase shares only when the company’s stock is trading below management’s best estimate of value and no better return is available from investing in the business. Companies that follow this guideline serve the interests of the non-tendering shareholders, who, if managements’ valuation assessment is correct, gain at the expense of the tendering shareholders.”

Professor Rappaport’s view is in line with Warren Buffett’s recent criticism of buybacks (See: “Warren Buffett Attacks Buyback-Option Schemes“) and a growing willingness among more progressive business thinkers to question the wisdom of the trillion dollar stock buyback movement that has so distorted the equity market for over a generation.

Of course, Professor Rappaport’s comparison of stock buybacks to a tender offer is not at all accurate. Buybacks are conducted on the open market under rules of secrecy. Selling shareholders have no idea whether a particular transaction is part of a buyback program or not.

Since most stock buybacks in recent years have been executed at prices considerably higher than any reasonable estimate of corporate value, based on management’s desire to boost value of their stock options, it follows that if corporate America were to take Professor Rappaport’s advice to heart, the major buying force supporting equity prices today would be removed and the stock market would crash.

The Ethics of Screwing Your Own Shareholders

Now, Professor Rappaport’s forgiving attitude of a company gaining “at the expense of the tendering shareholders” would not at all have been condoned by Benjamin Graham, Warren Buffett’s personal guru and the father of value investing.

Benjamin Graham and David Dodd in the investment classic, ‘Security Analysis’, opposed buying back stock on the market, even when done at less than intrinsic value, as shown in this quote:

During the 1930-1933 depression repurchases of their own shares were made by many industrial companies … The stock was bought in the open market without notice to the shareholders.

This method introduced a number of unwholesome elements into the situation. It was thought to be ‘in the interests of the corporation’ to acquire the stock at the lowest possible price.

The consequence of this idea is that those stockholders who sell their shares back to the company are made to suffer as large a loss as possible, for the presumable benefit of those who hold on.

Although this is a proper viewpoint to follow in purchasing other kinds of assets for the business, there is no warrant in logic or in ethics for applying it to the acquisition of shares of stock from the company’s own stockholders.

The management is the more obligated to act fairly towards the sellers because the company itself is on the buying side.

In other words, Professor Rappaport’s conditioned condoning of buybacks that cheat selling shareholders might be compared to John Ehrlichmann’s famous phrase from the Watergate era, — it is a “modified limited hangout” — a symptom of ethical ambiguity.

Whatever happened to fiduciary responsibility?

In any event, the Harvard Business Review article implicitly condemns most of the reasons used to justify stock buybacks during the 1990s (See: “The Great Misleading“), and in this way reminds me of the old joke about three lawyers at the bottom of the ocean — it’s a good start.

As reported in the BusinessWeek Online article, “The Skilling Trap” (June 12, 2020), Jeffrey Skilling, former CEO of Enron, said on the courthouse steps, after being convicted of white-collar crimes that will send him to jail, probably for the rest of his life,

	Gamblers' Ethics: Win Some, Lose Some

“Obviously I’m disappointed. But that’s the way the system works.”

The BusinessWeek article, went on to say:

… walking out of his trial into the prospect of decades of imprisonment, he stayed in character. He did not say that he was robbed of justice or express regret or defiance. He proved himself, considering the circumstances, a maestro of emotional detachment.

Jeff Skilling’s comments suggest a professional gambler who, having lost a fortune, shrugs and says,

“That’s the way the game is played. You win some, you lose some.”

It may be unfortunate and lamentable for society, but Jeff Skilling was simply telling the truth as he saw it, according to tenets of moral relativism learned at the Harvard Business School and his interpretation of corporate behavior observed while working as a consultant with McKinsey and Company.

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