Contrary to the familiar adage, every cloud does not have a silver lining. Thankfully, however, some do. The clouds cast by the recent freshet of corporate fraud and other derelictions have a brighter side that will improve the efficiency of equity markets in the future.
Among the acknowledged sources of brightened prospects are the recently enacted Sarbanes-Oxley law requiring chief executives and chief financial officers to certify the accuracy and completeness of corporate accounts, and invoking serious criminal penalties including jail time for violations; improvements that have been made in the Securities and Exchange Commission's capabilities for rigorous yet sensible regulatory scrutiny of public companies; and the wake-up shock administered to corporate officers and independent directors to take their fiduciary responsibilities more seriously in the future than they may have in the past.
These developments, while important, are confined to the sell side of the market. More important, and less recognized as a stimulus to more efficient equity markets, is the buy side. Efficient markets require participants -- buyers no less than sellers -- to have equivalent access to information and the capacity to use it. By strengthening incentives for investors to become more informed and knowledgeable, recent corporate malfeasances should help to promote more efficient equity markets, improved resource allocations, and a more productive economy.
A recent comment by AFL-CIO President John Sweeney -- not always a fan of efficient markets -- is a cogent reminder of the direction of needed change: "The sad truth," observed Mr. Sweeney, "is that American consumers can shop with more assurance of quality and safety at their corner grocery store than American investors can shop for equities in our stock market."
To be sure, bets with a longer-term horizon are inherently more risky than ones with a shorter term. But the principal reason consumers can shop with more assurance in markets for groceries as well as for appliances, vehicles, housing, and other durable consumer goods is that consumers are more knowledgeable about these products than they are about the products offered in equity markets.
Financial professionals scoff at this line of argument, contending in rebuttal that investment products are too technical and arcane for individual investors to understand as well as they understand consumer products and services. This rebuttal has limited merit, as well as more than a limited dose of self-interest associated with it.
Individual investors don't have to become financial professionals any more than consumers of health care have to become physicians. But it is entirely possible for investors to become sufficiently knowledgeable about investment products to ask the right questions and demand the information necessary to make better decisions in accord with their own preferences and judgments. Indeed, in the wake of recent corporate defalcations, investors now have stronger incentives to become better informed about the following types of technical issues that will affect investor behavior and, in the process, contribute to more efficient equity markets:
- The governance practices of companies in which individuals and institutions
invest, or in which investment is contemplated. For example, investors can
research the credentials of non-affiliated directors, whether they are genuinely
"independent" and free of conflicts of interest in their relationships
with top management, and whether independent directors have dominant and preferably
exclusive membership on the key audit, compensation, nominating, and governance
committees of the board.
- The conceptual as well as empirical differences among corporate income,
earnings, revenues, and profits. Investors can find out precisely how earnings
have been measured in the past, whether recent and current measurement of
earnings (of key importance for calculating price/earnings ratios), has been
changed from previous benchmarks, whether earnings have been inflated or deflated
(for example, by capitalizing rather than expensing such transactions as software
replacement and equipment maintenance, recording revenues in advance for goods
and services provided, or underfunding or overfunding pension obligations).
- The number of stock options issued or replaced, to whom issued and in what magnitudes. Investors should know whether or not options are, or may in the future, be expensed (there are plausible arguments on both sides). Of equal or greater significance than whether options are expensed is the particular valuation method used for establishing option values (there are several reasonable methods with different effects on corporate earnings).
The efficiency of equity markets definitely will be enhanced by rigorous enforcement of old and new regulatory legislation. But in the final analysis more efficient equity markets depend fundamentally on better-informed and more discerning individual and institutional investors. While the sell side of the market needs to be monitored, the buy side requires serious upgrading as well.
Mr. Wolf is a senior economic adviser and corporate fellow in international economics at RAND, and a senior research fellow at the Hoover Institution. He sits on several corporate boards.
This commentary originally appeared in Wall Street Journal on September 27, 2002.