Think Before You Double Down on an Investment

A new heart attack is available at KFC! The Double Down features two pieces of fried chicken, bacon, an indistinguishable mixture of cheese, and an unidentifiable sauce to now bring you a sandwich as close to toxic as the American fast food business has ever been. Unfortunately KFC neglected to complement the Double Down with a side of Lipitor. Nonetheless, don’t expect the Double Down to be a big hit at Goldman Sachs.

Like KFC, Goldman is in the business of selling cutting-edge poisonous products – not purchasing them – all to add a few extra zeros to the bottom line. Fortune Magazine reported that Goldman raked in mere $1 billion in fees from its sale of collateralized debt obligations (CDOs) last year, which pales in comparison to its $12 billion in profit for the year. Rather than including a disclosure of the true risk behind these securities, Goldman went ahead and sold them with a Triple-A rating. I hate when they forget to put the toy in with the Happy Meal.

While Goldman was wrong for not fully disclosing the true risk behind the CDOs, the financial giant is not in the wrong for having put them on the market. As it should, the SEC has filed charges of fraud against Goldman, which, however, should not to be confused with charges against Goldman for the actual sale of CDOs and other now-worthless mortgage-backed securities. Creating a product that people want and selling it to them – so long as they know what they are getting themselves into – is perfectly acceptable, and it falls on the individual to make informed consumption decisions.

Take the tobacco industry for example. In the past, consumers were buying cigarettes under the false understanding that cigarettes had no long term health effects. When it came to light that cigarettes were in fact dangerous and caused cancer, Big Tobacco faced class action lawsuits and multibillion dollar settlements due to its inadequate disclosure of the health risks of smoking cigarettes. In a very similar fashion to that of Big Tobacco, Goldman now faces a lawsuit for its own misleading statements and marketing materials regarding the financial risk of investing in CDOs.

Although it may be considered unethical, Goldman cannot be blamed for the actual selling of CDOs and other mortgage-backed securities. Like the fast-food and tobacco products, financial investment products carry a certain level of risk, and consumers electing to purchase the product assume the attached risk. Although firms may be frowned upon for selling the above-mentioned products, it is ultimately the choice of the consumer to make the purchase. Without buyers, there would be no sellers, and businesses cannot be blamed for making a product that consumers want to buy.

Had Goldman provided truthful and accurate information as to the true risk of the financial products it was selling, it would not be in the wrong and very likely not facing any charges from the SEC. Just as cigarettes may give you lung cancer and fast food may cause you to gain weight, financial investment products may cause you to lose money. So long as the customers are fully aware of any and all risk associated with their purchasing and consumption decisions, transactions involving these types of products are completely allowable.

It is the function of businesses in an economy to provide a wide variety of goods and services, and consumers ultimately must make informed purchase decisions for themselves. Others can always be blamed for incorrect or poor decisions, but at the end of the day, it is the individual who gives the final stamp of approval. Although investors are right in pointing fingers at companies like Goldman in this situation, it is important to remember to be very careful going forward. Read the side of the cigarette carton, read the nutrition facts before going through the drive-thru, and thoroughly research before making investment decisions.

Stop the Banker Hate!

It is increasingly irritating to see politicians speak of making major changes to business, commerce, and the economy without a true understanding of the implications of the changes. Whether a politician actually lacks an understanding of business and economics or whether he or she is merely reacting to that which is under the political spotlight, a vast majority of the time the changes are either unfair or unfounded, which can lead to problems down the road.

Bloomberg reported last week that U.K. Prime Minister Gordon Brown promises to implement new curbs on the bonuses of bankers if he is re-elected next month. Although it needs to reminding, keep in mind that the financial sector and bankers in particular are under the gun in light of the credit and financial crises of 2008-2009. People are pissed off about how much employees of financial firms made during and after the recovery from the crisis. After all, it was the people’s tax dollars that were used to bail out and rescue nearly all of the major financial firms of the world. The people want change, and they want this to never happen again. However, the actions Brown promises to carry through are unfair.

As mentioned in the post regarding CEO compensation, it is common that companies within specific struggling sectors of the economy come into the public spotlight, appearing in the news and on front pages of newspapers, and invariably the negative sentiment finds its way to Washington. Congresspersons and Senators have an angered demographic, and change or punishments need to be executed to appease constituents. Unfortunately, different sectors struggle at different times, and it is unfair to attempt to place strict restrictions on compensation structures or firm profits.

Recall Obama before he was elected President of the U.S. During his campaign, while oil prices were high and oil companies were raking in massive profits, he vowed to tax profits and put a limit how much money these firms could make. In the end, oil prices fell, gas prices came down, and the public forgot about how much they hated big oil companies. This sounds eerily similar to that which Brown is saying now. Perhaps both used it to gain the support of those upset and requesting change?

When U.S. automakers began outsourcing labor and auto construction in the 90s, many U.S. workers lost their jobs and turned to government to make change. In a similar fashion to that of the automotive industry, this fell by the wayside as new material found its way into the news and at the top of the broadcast.

It is unfair to focus on just one sector and try to specifically reform, overhaul, or place strong restrictions upon it. As mentioned above, politicians may promise this in an effort to get elected or re-elected, or they may promise change during their tenure in order to appease the people. However, different sectors are targeted at different times, and serious change should not be enacted merely in reaction to public distaste. It may have been the automotive industry in the past, the financial firms today, or even the healthcare insurers and companies in the future, but politicians, make sure you know what you are doing.

Critique the Focus

In an episode of Seinfeld, George Costanza built a small bed and napping area beneath his desk at Yankee Stadium where he worked. I have a sneaking suspicion that Seinfeld is a huge hit at the SEC. I pose a question to the SEC very similar to that posed by audiences to Costanza: Do you actually do anything constructive at work?

In all fairness, SEC regulators actually do something. They watch porn. How does that sound for a job? Get paid to watch people screw, and in the same act, screw the people.

The focus of SEC regulators is in entirely the wrong place. SEC employees aim to satisfy their boss, the U.S. government, under the false assumption that if the boss is happy, the customers – U.S. citizens – are happy as well. However, the SEC must aim to please in exactly the opposite fashion. Please the customers first, and your boss will be happy (eventually, if not at the time), allowing you to keep your job and pursue your interests. In other words, the SEC should focus on what is best for the people, and in so doing, will satisfy the U.S. government.

Unfortunately, this has not been the case over the past few years. Whistleblower Harry Markopolos – who, in the context of our story, we can call a customer – submitted a report to the SEC back in 2005, describing the financial impossibility of Bernard Madoff’s returns and ultimately concluding Madoff was running the largest Ponzi scheme in history. A college junior with knowledge of the basic fundamentals of finance and investment strategies could have arrived at such a conclusion, given Madoff’s SEC filings. It seems apparent the securities and regulation “experts” at the SEC must have forgotten these elementary principles, or at least, did not come across this material at thedailybabelog.com.

When, of course, it was revealed that Madoff was running a Ponzi scheme, customers were unsurprisingly upset, and many had lost their life savings. This could have been prevented had the SEC been focused on its customers rather than their boss, who was content at the time. SEC regulators pulled a Constanza and hit the snooze button when the customers needed them the most.

In that brief example, the customers were dissatisfied, while the boss seemed to be content. A similar negative outcome is experienced in the converse situation in which the boss is upset and forces change not in the best interest of the customers.

Facing an upset superior, the SEC recently enacted curbs on short selling in an attempt to appease the pressuring U.S. government. Whether the boss was pleased or not aside, the focus was not on the customers. The customers are mad that their houses are worth nothing, their investment portfolios have crumbled, and they have been laid off, not that investors are utilizing short selling as a legitimate investment strategy. Focus on the customer!

Sure, the customers are angry and want the SEC to do something. But why short selling? The merits of short selling and the uselessness of this SEC regulation was discussed in a previous post. The customers know they have little understanding of financial markets and the forces that move it. That is why they pay taxes to the U.S. government, who has hired the SEC to implement policy in the best interest of the people. Get out from under your desk, close the browser window for hiboobs.com, and open up a real financial textbook.

Over the past couple of years, suffice it to say there has been a fan with some poop involved. The SEC, had it more carefully regulated mortgage-backed securities and financial derivatives trading, could have prevented or at least ameliorated the magnitude of the economic crisis and Great Recession. However, that is all in the past, and what needs to be determined is how such severe mistakes can be avoided in the future. The focus on the content boss, causing neglect for the telling signs of a major economic fallout, is to be blamed. Focus on the customers, what is best for the customers, and do not sleep on the job, and next time we might be able to avoid a $700 billion bailout. Oh yeah, keep the web-browsing clean while you're at it.

Is Apple a Buy?

Apple (AAPL) stock is trading at an all-time high, as of about midday Friday. No doubt, Apple is a leader in innovation , revolutionizing the way Americans and the world listen to music and communicate on the phone. Earnings are strong and organic growth appears to be experienced in the U.S. and abroad. Does this point to a higher stock price, pushing the all-time record to new highs? Maybe, at least in the near future. Is this stock a buy? Here are three reasons why you should absolutely not buy this stock.

1) Company executives are selling stock.

A million shares of Apple stock were sold by company executives – including the COO and CFO – last Friday, which were restricted shares granted as compensation back in 2005. The restricted shares were not unlocked for sale until this week, and several executives took advantage. This is a signal that those executives do not believe the stock will continue to rise, otherwise they would have wanted to hold onto the shares. While it is possible the execs elected to sell to diversify their investments, minimizing their risk and exposure to Apple performance, the investment community should not neglect this bearish signal.

It may be suggested that the executives sold their restricted shares to have more cash on-hand, and perhaps use it to make some purchases. However, COO Tim Cook received a $5 million bonus two weeks ago; in other words, he is not strapped for cash. It is not out of the question, but don’t bet on it.

2) The iPad sucks.

As Apple enthusiast and blogger Sebastien listed in his post, there are many reasons to hate the iPad, and it certainly let people down who were anxiously awaiting its presentation. Apple and its investors are optimistic on iPad sales, and in addition to its drawbacks, competition in the tablet business – the Microsoft Courier, in particular – are going to hurt iPad sales. As Apple blogger Darrell Etherington wrote, the Courier especially could compete with the iPad. The iPad may sell, but don’t expect good reviews and don’t expect it to meet the expectations of the investment community.

3) Steve Jobs could die soon.

Rumor has it that Steve Jobs is in good health, but he has seemingly impossibly overcome pancreatic cancer. Despite what his doctors and the company have said, his health is still fragile, and he is still very prone to another cancer outbreak or life-threatening illness. It is also not out of the question that Apple has not fully disclosed all the details of Jobs’s health. Jobs rescued Apple from its near bankruptcy and has been driving its innovation ever since. When Steve Jobs dies, Apple stock will fall at least 10%. Can you imagine someone else giving the quarterly Apple keynote presentations? Jobs is the life and blood of that company.

If you got into Apple early, congratulations on your successful investment. Take your gains and cash out. If you are looking to get into Apple now, you are too late. Apple has peaked, and the above reasons are factors that make Apple a risky stock to buy, as well as one likely to fall. Dump it, and cash out…if you have cash to invest, look elsewhere.

TARP - Not the Price It Appears to Be

The Troubled Asset Relief Program (TARP) was enacted by the U.S. Government in 2008 to provide struggling financial firms and key U.S. employers with cash to maintain solvency and avoid bankruptcy. To disburse this cash to the firms, the U.S. Treasury bought shares of preferred stock in the companies, as well as purchased toxic assets, such as mortgage-backed securities, off of the companies’ balance sheet. The total amount allocated to TARP was $700 billion, which is commonly misconceived as the actual price of the program. Many are under the misconception that the $700 billion was a sunk cost – U.S. taxpayer dollars that were spent, added to the U.S. national debt, and will never return. However, the fact of the matter is that in the end, the actual cost of the program will only amount to a fraction of the $700 billion originally budgeted.

The TARP dollars were distributed in the form of a loan or investment in the company being “bailed out,” and the U.S. government distributes those funds under the full expectation that the funds will be repaid and even a certain rate of return will be rewarded. For example, the $45 billion loaned to Bank of America as a part of the TARP program was repaid in late 2009. The $25 billion in preferred shares purchased by the U.S. Treasury in Wells Fargo yielded a $371 million dividend early last month.

Like any loan, some will default and the loaned funds will go unpaid. Of the $700 billion issued, some of the loans or investments will go south and go unpaid resulting in a loss; however, the actual cost of TARP – a fraction of $700 billion – versus the benefit – rescuing the U.S. economy and world financial system – was well worth it. Indeed, the Congressional Budget Office has issued a statement detailing the cost of TARP at $109 billion, a fraction of the original $700 billion. Considering the companies receiving TARP funds can be regarded as “risky” loans or investments, this cost is relatively low.

One’s stance on the bailout and the way the U.S. government has handled it aside, everyone should at minimum be clear as to how the program works, what its goals are, and what the true cost to U.S. taxpayers is. Hopefully this post has been successful in that regard.

Striking Optimal CEO Pay Structure

In light of the recent financial crisis and “Great Recession,” CEO and executive compensation schemes have come under fire by employees, investors, and the United States Government. Businesses and more specifically, financial firms, assumed high levels of leverage and risk, and over the past two years have reported massive and mounting financial losses as a result of poor investment decisions. Yet, amid these losses, company executives and CEOs have still experienced large bonuses and compensation packages, much to the chagrin of shareholders, laid off employees, and even the U.S. government. This has led boards of directors, policymakers, and investors of all types to question how CEO compensation packages should be structured. The focus is currently on c-suite executives at banking and financial institutions, whereas in the past it has been on other types of companies, such as automobile manufacturers, and in the future it will be on another industry experiencing losses with highly paid CEOs. However, while I cannot offer an end-all, be-all answer or a definitive formula to calculate how exactly to compensate CEOs, I will put forth in this paper the optimal pay strategy that will serve the best interests of the company, its employees, and its shareholders. To maximally incentivize and obtain the best possible performance from its CEO, companies should utilize a compensation structure that is cash-based, low salary-high bonus, and involves only a preset salary and no preset bonus figures or benchmarks. Furthermore, total compensation and year-end bonuses should be decided upon by utilizing a high degree of managerial discretion.

To begin the discussion, it is best to take a step back and actually visit what it is exactly a company seeks to extract from its CEO and what it is the CEO demands in return. The CEO oversees the entire operations of a company, putting the final stamp of approval on the company’s major investment and business decisions. These decisions are made with the intention of generating revenue, profit, and ultimately creating value for distribution to company investors, shareholders, and employees. In return, the CEO demands compensation for his or her time, effort, and results, essentially earning a piece of the created value pie. The question of how this piece of the pie should be composed to yield the maximum overall size of the pie is what requires discussion.

Contrary to widespread practice today, compensation packages should be paid in cash, rather than equity. Common equity-based pay devices include shares of stock, stock options, and warrants. The salary and bonus paid to a CEO should be cash-based, where the salary is paid in cash periodically throughout the year, and the bonus is paid in cash at the time the compensation decision is made. Indeed, research shows that companies exhibiting sustained earnings over time tend to compensate their executives more with cash than equity (#1). Nonetheless, in nearly every Fortune 1000 company, CEOs receive a significant portion of their total compensation from equity-based pay. The problems associated with this type of pay structure and the specific case for cash over equity is best made by pointing out of the shortfalls of equity-based pay and the issues they create.

Equity, and more specifically, stock option compensation allows the CEO to personally profit from inside information, which could very well cause outside investors and the company itself to lose. As a CEO accumulates ownership and shares of stock in a firm, he or she will rationally elect to exercise stock options and sell shares of stock to yield the highest possible profit. Typically, this will occur at a point in time when the CEO believes the company’s stock price to be at a high – in other words, the CEO expects poorer performance going forward and wants to cash out while the company is hot. By selling shares or exercising options, the CEO is indirectly communicating his or her expectation of weaker future performance; the investment community picks up on this and reacts by selling shares and taking similar bearish positions on the company’s stock. Studies have shown that large option exercises typically occur after abnormally positive earnings performance, and post-exercise, the company tends to perform more poorly (#7). So in the process, the CEO gains by cashing out at a high point, and shareholders lose by a stock price decline as a result of the large sale of stock by the CEO and the ensuing sell-off by the investment community taking a bearish position.

It can be argued that the above stated problem can be solved by awarding stock options with periodic, set exercise dates. The investment community would then not react negatively to the exercise of the stock options, and the CEO could not take advantage of inside information to sell stock at a high. However, this may cause the CEO to alter his or her strategy for the company and not take on projects or investments it might otherwise take on. As pointed out in a study, managers are more likely to take less risky endeavors for their company in order to preserve the company’s stock price if his or her options are in-the-money, and if their options are out-of-the-money, the manager may be more risk-tolerant in an effort to possibly boost the company stock to an in-the-money range (#9). The CEO should make decisions that are best for the company with personal interests set aside, and stock options with set exercise dates alter this decision-making process.

A final problem that comes with equity-based pay is the increased incentive for the CEO to make financial accounting manipulations – legal or otherwise – to potentially boost the company stock price before he or she exercises stock options. Especially if the CEO expects weaker performance in the future, manipulations to the accounting statements can be made to artificially inflate earnings at present (there are legal ways to do this), which could result in a higher stock price, allowing the CEO to exercise his or her options and maximize personal profit. However, for reasons mentioned earlier, this will cause the company’s shareholders to lose. In addition, it has been proven that poor earnings in post-exercise periods are a result of the reversal of inflated earnings in the pre-exercise period (#7).

Because the two main ways to compensate a CEO are through equity and cash, the information presented thus far against equity-based pay points to cash as the optimal choice. Although the company will need to have the cash on-hand to make payment, it avoids the aforementioned equity-based problems, as well as possible cash flow or stock dilution issues in the future come stock option exercise time. If a CEO truly believes in the performance of the company going forward, he or she can always use the cash compensation to purchase actual shares of the company and obtain the equity that way. The main argument against cash-based compensation is that it does not cause the CEO to have a personal vested interest in positive company performance, as stock ownership would. However, this issue can be side-stepped by implementing a low salary-high bonus pay scheme.

A low salary-high bonus compensation structure involves paying a CEO a salary that is very low relative to the bonus he or she could possibly earn, which will incentivize the CEO to seek optimal company performance. The year-end bonus could end up being as much as five or ten times the CEO’s salary, or even more. The reasoning behind this strategy is that a salary is a fixed, guaranteed amount the CEO will earn, regardless of company performance. No matter how the company performs, the CEO earns that fixed salary. A high salary with low bonus will provide a smaller incentive for the CEO to maximize his or her firm’s performance, because the CEO stands less to gain from improving firm earnings. Shifting compensation from a salary form to bonus form puts the CEO in a position in which his or her compensation is almost entirely based upon company performance, so the CEO will put forth his or her best effort and the most time into making sound strategic investment and growth decisions for the firm.

A problem cited with this type of pay structure is it causes the CEO to place too much emphasis on the current fiscal year performance to get a large cash bonus, rather than a long term growth and performance strategy for the company. As mentioned earlier, riskier projects or certain accounting manipulations could be made in order to boost current-year earnings. This problem is also reason to avoid certain bonus benchmarks, such as a set dollar bonus if some company performance metric (stock price, earnings, revenue growth percentage, etc.) reaches a specific level. Again, the CEO may engage in some clever financial footwork to achieve certain same-year performance levels. That being said, evidence suggests that CEO pay does increase in the short term with unexpectedly good accounting performance, but this later reverses and is followed by lower CEO pay in later years as the company does not perform as well in the future. This same evidence suggests there is a net zero gain in CEO compensation from unexpectedly good accounting performance (#2). While the aforementioned is a problem – at least in the short run – the problem can be averted by implementing a high degree of managerial discretion in the bonus decision-making process.

Managerial discretion as it pertains to compensation can be defined as the ability of managers to use their own opinions and evaluation of performance in determining the compensation of an employee. The goal of managerial discretion is to better link the pay of a CEO to his or her performance and give a fair, earned, and deserved bonus to the CEO. Managerial discretion eliminates the possibility of a CEO receiving a bonus based on short-term above-expected financial performance as a result of accounting manipulations or short-term budget cuts, because directors can recognize the manipulations and limit their influence as a factor in the true evaluation of the CEO’s performance. Indeed, a study found that executive compensation is more closely related to performance when a high degree of managerial discretion exists, as compared to a firm with low managerial discretion (#4). While budget cuts or financial manipulations may serve a purpose and provide some measure of value to the company, company directors want to compensate the CEO and other managers for the true value they create for the company. A high degree of managerial discretion in the pay process can ensure they are compensated for value-adding, long-term activities, rather than short-term fancy financial footwork.

A high degree of managerial discretion in a cash-based low salary, high bonus CEO compensation structure will allow the company to extract as much as possible from its CEO and ensure all of his or her decisions are in the best interest of the company. The optimal medium between what the firm gets from its CEO and what the CEO gets from the firm can be found, maximizing the value created for employees and investors. The incentive issues associated with equity-based pay, such as temptations to make accounting manipulations, take on unnecessary risk, or sacrifice long-term performance for short-term success, are eliminated with cash-based pay. The low salary, high bonus structure compensates for true performance, and the managerial discretion makes sure the performance is both accurate and in the best interest of the company. Yet, today most companies still pay their CEOs primarily with equity and a low degree of managerial oversight. It is still a mystery as to why this is happening, but the solution – or at least, the theoretical solution - with supporting evidence is there.

#1 Executive Compensation and Earnings Persistence. Allan Ashley, Simon Yang.

#2 Accounting and Stock Price Performance in Dynamic CEO Compensation Arrangements. Boschen, Duru, Gordon, Smith.

#4 Bank Performance and Executive Compensation: A Managerial Discretion Perspective. Magnan and St-Onge.

#7 Private Information, Earnings Manipulations, and Executive Stock-Option Exercises. Bartov, Mohanram.

#9 Executive Stock Options: Early Exercise Provisions and Risk-taking Incentives. Brisley.

Investment Banking Analyst – Part 2: Stress

Continuing from the previous discussion of the sleep deprivation effects of being an investment banking analyst, the arguably most detrimental aspect of the job is stress. The stress is generated from a lack of sleep, free time, and opportunity to receive care from others, as well as immense pressure in the workplace to produce error-free work and meet tight deadlines. Stress obviously has a long list of health effects; the most important of which are, arguably, the effects on aging.

As mentioned in Part 1 of this series, sleep deprivation can cause an investment banking analyst to feel as though he or she has physically aged four years in two years’ time. While sleep deprivation plays a major role in this feeling, stress also is a major factor in driving that feeling. Stress can also turn that feeling into a reality – stress has been noted to cause grey hair at an earlier age, or even hair loss at an earlier age. Looking and feeling older are not desired traits by young adults around age 25.

Another fallback of the immense amount of stress placed upon investment banking analysts is they grow used to it and learn to expect stress in their lives. That is not to say necessarily that analysts learn healthy ways of dealing with stress, however. Stress becomes such a constant and ongoing part of their lives that even in situations without stress, analysts commonly find or create stress to make that situation revert back to “normal” for them. Although younger Americans are typically more stressed on average, investment banking analysts take this to a whole new level as stress becomes an unhealthily expected part of their daily lives.

As touched upon briefly before, stress can cause a change in physical appearance, but it can also take a toll on the overall health of the body’s organs. The normal physical aging and aging in appearance process an individual’s body might go through is severely accelerated by working in investment banking. In addition to looking and feeling older, the body may actually be older at the end of one’s stint as an analyst. Stress can increase the risk of cardiovascular disease and hypertension in the heart, ulcers and other digestive issues, and even skin problems, which would have either not occurred at all or occurred in later life. This accelerated aging and creation of health risks are downsides of the job directly attributable to stress.

Stress in one’s life should decrease as they age. The issues and uncertainty associated with puberty, maturing, finding a job, and starting a family certainly cause stress to be high beginning in the late teens to mid twenties. However, as people grow older, more decisions are set in stone and settlement takes place, thereby reducing uncertainty and the sense of worry. This would lead to stress decreasing as people age, which holds true for Americans. I would also expect this to hold true for investment banking analysts, but due to the high stress in investment banking and analysts being accustomed to stress as part of their lives, I predict analysts maintain a higher level of stress than the average and take longer to begin becoming less stressed. As far as aging is concerned, a lower level of stress for a shorter period of time would appear to be ideal, but in the case of an analyst, he or she would experience the exact opposite.This could lead to serious aging consequences down the line.

In summary of Parts 1 and 2, sleep deprivation and stress are very real aspects of the lives of an investment banking analyst on Wall Street. Both inevitably accompany the job and create serious impacts on the aging process. College students considering entering investment banking should strongly consider these issues before pursuing a career in the field.