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"What's Wrong With Wall Street?" Short-Term Gain and the Absentee Shareholder.

Arbitrageurs Anonymous

Warren Buffett's famous proposal, in case you missed it, is that the government slap a 100 percent tax on all capital gains from stocks, options, or futures that the seller has owned for less than one year. This is a sin tax, not intended to raise a single penny in revenue. The idea is to discourage a socially destructive addiction: the Wall Street Trading Habit.

We've tried sin taxes on cigarettes and liquor and neither has stopped people from smoking and drinking, but taxing profits 100 percent is almost guaranteed to stop people from short-term trading. Short-term investors--which according to published reports is nine investors out of ten these days--admittedly are a gung-ho lot, but it's hard to imagine any who are gung-ho enough to continue buying and selling pro bono.

Buffett's turnover tax has gotten a wider and more enthusiastic audience than it might have were it you or me or even David Stockman proposing it. Investors of all shapes and sizes listen to Buffett not simply because his words have made them wiser but because his actions to date have made so many so much richer. Had you invested just $2,000 in Mr. Buffett's company, Berkshire Hathaway (BKHT), back in the early 1960s you would have made 571 times your money by now. The original $2,000 would be worth $1.142 million. (On the other hand, Mr. Buffett himself once invested $58,000 in The Washington Monthly, proving that he's not infallible.)

If you're not already convinced that short-term trading is either (a) destructive, or (b) worth stopping, you will be after you read Louis Lowenstein's book(*). The jacket blurb identifies him as a finance professor and former merger and acquisitions lawyer, but obviously he doesn't want to be remembered that way any more than Paul wanted to be remembered as a fisherman. He's the first convert to Buffett's cause to break ranks with the trading establishment and to write down a chunk of startling gospel. (Actually, Lowenstein has his own cause, shreholder democracy, but he's much less persuasive about that than he is about the evils of short-term trading.)

The trading habit has become more compulsive since the 1960s, when the annual turnover rate for stocks was 12 percent. Now it's 87 percent. In the late 1950s on a busy day in the New York Stock Exchange, three million shares changed hands. Today, three million shares are traded every ten minutes.

We're rapidly approaching 100 percent turnover, when every share in the country, on average, will be traded once a year, and some obviously will change hands much more often. That's $3 trillion worth of stocks shunted from one portfolio to another, with the result, as Lowenstein points out, that "at the end of the year, the institutions as a group own roughly the same stocks they did in the beginning." It's gotten to the point that a ten-year Treasury bond normally is owned for only 20 days!

It's not mom and pop doing all this trading. It's the prudent portfolio managers they "hired" to run the mutual funds plus the pension managers who invest the corporate pension money who've got the Wall Street trading habit. Of course, it's not the managers' fault entirely. Ultimately, the people to whom this money belongs demand that their quarterly returns are equal to everybody else's quarterly returns, and the portfolio manager who doesn't please them soon finds himself out of a job.

So far we've been talking about stocks and bonds, which are supposedly the long-term investments. For the short-term end, which is to say something you've owned between coffee and dessert, there's futures and options. Buyers and sellers of stock index futures bet $26 billion a day: $13 billion up and $13 billion down.

A stock index future is just like a port belly future, only instead of being a commitment to buy pork, it's a commitment to buy a "basket" of stocks. Between these futures, plus the options on stocks, the options on stock indexes, and the options on the futures, you've got enough frantic trading to equal the GNP of respectable nations. Even the supporters of the trading habit admit that only 20 percent of it has any use at all, meaning that 80 percent of it is nothing more than pari-mutuel wagering.

So what's wrong with a little gambling? Hostile takeovers, ill-conceived mergers, and even the Crash of October are all side-effects of the trading habit--or at least Lowenstein makes a convincing case of it.

High-priced toads

Let's start with the takeovers, the mergers, and the acquisitions. It's no accident that we're seeing more of these in the 1980s than in any previous decade. The reason it's so easy to take over a company today is that billions of loose shares have fallen into the hands of the short-term traders who are only too glad to deal them for a short-term advantage.

In the old days, when people invested in companies and not The Market, there were sizable numbers of shares held by founding families, believers in the enterprise, widows, orphans, and prudent long-termers. Millions of shares kept in bank vaults and safety deposit boxes simply were never put on the trading block, thus making it impossible for outsiders even to threaten to buy up 51 percent of a given company. With so many shares unavailable, how could they ever mount a decent corporate raid?

In recent decades, as the handling of stocks has been turned over to professionals, an increasingly greater percentage of shares has been coaxed out of safety deposit boxes and into the portfolios of big institutions. Today, these institutions control 70 percent of the shares of most major companies. Thus, the fates of such companies is now influenced by a succession of skittish and desperate portfolio managers who willingly sell out their interest in a company on the next up-tick to gain a momentary advantage over their competitors. (I've wondered how the companies even keep up with where to send the annual reports.) Many of the mammoth funds buy and sell stocks wholesale, to "index" their portfolios, without a thought as to the characteristics of the individual issue. The large pools of shares, even a majority of shares, are immediately accessible to the latest bidder. With so many shares up for grabs, it's easy to see how Carl Icahn makes a living.

In the recent case of Gillette, it never would have been possible for Ronald Perelman of Revlon to launch a hostile takeover attempt, nor for Coniston Partners to continue to pimp for a buyer, without the constant availability of millions of Gillette shares that a decade ago would not have been for sale. Not that Gillette has done such a great job on its own, but this sort of preoccupation with immediate gains and losses and with fending off suitors puts pressure on companies to favor profitable short-term schemes over intelligent long-term plans.

It's often assumed that takeovers, mergers, and acquisitions scare bad corporate managers and force complacent companies to perform better. This book provides evidence that recent take-over targets are performing no worse than the companies that worked to acquire them--except that now they are more heavily indebted thanks to the acquirers.

Most of this data comes from a study by Lowenstein and Edward S. Herman of the Wharton School of 56 corporations that were the objects of hostile takeovers between 1975 and 1983. The results show that the target companies were making normal profits (returns on equity) before they were attacked and therefore could not be expected to do much better under new management. "It's like the fabled story that Buffett tells of the toads waiting to be turned into princes by princesses with magic kisses," Lowenstein writes. "If these bidders are not bona fide princesses, we are left with some very high-priced toads."

Mergers and acquisitions has become a $180 billion a year business in which companies are routinely sold at 80 percent more than they are actually worth. The ultimate ramifications are as yet unclear, but there's no lack of hints of troubles to come:

"The new Allied Stores Corporation was essentially the same company but with a hollowed out capital structure," says Lowenstein. "The buyer had not only paid 25 times Allied's earnings in its last fiscal year but had borrowed almost all of the purchase price from banks and an affiliate of First Boston Corp., its investment advisers. Campeau's own cash contribution did not cover even the financing fees and merger expenses. Allied's total debt jumped to $3.8 billion."

As to the Crash of October, so far the blame has been placed on either: (1) computerized arbitrage between stocks and futures, or (2) greed. Greed is always a welcome explanation for Wall Street's disasters, because nothing can be done about it. (Ironically, every time the market falls, investors are told to ponder their greed, but when the market goes up, giving them actual cause to feel greedy, they never think of it.) No wonder the movie Wall Street was a hit among professionals: greed once again was the villain, with the Crash of course serving as punishment, and now expiated by their losses, all the traders can happily go back to trading.

But neither greed nor arbitrage was the actual culprit in the Crash, according to Lowenstein, whose findings resemble those of the Brady Commission report. In fact, he argues that program traders, who buy and sell baskets of stocks against stock futures, could not possibly have been doing much trading on that dreadful October 19 because nobody knew what the prices were. The prices were changing too quickly and by midday the machines were beseiged by sell orders. Meanwhile, a lot of the panic selling was being done by the big fund managers. On a day like this no self-respecting portfolio manager would want to be caught underperforming other portfolio managers, so selling begat more selling.

The fact that these same portfolio managers had "insured" up to $100 billion worth of stocks in the futures market may have been the single most important contribution to the calamity. Apparently the protection plan involved the automatic selling of stock index futures (which means making money when the market goes down) along with the selling of actual stocks, a process that, once set in motion, threatened to take stock prices to zero. Ironically, the portfolio "insurance" made the market much riskier.

The idea that the trading habit is harmful and that as long as it persists we'll have other Black Mondays when desperate sellers overwhelm the buyers apparently hasn't occurred to the regulators or to the powers on Wall Street. Eight months after the crash, the 200-million share day still is regarded not only as normal but also as a sign of financial health. Just last night, I heard some Wall Street expert on network television tell the nation that the recent string of 100-million share days was an ominous symptom of a sick market.

Happy hour

This isn't the first decade in American history in which investors have turned into frantic traders. The last time there was a turnover rate in stocks equal to the current turnover rate was--you guessed it--1929. In that era, too, investors were more enamored of the market itself than of the underlying businesses. Basic values were so ignored that millions bought shares in the famous holding companies of utilities magnate Samuel Insull, even though any fourth grader could have figured out that his companies would collapse. By the late 1920s, the business of America couldn't support its high-priced stocks.

Today, can the business of America support its high-priced trading habit? Lowenstein estimates that we now spend between $25 and $30 billion a year just on trading shares (plus their attendant futures and options). The portfolio insurance alone eats up between 2 1/2 and 4 percent of a fund's annual resources. Institutions pay lower commissions than they used to, but the savings are more often offset by the volume. The same thing happens at happy hour at the neighborhood bar.

Meanwhile, if you add up all the prices of the stocks in the S & P 500 and you add up all the earnings of the companies to which these stocks belong the average return on investment is only 6 percent. Some years it's less, some years it's more, depending on what the stock market does and what the economy does. But as it stands today, trading costs eat up 20 percent of those earnings.

These are the numbers we can calculate. Who knows about the social costs, the ultimate waste of sending the best and the brightest to Wall Street, where they spend the rest of their lives studying whether stock prices are higher on Mondays, which is as useless as betting on Three Card Monte out on the street. Actually, it's worse than betting on Three Card Monte, which doesn't really hurt anybody but the immediate players. Half the graduates of our business schools now end up at firms like First Boston, working on mergers and acquisitions, and the result, apparently, is weaker companies. That hurts everybody.

If Buffett's tax were adopted all this would change overnight. Think of the relief of the portfolio manager who no longer has to worry about quarterly performance. Once again, he'd have time to think about long-term values beyond 20 days. Think of the relief of the corporate boards of directors if the available pool of shares for sale dried up on the Ichans and the Pickenses. Think of the useful ideas that might come out of the minds of college graduates, once liberated from fatuous dealmaking and useless prognosticating of ups and downs.

Forgive Lowenstein that beyond the end of short-term trading he sees a new shareholder democracy, in which millions of shareholders begin to participate in the affairs of Kellogg, AT&T, or IBM the way they participate in the Republican and Democratic parties. Forgive him that he glorifies some earlier and dubious halcyon age when bankers like J.P. Morgan stood out as financial role models--the same J.P. Morgan that created U.S. Steel out of watered stock. Forgive him that he writes like a lawyer and a bureaucrat. Congress ought to read this book, and then pass the turnover tax.

The result would be an immediate end to this second terrible addiction that wastes thousands of lives and billions in assets and threatens to destroy our very economic system. Say no to trading. (*) What's Wrong With Wall Street? Short-Term Gain and the Absentee Shareholder. Louis Lowenstein. Addison-Wesley, $17.95.
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Author:Rothchild, John
Publication:Washington Monthly
Article Type:Book Review
Date:Jul 1, 1988
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