Do Investors Now Require a Credibility Premium ?

Ethics Box 7 – Chapter 7

Do Investors Now Require a “Credibility Premium”?

J. Zietlow

Possibly following the moral advice of actor Michael Douglas in the movie, “Wall Street”--“Greed is good!”--numerous public companies published inaccurate and misleading financial reports in recent years. Stock brokerages further muddied the investment information waters by overrating the prospects of companies whose securities they helped bring to the market. These ethical lapses have serious implications for investors and for the value of their stock.

One expert estimates that legal but aggressive accounting boosts the reported earnings of U.S. businesses by at least 20%.[1] Not accruing enough expense for pensions, not treating options as an expense, and focusing investors’ sights on operating earnings (thereby taking their eyes off discontinued and other loss-ridden parts of the business) are the primary tools mentioned. A March 2004 survey of finance executives by CFO magazine asked these managers to put themselves in the role of investing their own money. Their response is revealing: a mere 27% would feel “very confident” that they were getting high quality and complete information from public companies (with 66% somewhat confident and 8% not confident). These same execs pointed to personal greed, ineffective boards of directors, and high-pressure CEOs as the primary causes of aggressive accounting. Lynn Turner, former SEC chief accountant, believes stock investors lost $100 billion over the past 6 years due to financial restatements. Warren Buffett said it best: “Situational ethics has reared its ugly head.”[2] President Bush echoed this sentiment, saying that business schools must be “principled teachers of right and wrong and not surrender to moral confusion and relativism.”[3]

Information put out by securities analysts working for stock brokerages has been equally flawed, or worse. According to Kiplinger’s Magazine, N.Y. state attorney general Eliot Spitzer levied a $1.4 billion fine on ten Wall Street firms, documenting ratings that were routinely inflated, bribes to other firms’ analysts to get them to write glowing reports, and pressure on individual analysts to reverse negative ratings.[4] In a HarrisInteractive survey of investors in 2003, when asked what the main issues facing the securities industry today, investors overwhelmingly responded “dishonesty” (43%, versus 9% indicating market volatility, and 5% citing accountability). The biggest problem cited by investors? They believe the securities industry is motivated by greed (69%).

Why should the analyst doing valuation care about all of this? Because when people don’t trust the numbers, they price assets to reflect both a risk premium (for business and financial risks) and what Robert Arnott calls “a credibility premium”. Stock prices are lower than they should be, as a result, and honest companies may get penalized along with the dishonest ones. The good news is that the new scrutiny and Sarbanes-Oxley law are having a positive effect: 77% of CFOs surveyed saw the new law makes it easier for them to resist pressure to misstate financials. Senior executives surveyed by PricewaterhouseCoopers are somewhat optimistic but mixed on whether investor confidence will be restored as a result: 31% thought it would be, 50% said there would be no impact, and 19% were unsure of the final impact.

[1] Robert D. Arnott, “Ethics, Earnings, and Equity Valuation,” in The Journal of Portfolio Management 29(Spring 2003): 8-16; other sources used in this box include: Don Durfee, “It’s Better (and Worse) Than You Think, CFO, May 2004 [accessed online at Carrie Johnson, “Board Finds Problems in Audit Firms,” Washington Post, June 25, 2004, pg. E1; Andy Serwer, “Dirty Rotten Numbers,” Fortune, February 18, 2002, pp. 74-81.

[2] Quoted in Serwer, pg. 75.

[3] Quoted in Paul Singer, “Business Schools add Ethics in Wake of Corporate Scandals,” Associated Press State and Local Wire, August 16, 2002.

[4] Fred Frailey, “How About Real Remorse?” Kiplinger’s, July 2003, pg. 14.