Wednesday, April 06, 2005

Managerial Heroin

Good article in the NY Times, with an interview with Michael Jensen from HBS. Our Kevin Murphy also gets a brief mention.

Q. After you proposed this in the Harvard Business Review, the use of stock options grew rapidly. But then you soured on the idea. Why?

A. Compensation committees wrongly looked at options as free, and awarded too many to too many people. It diluted the stock. And most stock option programs still rewarded management for building the empire, not the actual value. There was no penalty for investing in projects that did not return the cost of capital. When those projects pumped up the stock, management got a big win - but the shareholders would have still done better if the money had been paid out in dividends.

Q. Lots of companies are switching away from stock options to outright grants of restricted stock. Does that solve the problem?

A. No. Say I offer you $1 million in restricted stock - even if you think the stock will go down 10 percent, you're still getting $900,000, and you're happy as a clam. I'd be handing over a large amount of wealth, yet penalizing executives only slightly for the decline in the value of the stock.

Q. So the maximum stock price is the holy grail?

A. Absolutely not. Warren Buffett says he worries as much when one of his companies becomes overvalued as undervalued. I agree. Overvalued equity is managerial heroin - it feels really great when you start out; you're feted on television; investment bankers vie to float new issues.

But it doesn't take long before the elation and ecstasy turn into enormous pain. The market starts demanding increased earnings and revenues, and the managers begin to say: "Holy Moley! How are we going to generate the returns?" They look for legal loopholes in the accounting, and when those don't work, even basically honest people move around the corner to outright fraud.

If they hold a lot of stock or options themselves, it is like pouring gasoline on a fire. They fudge the numbers and hope they can sell the stock or exercise the options before anything hits the fan.

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