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Part II showed that governments’ accounting and managerial practices are at least as scandalous as those of certain private sector companies presently in the news. It concludes that politicians and governments have no moral basis on which to demand that businesses conform to certain standards of ethics and accountability.
It also follows from both first principles and the historical record that investors should be sceptical that governments’ laws and regulations (pre-existing or proposed in light of the Enron, WorldCom and other fiascos) can and will make their investments safer. Anglo-American countries already have enforcement agencies and thousands of securities laws. In America, for example, the Securities and Exchange Commission spends $US 500m every year protecting investors from fraud. Would new laws provide significantly more protection than existing ones? Alas, governments can no more protect investments than they can win a War on Drugs, a War on Poverty or a War on Terrorism. However laudable their motives, and try as they might, governments cannot keep these promises; accordingly, investors should not rely upon them for protection. Fortunately, the history of financial busts and the methods of Graham, Buffett and other value investors provide a path through the wilderness.
The Maestro’s Previous Tune
Andrew H. West, CFA, in an excellent, thought-provoking article entitled Less Government Regulation and More Laissez-Faire Required to Prevent Further ‘Enron’ Scandals (7 March), notes one of the most famous alumni of New York University’s Stern School of Business, Dr Alan Greenspan, predicted almost forty years ago that government regulations could beget events such as the Enron, WorldCom and other messes that have surfaced since December 2001. Greenspan stated in an essay entitled “The Assault on Integrity” that:
Reputation, in an unregulated economy, is a major competitive tool. It requires years of consistently excellent performance to acquire a reputation and to establish it as a financial asset…Thus the incentive to scrupulous performance operates on all levels… It is a built-in safeguard of a free-enterprise system … Government regulation is not an alternative means of protecting the consumer. It does not build quality into goods, or accuracy into information. Its sole “contribution” is to substitute force and fear for incentive as the “protector” of the consumer.
Mr Greenspan continued:
What are the results? To paraphrase Gresham’s Law: bad “protection” drives out good. The attempt to protect the consumer by force undercuts the protection he gets from incentive. First, it undercuts the value of reputation by placing the reputable company on the same basis as the unknown, the newcomer, or the fly-by-nighter. It declares, in effect, that all are equally suspect … Second, it grants an automatic guarantee of safety to the products of any company that complies with its arbitrarily set minimum standards … The minimum standards, which are the basis of regulation, gradually tend to become the maximums as well. A fly by night securities operator can quickly meet all the S.E.C. requirements, gain the inference of respectability, and proceed to fleece the public. In an unregulated economy, the operator would have had to earn a position of trust.
Vast numbers of studies have been conducted about regulation. Vanishingly few, however, conduct cost-benefit analyses that take into account the positive effects of self-regulation or the negative displacement effect of a regulation (whether good or bad) from one individual or group to another. In contrast, legion are the congratulatory analyses by proponents of regulation (including those regulated) about the number of lives, injuries and dollars saved. Richard Epstein (Bargaining with the State, Princeton Univ. Press, 2001, ISBN: B00005NQWO) analyses the often Kafkaeque (perhaps a Fellini film is a better analogy) and corrupt relationships that can prevail between regulators and the regulated. West also notes that Baruch Lev, professor of accounting at NYU, has contributed much food or thought to the subject of corporate regulation. In the manner of Benjamin Graham a half-century before at Columbia, “Professor Lev brought [to class] a financial report prepared by US Steel from around 1903, a time before the government established the SEC or got involved in accounting standards. He pointed out that in almost every respect, US Steel’s financial statements offered as good or better disclosure and better information than financial statements do today. And they were provided more frequently, monthly. Back then, US Steel and its auditor had to earn investors’ trust in the marketplace. Now, companies just try to get away with murder, while minimally adhering to the letter of the law and accounting rules.” West concludes “investor skepticism is the first line of defense against fraud in a free economy, but becomes dull in a regulated environment.”
Thomas Donlan (Barron’s 15 July) agrees. “As long as the stock market was going up, lawmakers, officials and so-called investors never minded much about corporate governance. They never minded about the integrity of auditors. They never minded about the veracity of press releases. They never minded the many warnings from those who said it wasn’t different this time. Those who drove the market so high without regard for fundamental value excused all manner of mistakes and malfeasance. The federal government cannot exorcize the blame that rests on the boom and its bulls. Lower prices and public skepticism are reforming the market more effectively than new laws ever could.” The Economist (11 July) also agrees: “in truth, the most effective remedy for these ethical and mental breakdowns has already been dispensed, frustrating as this is for politicians with careers to make. Shares may still be dear, but the technology-stock bubble has well and truly burst [sic]. The mood has changed from mania to remorse. Until further notice, regulation or no regulation, investors will be on their guard, and financial orthodoxy and corporate probity will once again be celebrated and valued.”
The Times Are Once Again Tailored to Graham
Somewhat like Mark Twain’s cat (“having sat upon a hot stove lid, he will not sit upon a hot stove lid again. But he won’t sit upon a cold stove lid, either”), many market participants who once squatted everywhere now fear to tread anywhere. One emotion, greed, has yielded to another, fear; but at no time in recent years has sober and reasoned scepticism figured prominently in their minds. In the first edition of Security Analysis: Principles and Techniques (presently available under the title Security Analysis: The Classic 1934 Edition, McGraw-Hill Trade, 1996, ISBN: 00702449601996), Benjamin Graham introduced a format to which he adhered in the subsequent editions that he supervised. The book builds steadily, introducing one concept and then another, until the reader possesses a toolkit required in order dispassionately to analyse stocks, bonds, debentures and associated instruments, and government and other securities. Readers were shown how to assess a company’s financial statements, spot discrepancies therein and distinguish sharply between price and value. It is a mistake, Graham contended, to rely without careful scrutiny upon the corporate version of its own condition. Managers can err, exaggerate and even lie; hence revenues, earnings and so on can be manipulated (see, for example, his delightful “Satire on Accounting Shenanigans: U.S. Steel Announces Sweeping Modernization Scheme in Lawrence” A. Cunningham, ed., The Essays of Warren Buffett: Lessons for Corporate America, The Cunningham Group, 2001, ISBN: 0966446119). Not unlike a detective or an archaeologist, a Grahamite investor sifts through and weighs evidence, removes the fluff, makes cautious assumptions and considers various dour possibilities.
Given the accounting and managerial shenanigans of the Roaring Twenties, the early editions of Security Analysis placed particular emphasis upon bonds (especially those of heavy industrial companies) and railway securities. These examples served investors well during the 1930s. The railway era has passed into history; but, as Janet Lowe (Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street, Penguin, 1996, ISBN: 0140255346) notes, “there is one advantage in reading Security Analysis in its earlier editions. The investor will be cleansed of any notion that there is much that is new on Wall Street. It soon becomes clear that scams, frauds, misrepresentations and clever approaches to salesmanship simply get dressed up in new clothes for subsequent generations of investors. The underlying ruses have not changed much.”
During the Depression, probably more so than today, the public regarded Wall Street as a corrupt place. Graham’s response, as summarised in a recent description of his Northern Pipeline triumph (“An Original Activist Showed Shareholders [How] to Be Skeptical” The Wall Street Journal, 5 June), was to strive to distinguish the worthy wheat from the suspect chaff. As in the 1930s so too in the Noughties: investors “should be skeptics, not sheep.”
 
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