LOM Weekly Persepectives

Some of the booming sales figures reported by corporations in the glory days of the late nineties was phony. So say officials of the U.S. Securities and Exchange Commission who have been investigating the problem in a range of industries. This doesn’t come as a big surprise to those observers who have become thoroughly disenchanted with the illusionists operating on Wall Street, in accounting firms, or among corporate management. Al Dunlap who ran Sunbeam, some years ago, was particularly adept at stuffing the sales pipeline with unsold goods. He may now be surprised to learn how much more accomplished his successors have become in creating sales growth out of thin air, swapping assets or services back and forth. But "Chainsaw Al" was a crude sort who wasn’t well-versed in modern and subtle means of generating fictitious sales growth. However, he had other qualities. You may recall that he got his nickname because of the discreet way he went about reducing headcount and eliminating under-performing units.

Dubious sales figures make it that much more difficult for investors to carry out proper analysis. For a start, sales growth is a means of distinguishing successful growers from laggards. For another, one favourite measure of valuation is the calculation of the price to sales ratio. This is done for two main reasons. First, the sales data is normally thought to be less susceptible to management and accounting manipulation than earnings numbers. Second, for many firms in the technology sector, the price to earnings ratio is not meaningful because profits are mostly nought or negative. Consequently, the price to sales ratio is, under normal circumstances, a useful substitute.

Michael Lewis, a Bloomberg columnist, recently wrote that Warren Buffett is more than a little peeved about the level of compensation received by top executives in corporate America. Rich remuneration has been a bone of contention among some shareholders for a long time, but was largely forgotten during the boom times of the nineties. Shareholders may have turned a blind eye to the extravagances in the good years, but now that times are tougher are they going to press for a leaner look at the top? Well, don’t expect too much. The compensation system for top execs is nicely rigged, though this does not prevent the privileged from constantly and sanctimoniously declaring the benefits of competitiveness to other folk. The executives go to the same golf clubs, have the same interests and sit on each other's compensation committees. Also, big institutional stockholders generally play along. Meanwhile, those who have conducted studies have found little relationship between executive compensation and company performance. The hype about brilliant management and scarce talent is largely overdone. An anonymous person who once said that most companies are badly managed was closer to the mark.

Several years ago, U.S. investors flew out of emerging markets among cries of "crony capitalism". Now that crony capitalism is shown to be alive and well in the United States too, the foreign markets don’t look at all bad. Many emerging markets are sporting decent valuations that are, naturally, accompanied by a bit of traditional cronyism and a dose of volatility. The opportunities and the potential are once again proving attractive to overseas investors, many of whom have already made their move. With U.S. equity markets continuing to struggle, there should be further support for emerging stock markets. But this time round the enthusiasm is being tempered with a little caution and some selectivity.

The chairman of the Fed remains perennially optimistic about productivity growth. He believes that firms are about to reap great benefits from the last decade’s high rate of investment spending. The theory is that in the late nineties the installation of new equipment and technology disrupted operations, thereby reducing productivity growth. Now that there is less new stuff being added, there will be fewer disruptions and greater opportunity to fully use the equipment already installed. However, this is a curiously static and old-fashioned view of how the world works. It is more applicable to the older technology of the metal-bashing sort than the newer technology of information and communication. One problem with Greenspan’s view is that innovation under the newer technology is much more rapid, and lots of equipment is quickly made redundant.

In the growth slowdown of the past two years much hardware, which remained unsold in inventories because of slow demand, was surpassed by newer technology and found few buyers. If the hardware's productivity-enhancing qualities were top-notch it would have been priced accordingly -- not sold at knock-down prices. To be competitive a firm needs cutting-edge technology, not yesterday’s products. As for already-installed hardware and software, the learning curve is usually quite rapid. It has to be fast, because software and hardware are changing very quickly. Greenspan's notion that people have the luxury of spending many years to learn the most efficient use of static technology is overstated. The world is changing too fast for that to be possible. This is quite different from the case of, for example, over-investment in traditional assembly-line equipment that once installed before a period of demand slowdown would be tweaked and used more efficiently when demand picked up.