Joe Nacchio and the Conservative Investors

The best thing about mark-to-market accounting is that it forces investors

to ignore sunk costs. If a stock is trading at $30, it’s either a good investment

at $30 or a bad investment at $30, regardless of whether you bought it at $3

or at $103. If you mark to market every day, that essentially forces you to

justify every one of your holdings every day, at its market price that day.

(The bad thing about mark-to-market accounting is that it forces you to justify

every one of your holdings every day, which can mean that you trade in and out

of stocks much more than is optimal.)

Now let’s say you own a quiet and boring utility, like US West. If you mark

to market, you’ll wake up one day realizing that you no longer own the quiet

and boring US West, and instead own a high-flying dot-com called Qwest, trading

at some enormous valuation. Whatever reasons you had for owning US West would

probably no longer be good reasons for owning Qwest, and so you would probably

sell your Qwest stock and buy something

more boring instead.

Or let’s say you own an old and storied publishing company, like Time-Warner.

One morning you wake up and realize that you suddenly now own AOL instead. Eek!

That’s not what you wanted to own at all. So you sell, and invest the proceeds

in a nice new mattress.

In an ideal world, that’s how M&A would work. There would be no difference

between cash offers and stock offers, because cash can always be used to buy

the stock of the new company, while the stock of the acquiring company can always

be sold for cash.

In this world, however, M&A deals never work like that. If people get paid

cash, they’re unlikely to spend that cash on the stock of the company which

just bought them out. On the other hand, if people get paid in stock, they’re

likely to keep it.

That’s why Floyd Norris is so

upset about the six-year

sentence that Joe Nacchio received today.

There are some companies that are meant to be speculative vehicles. Others

are supposed to be the kind of stock that the proverbial widow and orphan

can safely own. When investors in one of those are defrauded, the crime takes

on a special level of venality…

As the local telephone company, US West had attracted conservative investors.

Retirees trustingly left their life savings in the stock. And they were all

but wiped out. By the bottom in 2002, an investment of $64 in US West at the

end of 1998 was worth less than $2.

It’s easy, but unrealistic, to say that conservative investors, if they were

really conservative, should never have held onto their Qwest stock in the first

place: the conservative thing to do would have been to sell it and invest it

in bonds or something instead. But of course the twin obstacles of inertia and

capital-gains tax meant that many fewer individuals – and even institutional

investors – did that than should have done.

So is Norris right that Nacchio should have received a harsher sentence on

the grounds that he defrauded "the proverbial widow and orphan" alongside

more sophisticated investors? I do think that sentences for white-collar crimes

should indeed be tougher than they are: many people were much more badly harmed

by Nacchio than they would have been had he simply come up to them on the street,

bashed them on the head, and stolen the contents of their wallets. Which might

well have resulted in a harsher sentence.

And CEOs do, ultimately, have a responsibility to their shareholders –

if their shareholders are conservative, then they should be conservative; if

their shareholders are aggressive investors wanting outsize returns, then the

CEO should take more risks.

But in practice it doesn’t work that way. Shareholders can change their mind

much more easily than CEOs can. So if you want something conservative, you choose

a company run in a conservative manner; if you want something more aggressive,

you choose a company run more aggressively.

So while I agree with Norris that Nacchio’s sentence is too short, I disagree

that it should have been bumped up just because he inherited some conservative

shareholders when he bought US West. The least that a shareholder can do is

be aware of what kind of company he owns. And if you don’t like the kind of

company you own, the easiest thing to do is simply to sell your shares. You

might not like the tax consequences, but a 15% capital-gains tax bill is a lot

less painful than owning a stock which plunges to zero.

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