CHAPTER 6 Greed Is Good, ’90s Style

The market has seen its share of ups and downs over the decades, but the

rocket ride and dramatic downslide of the late 1990s was a perpetual

headline maker—another example of humankind’s historical prerogative to

get excited, especially as a group.

Manic booms shouldn’t be all that surprising. There are examples

throughout time, from the famed Tulip Bulb Mania in Holland in the 1630s

to the soaring U.S. stock market of the 1920s. The particular spurt that took

place in the United States during the last five years of the 20th century was

aided by the advent of a pervasive new technology, the Internet. Regardless

of years of study of tribal irrationality, however, everyone wanted in on the

party, the market was going up, and there was a massive disconnect between

reality and perception. The Internet became a platform of possibility for

every industrious innovator on the globe. Its uses seemed infinite, and in

1995 one of the leading upshots of this bountiful playing field, Netscape,

went public and doubled its value in its first day of trading.

A rash of IPOs followed, and initial public offerings briefly became an

inherent right of the Internet pioneer rather than the privileged platform to

capital they’d historically been. The share prices of new companies, many

with no profits, and most with significant losses, soared. Traditional valuations

were overlooked in favor of new-fangled metrics. Institutions, retail investors,

and day traders pumped up paper values, which took on more

meaning than tangible assets or real cash flow.

The market went nowhere but up, glamorizing companies with products that had hundreds of “eyeballs” but no profits, over companies with

steady cash flow, solid earnings growth, and experienced management. Even

value investors who relied on traditional valuation models such as priceearnings,

return on invested capital, or book value had a difficult time staying

on the sidelines of this gold rush. During this time, it seemed that IR took

on a qualitative role, more concerned about preserving unrealistic valuations

than with delivering an investment thesis based on underlying fundamentals.

However, when there are no fundamentals to refer to, the qualitative road

was the only one to take.

The strong economy created a perception of wealth and disposable income

that steered new investors to the market. These individuals were vulnerable

to the hype and weren’t familiar with the cyclical nature of the stock

market and its inherent risks. Nor did they seem familiar with the process of

analyzing companies. Dips in the market were seen as buying opportunities

rather than possible downward trends, and a heavy portion of assets were

allocated to tech stocks rather than to a diversified basket of established

companies.

Not only was technology the source of the excitement, but it was access

to the affair. Las Vegas meets your 401(k). The Dow passed 10,000, and

NASDAQ pushed through 5,000.

THE ROCKY FOUNDATION FOR ANALYSTS

The analyst’s role is to evaluate companies objectively. The Chinese Wall

that separates research from the investment bankers allows bankers to work

with privileged, highly confidential client information, and to keep that information

from leaking to research, sales, and trading. It became an odd

parallel, then, when analysts started to receive compensation for sourcing investment

banking transactions—in effect, breaking through the cornerstone

of investment banking integrity, the Chinese Wall.

These analysts, who worked closely with many companies and had the

power to make or break them with their research, started funneling those

companies toward their investment bankers to raise money. That was

the beginning of the gravy train, and analysts started asking more corporate

finance questions than questions leading them to a better understanding

of a company’s underlying fundamentals. Since investment banks can receive

fees between 3 percent and 7 percent of the total money raised for any

given deal, it’s no wonder banking became the primary focus: in most cases

it’s the investment bank’s biggest revenue generator. A mad dash to create

transactions took place.

Then a funny thing happened on the way to the investment bank. The

Buy, Hold, Sell recommendation system eroded even further. Suddenly, anything

other than a Buy had the potential to offend management and risk the

loss of investment banking business. Strong Buy, Buy, Outperform and Accumulate

were all examples of “investment banking ratings,” designed to

shed positive light on companies and massage the ego of many high-flying

(and not particularly capital markets–savvy) CEOs whose ego might not tolerate

a HOLD rating. The punchline to the joke, and the reality for almost

every investment professional on Wall Street, however, was that almost any

rating other than Strong Buy was considered a Sell. Though this practice is

beginning to shift back again, it still holds true today in many firms.

Analysts were less to blame for these conditions than upper management

at the investment banks, however. If analysts didn’t play along and recommend

potential or existing banking clients, they might position themselves

to be fired. At the very least, analysts who didn’t wave the flag ran

the risk of alienation by buy-side fund managers, potentially cutting off millions

in commission business for the investment bank. Finally, any rating

but a Buy in all likelihood put the analyst in the penalty box with management,

cutting off access and one’s ability to do the job. Sure the analysts

were to blame, but the entire system was broken, from the top down, not

just research.

MANAGEMENT’S MUDDLE

A few corporate senior managers also ran into problems as the markets

surged. Because stock options became a popular form of compensation,

there was too much emphasis on short-term stock performance. Though

many executives did not focus on this particular incentive, too many did.

These executives who made the daily stock price a factor in their strategic

business decision making, certainly made some bad ones.

Feeling the heat to meet short-term incentives, many executives set expectations

high for current performance, saw their stock prices increase,

and raised equity or sold personal positions. When these objectives were

out of reach, a meet-the-number mentality led to unethical accounting decisions

that prioritized short-term goals and the continuation of upward

momentum.

In a few cases, some of which are now well-known, this short-term

thinking wrought accounting frauds that ultimately cost employees and the

investing public millions. The transparency and integrity of corporate governance

came into question. Things had to change.

Greed Is Good, “90s Style 37

SNAPPING OUT OF IT

In an abrupt about-face, the market started to retreat and the boom that defined

the New Economy gave way, thankfully, to the old economy where

earnings and cash flow mattered. The market slid down the slippery slope of

a boom unraveling. The economy slowed, discretionary income dipped, and

suspicions about inflated valuations increased. Start-ups swirled toward

cash-constrained positions and established companies lost their pumped-up

values. Many Internet companies began to trade at a discount to the cash on

their balance sheet. 9/11 devastated the economy and morale, and the economy

petered into a major correction. As investors and companies adjusted

to the new market, issues in accounting and disclosure dominated the headlines.

The understanding that the system was broken was almost ubiquitous.

Prompted to action, the government stepped in.

 “The major damage was not done by crooks. It was done by good

people , honest people , and decent people who I’d be happy to have as

trustees of my will. The CEOs in America basically drifted. They

drifted into situational ethics. It got out of hand.”—Warren Buffett,

March, 14, 2003, Forum for Corporate Conscience, referring to executive

pay and corporate accounting in the late 1990s.

The market has seen its share of ups and downs over the decades, but the

rocket ride and dramatic downslide of the late 1990s was a perpetual

headline maker—another example of humankind’s historical prerogative to

get excited, especially as a group.

Manic booms shouldn’t be all that surprising. There are examples

throughout time, from the famed Tulip Bulb Mania in Holland in the 1630s

to the soaring U.S. stock market of the 1920s. The particular spurt that took

place in the United States during the last five years of the 20th century was

aided by the advent of a pervasive new technology, the Internet. Regardless

of years of study of tribal irrationality, however, everyone wanted in on the

party, the market was going up, and there was a massive disconnect between

reality and perception. The Internet became a platform of possibility for

every industrious innovator on the globe. Its uses seemed infinite, and in

1995 one of the leading upshots of this bountiful playing field, Netscape,

went public and doubled its value in its first day of trading.

A rash of IPOs followed, and initial public offerings briefly became an

inherent right of the Internet pioneer rather than the privileged platform to

capital they’d historically been. The share prices of new companies, many

with no profits, and most with significant losses, soared. Traditional valuations

were overlooked in favor of new-fangled metrics. Institutions, retail investors,

and day traders pumped up paper values, which took on more

meaning than tangible assets or real cash flow.

The market went nowhere but up, glamorizing companies with products that had hundreds of “eyeballs” but no profits, over companies with

steady cash flow, solid earnings growth, and experienced management. Even

value investors who relied on traditional valuation models such as priceearnings,

return on invested capital, or book value had a difficult time staying

on the sidelines of this gold rush. During this time, it seemed that IR took

on a qualitative role, more concerned about preserving unrealistic valuations

than with delivering an investment thesis based on underlying fundamentals.

However, when there are no fundamentals to refer to, the qualitative road

was the only one to take.

The strong economy created a perception of wealth and disposable income

that steered new investors to the market. These individuals were vulnerable

to the hype and weren’t familiar with the cyclical nature of the stock

market and its inherent risks. Nor did they seem familiar with the process of

analyzing companies. Dips in the market were seen as buying opportunities

rather than possible downward trends, and a heavy portion of assets were

allocated to tech stocks rather than to a diversified basket of established

companies.

Not only was technology the source of the excitement, but it was access

to the affair. Las Vegas meets your 401(k). The Dow passed 10,000, and

NASDAQ pushed through 5,000.

THE ROCKY FOUNDATION FOR ANALYSTS

The analyst’s role is to evaluate companies objectively. The Chinese Wall

that separates research from the investment bankers allows bankers to work

with privileged, highly confidential client information, and to keep that information

from leaking to research, sales, and trading. It became an odd

parallel, then, when analysts started to receive compensation for sourcing investment

banking transactions—in effect, breaking through the cornerstone

of investment banking integrity, the Chinese Wall.

These analysts, who worked closely with many companies and had the

power to make or break them with their research, started funneling those

companies toward their investment bankers to raise money. That was

the beginning of the gravy train, and analysts started asking more corporate

finance questions than questions leading them to a better understanding

of a company’s underlying fundamentals. Since investment banks can receive

fees between 3 percent and 7 percent of the total money raised for any

given deal, it’s no wonder banking became the primary focus: in most cases

it’s the investment bank’s biggest revenue generator. A mad dash to create

transactions took place.

Then a funny thing happened on the way to the investment bank. The

Buy, Hold, Sell recommendation system eroded even further. Suddenly, anything

other than a Buy had the potential to offend management and risk the

loss of investment banking business. Strong Buy, Buy, Outperform and Accumulate

were all examples of “investment banking ratings,” designed to

shed positive light on companies and massage the ego of many high-flying

(and not particularly capital markets–savvy) CEOs whose ego might not tolerate

a HOLD rating. The punchline to the joke, and the reality for almost

every investment professional on Wall Street, however, was that almost any

rating other than Strong Buy was considered a Sell. Though this practice is

beginning to shift back again, it still holds true today in many firms.

Analysts were less to blame for these conditions than upper management

at the investment banks, however. If analysts didn’t play along and recommend

potential or existing banking clients, they might position themselves

to be fired. At the very least, analysts who didn’t wave the flag ran

the risk of alienation by buy-side fund managers, potentially cutting off millions

in commission business for the investment bank. Finally, any rating

but a Buy in all likelihood put the analyst in the penalty box with management,

cutting off access and one’s ability to do the job. Sure the analysts

were to blame, but the entire system was broken, from the top down, not

just research.

MANAGEMENT’S MUDDLE

A few corporate senior managers also ran into problems as the markets

surged. Because stock options became a popular form of compensation,

there was too much emphasis on short-term stock performance. Though

many executives did not focus on this particular incentive, too many did.

These executives who made the daily stock price a factor in their strategic

business decision making, certainly made some bad ones.

Feeling the heat to meet short-term incentives, many executives set expectations

high for current performance, saw their stock prices increase,

and raised equity or sold personal positions. When these objectives were

out of reach, a meet-the-number mentality led to unethical accounting decisions

that prioritized short-term goals and the continuation of upward

momentum.

In a few cases, some of which are now well-known, this short-term

thinking wrought accounting frauds that ultimately cost employees and the

investing public millions. The transparency and integrity of corporate governance

came into question. Things had to change.

Greed Is Good, “90s Style 37

SNAPPING OUT OF IT

In an abrupt about-face, the market started to retreat and the boom that defined

the New Economy gave way, thankfully, to the old economy where

earnings and cash flow mattered. The market slid down the slippery slope of

a boom unraveling. The economy slowed, discretionary income dipped, and

suspicions about inflated valuations increased. Start-ups swirled toward

cash-constrained positions and established companies lost their pumped-up

values. Many Internet companies began to trade at a discount to the cash on

their balance sheet. 9/11 devastated the economy and morale, and the economy

petered into a major correction. As investors and companies adjusted

to the new market, issues in accounting and disclosure dominated the headlines.

The understanding that the system was broken was almost ubiquitous.

Prompted to action, the government stepped in.

 “The major damage was not done by crooks. It was done by good

people , honest people , and decent people who I’d be happy to have as

trustees of my will. The CEOs in America basically drifted. They

drifted into situational ethics. It got out of hand.”—Warren Buffett,

March, 14, 2003, Forum for Corporate Conscience, referring to executive

pay and corporate accounting in the late 1990s.