Renegades!

Risk of Loss: Business Strategy and Foreign Policy

There was a revelation in a recent article about Porsche: Porsche had renounced quaterly reporting, and was instead continuing its policy of yearly reports. In North America, Porsche would never be able to report to the SEC on the NYSE or the TSX because of this policy. Similarly, in Germany it appears that Porsche may be delisted. What is going on at Porsche? Why has Porsche rejected the short term misery of quarterly reporting?

You may recall a few years ago when Enron was in trouble: The company was tanking, the markets were reeling and the regulators were getting a head full of steam. Analysis of the inner workings of Enron revealed that a big part of the company culture revolved around the obsession with stock prices and, naturally, the earnings reports that would drive up the share price. In fact, rather than focus on quality earnings, ingenious accounting and financial schemes (costing real money) were devised that made it appear every quarter as if the cash was rolling in and that the company was on the up and up. The ability to manufacture earnings and hit the expectations of the analysts eventually became the chief duty of the senior executives.

In focusing on the markets, businesses realize that driving down the associated 'risk' with their stock, will lead to a perception of stability and consistency. In fact, if there is a positive earnings shock when a company reports its earnings, a company will pay in the long run for appearing to be 'unpredictable'. The result of this attitude is considerable stress on management to manipulate figures-and so they do. In a sense, Enron's metamorphisis from 'company' to 'accounting fraud clearinghouse' was the natural outcome of such attitudes. But the Enron debacle is not the only outcome of this attitude. In many ways, companies themselves are becoming more and more 'risk averse' because they know that taking chances can be punished if these 'chances' result in a missed earnings result. Porsche, the wiser, older European brother of the relatively "'roided up" American companies, realizes the havoc that playing with these market games can result in.

Further encouraging this trend has been the focus on unreported stock options, which radically skew the alignment of management and company goals. In business, where the hired gun at the top may only stay on for a few years (or months, in some cases), the motivation for a CEO is to ramp up the 'appearance' of success at the company to drive up the share price. Unfortunately, options are an amplification of share returns, which amplifies the CEO's motivation to manipulate. Futher exasperating this situation, is the insane bonus structure of the so much of the executive compensation. Paying a CEO a decent wage has been replaced by a system of compensation where 'performance rewards', where in theory, the reward is the fruit of the CEO's hard work. And the report card of the CEO? You guessed it-the quarterly earnings report. That report must have the earnings hit the analyst consensus to drive down the risk associated with the company. It must say 'earnings are gradually increasing'. It's the report that whispers sweet reassurances to investors and creditors. The report that, if 'successful' drives down the credit risk and the cost of borrowing for a company.

To downplay risk, however, the companies that slave away to meet their quarterly estimates also engage in what you might call a 'policy of stability'. That is, using principles that are sometimes short term oriented and extremely short sighted. Take the American election: the markets had factored in a surge if Bush won because there would be 'stability' because a change in the government meant short term inconsistency. Or take for instance, take the Venezuelan election. The business community, in its drive for consistency, was backing Chavez. Chavez, obstensibly a socialist dictator who (in hindsight) very obviously stole the election, was backed because he represented the choice of stability.

If, for example, the opposition forces were to win, there would be blood in the streets. In fact, when Chavez won, there were gunmen in the street killing protesters anyway, but if there was an opposition victory, the blood would flow. In the short term, the price of oil would skyrocket since Venezuela is such a key player in OPEC. There would be a regime change that would mean new contacts would need to be made, new lobbyists would need to be hired, an examination of new government policies would have to be reviewed and in short-political anarchy and the dreaded 'uncertainty'. Earnings might be missed, heads could roll and the market would react violently.

This is a very limited example, but you can apply these principles to just about any state. Russia, for instance, is becoming a hotbed of business under Putin because his government represents a 'stability' of sorts. Stable autocracy, it seems, is becoming a hot item in some circles, because it represents short term certainty. If your business has a problem in the factories of China with labour unrest you can be certain of who to talk to in the local Chinese government to have that fixed. If you want that new distribution centre on the Venezuelan coast, you can find the right man in Chavez' government to make it happen.

The problem with the short term stability favoured by companies, and by extension, the markets is that this focus leads to long term instability. Long term profits and certainty are being sacrificed to the quarterly earnings gods.

To put it in more succint terms: if business wants to lie down with dogs, it will wake up with fleas. Chavez, Putin and all the dictators who are sucked up to by businesses are not men who breed long term success for capitalism. They destroy political opponents through repression, leading (according to new reports) to violent underground and sometimes overt reactions by the opposition.

They are also unpredictable in the long run. Look at Yukos: the founder was jailed because of his views and political affiliations. The business community has deluded itself into thinking that this was 'just a warning to other businesses to stay out of Putin's way', because what exactly counts as "Putin's way"? What exactly will set him off? He is an autocrat taking actions without repercussions. What will prevent his nationalization of a foreign firm that does too much business with a political rival? And by extension, if those same political rivals are stifled through the legitimate political organs, how far will they go to make sure their voices are heard in the street?

Autocratic states are not known for their peaceful regime changes, so when the hammer drops in places like Venezuela or Russia, what will be the price the business community will pay in the markets? How will the new and violent regime react to the businesses that supported the old regime? How would this regime change be handled if it were take place, but in the context of a democratic election? How would this change the associated risk of doing business in any one country?

There is no easy solution to these problems. Business has to continue in these countries in a political sense as free markets eventually will lead to democracy. There has to be a change at the top in terms of the focus in short term profits. While regulators in Germany agonize over Porsche's insistence that the company stay away from quarterly reports, Porsche carries on business as it has for many, many years: focusing on cranking out a superior product and letting its yearly report speak for itself. My own impression is that management is spending time on the sales and development of their product rather than spending untold man hours with a team of specialized accountants thinking up ways to stay within Generally Accepted Accounting Principles but still meet the earnings consensus figures.

A happy medium might be to approach the situation as a Burkean conservative: support democracy, but not a revolution. If businesses are operating in some of these countries, they have to realize that they take a risk from a public relations and logistical standpoint: autocrats can and will turn on you. Someday, Chavez and his cronies will be thrown out of office, and those affiliated with him will suffer. To counter this, supporting democratic and capital institutions or parties in an anonymous fashion or under the guise of promoting business will go a long way.

There has to be a realization that in the short term, democracy is a messy process and if not properly implemented can result in disaster. The long term benefits of supporting democracy will result in long term certainty in regime change, the rule of law, and the enforcement of legal contracts. These are the basics of modern capitalism: if you do not have these founding principles, the result might be short term gain (assuming you are in the 'good books' of the regime) but only at the expense of long term anarchy.

posted by Shamrocks! @ 10:09 AM