Freeman

IT JUST AIN'T SO

The Stock Market Is a Swindle?

APRIL 01, 2007 by JUDE BLANCHETTE

Filed Under : Capitalism

Jude Blanchette is a freelance writer living in China.

Michael Kinsley, founding editor of the online magazine Slate, columnist for the Washington Post, and American editor of the Guardian (UK), is a smart guy. His columns are often witty and incisive. Even where Kinsley is wrong (and he often is) he provides the reader a valuable lesson in critical thinking.

So perhaps we can forgive him for his November 26, 2006, Post column, “A Capitalist Swindle.” Virtually every sentence contains a factual, analytical, or theoretical error. It starts with small tips of the hat to the then-recently deceased Milton Friedman, the ability of capitalism to set the price of potatoes, and the fact that some things that wear the mantle of capitalism are not, in fact capitalism. So far so good, but after reading the entire piece, one wishes that Kinsley had dropped his pen there.

But he didn’t. The gist of Kinsley’s article is that the folks of Middle America are being swindled out of their money via financial trickery.

Private investors buy a company from its public stockholders. They have a letter from an investment bank saying the price is a fair one. They usually have the support of management, or they actually are the management. The public stockholders have little choice. [!] But time and again—surprise, surprise—the investment bank turns out to be wrong. The company is actually far more valuable!

These Wall Street mavens swoop down on unsuspecting shareholders, rip the company from their grip, swipe a hefty dose of profits, and then turn around and sell the company for a nifty return.

“The free market cannot be setting the right price for financial assets such as shares of stock because often there are different prices with equal claims to be the product of free-market capitalism. They can’t all be right,” Kinsley says.

Sigh. To begin, no one rips stock from the hands of shareholders. If the offer isn’t attractive, the shareholder doesn’t have to sell. Next, contrary to Kinsley’s assertion, there can be many different prices for a given good. Take a simple example. Not far from my apartment in Shanghai there is a clothing market frequented by locals and tourists. If you were to plant yourself outside a particular shop you would hear umpteen different prices quoted for the same shirt, depending on the time of day, the amount of traffic in the shop, the supply of shirts in the back storage room, and the purposes, gullibility, or ignorance of the customer. Different buyers and sellers are willing to accept different prices for the same thing. All the more for something as complex as a company or shares in a corporation.

But I gather Kinsley has a different point in mind, namely that private-equity firms game the system and extract profits that would otherwise go to shareholders. Typically, a private-equity firm acquires majority ownership of a company, or a company’s managers purchase it and take it private. When the company’s value is used to borrow the money that makes the purchase possible, it’s called a leveraged buyout. If successful, the new owners later sell the shares for a nice profit. Kinsley’s suspicion and criticism are only the latest from government regulators, investors like Warren Buffet, and pundits who presumably want more government regulation.

Kinsley continues, “The stock market leaves money on the table waiting for ‘private equity’ to swoop down and pick it up.” Depending on how literally one wants to read Kinsley, this could be considered a true statement. But the act of spotting and then “picking up” this (potential) value is, in fact, the process by which that market moves toward greater efficiency. What Kinsley misses in private equity’s swoop is the value added after the purchase. Once in the buyers’ control the vast majority of companies go through restructuring—a process that often is slow and laborious when the company is publicly held. Restructuring is based on a plan devised by those who acquire the stock. That accounts for the different prices: the value of assets does not flow from their mere physical nature but from ideas about how they might be used. Assets held under one set of ideas are not equal in value to the same assets held under another set. Someone with a keener imagination about a company’s potential is often able to buy the company at what later looks like a bargain price from someone with a less-keen imagination. There’s nothing suspect about that.

Is there value added in leveraged buyouts? One way to assess this is to look at the companies when they are reintroduced as IPOs (initial public offerings), a process known as a reversed leveraged buyout (RLBO). According to research by Josh Lerner of Harvard and Jerry Cao of Boston College, “Reverse LBOs appear to consistently outperform other IPOs and the stock market as a whole. The positive returns appear to be economically and statistically meaningful. Moreover, there is no evidence of a deterioration of returns over time, despite the growth of the buyout market: RLBOs performed strongly in the late 1980s, the mid-1990s, and the 2000s.” To reach these findings, Lerner and Cao analyzed 496 RLBOs between 1980 and 2002. Lerner says that his and Cao’s findings are “inconsistent with many of the claims in the press.” Perhaps they had a certain Post columnist in mind.

So once the fruit of the private-equity–led restructuring is allowed to ripen, we more often than not see that the process has yielded value for the company, for investors, and for the economy as a whole, which now has a more efficiently run company in its midst. Some in the press are quick (and right) to point out many of the unseemly practices of some private-equity groups, but it appears that these cases are isolated.

Moving beyond the evidence, let us suppose for a moment that Kinsley is correct, that markets can’t accurately price company shares and that private equity yields no benefits. What mechanism does Kinsley propose for getting prices “right”? On this point he is silent. It’s hard to image government regulators with better knowledge than market traders. No, it’s impossible. For all the faults of private equity, indeed, for all the faults of any human endeavor, it’s hard to see how handing power over to the corporatist state would help.

I’d like to return to two earlier statements Kinsley made in the piece. The first, as previously mentioned, is that some things “masquerade as capitalism at work and claim its virtues, but aren’t. . . .” Astoundingly, two sentences later, Kinsley remarks, “To all appearances, the stock market is capitalism operating under near-laboratory conditions.” Can he really mean the American stock market? The financial sector in the United States, despite what the media reports, is so highly regulated that it’s hard to term it private. This is not a tale of America ‘s most persecuted minority, but rather a more twisted saga of big business and big government in collusion. North Korea the American economy is not, but let’s not delude ourselves into thinking any aspect of our markets is laboratory-like.

Kinsley studied economics at Harvard, which perhaps explains his willingness to wade into economic and financial matters. But he obviously didn’t learn much about the economics of the stock market there, which indeed explains why this column was so dreadfully bad.

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