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Jubak's Journal
Recent articles:
• We need a new guard dog at the SEC, 11/18/2003
• 5 stocks to love -- that everybody hates, 11/14/2003
• Will the Dow hit 11,000? Ask the Fed , 11/11/2003
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| | Jubak's Journal
The SEC makes dishonesty pay
Providing a veneer of honesty, feeble standards let brokerages and traders get away with millions without breaking the letter of the law.
By Jim Jubak
Whose side is the Securities & Exchange Commission on?
We all know for whom the SEC is supposed to work. The agencys job, in the words of the SECs own Web site, is to enforce securities laws, to promote market stability, and, most importantly, to protect investors.
The reality is very different. The agency has been co-opted by the financial industry it is supposed to oversee. Its regulations have become minimum standards that act to serve as the lowest common denominator for the financial industry. The SEC has, in fact, become a critical link in protecting the profits of mutual funds and Wall Street traders and market makers.
No apology, just regret
For example, Morgan Stanley (MWD, news, msgs) just paid a $50 million fine to settle charges that it failed to disclose incentives its brokers received to push specific mutual funds.
Brokers received extra commissions when they sold shares from one of 16 outside fund companies that had paid Morgan Stanley substantial fees for preferred marketing. (This practice is called directed brokerage in the fund industry.) They also received extra commissions if they sold Class B shares of Morgan Stanleys own mutual funds, since these funds carried higher back-end sales charges than Class A shares. The point of the incentives was to encourage brokers to sell funds that brought in more revenue to the company, even if they werent especially well-suited to the investor or even if they cost that investor more money.
As is usual in these settlements, Morgan Stanley neither admitted nor denied wrongdoing, but the companys attitude was very clear in a statement from CEO Phillip Purcell: I regret that some of our sales and disclosure practices have been found inadequate.
The SEC settlement leaves untouched the rest of Morgan Stanleys program for marketing funds. Those practices include things like fund of the month sales strategies, converting the commission-based accounts of investors scared by the bear market into flat-fee Portfolio Architect accounts (where the only options were Morgan Stanley-run funds), and transferring older holdings of Morgan Stanley funds to Portfolio Architect accounts so that the investor would begin paying fees on those assets, too. Those practices, and the extra commissions paid to Morgan Stanley brokers, are all part of an ongoing investigation by regulators in Massachusetts.
Its easy to find other examples where the letter of SEC regulations has become the minimum practice in the industry. Consider all the hoopla over appointing independent directors to the boards of trustees for mutual funds. Turns out that the regulatory definition of independent is so meaningless that a fund managers uncle can even sit on the board and qualify as independent. (Im not making this up: The SEC approved the uncle of Ryan Jacob as an independent director on the Jacob Internet fund (JAMFX).)
Fines are just a cost of doing business
From this perspective, even the fines that the SEC occasionally imposes on companies that violate these minimums serve financial industry interests. Its not just that $50 million is a drop in the bucket for a company like Morgan Stanley with $33.4 billion in revenue and $3.6 billion in income over the last 12 months, but that these fines are money well-spent by the financial industry. These SEC punishments work to convince public investors that the financial market is honest and to discourage investor due diligence.
Lets say that most investors believe that all mutual funds are run honestly and tell the truth to investors because an agency of the federal government says they do. (I think that most investors did indeed believe this before the current round of investigations.) That removes much, if not all, incentive one might have to research the actual honesty and truthfulness of the fund company.
Lets further say that this guarantee from the federal government shields each fund company exactly the same, whether theyre actually honest or not. That removes a powerful market incentive to actually deliver the honesty that the government promises. In truth, the fund company that is dishonest with its investors will have a significant advantage because it can behave any way it likes to beat competitors without worrying that investors will penalize it.
This government guarantee can cost investors big money, if it turns out that the guarantee wasnt founded on solid information or on thorough investigation by the regulating agency.
The SEC is becoming the problem
In this way, the SECs mere existence, as long as it remains a regulator content to keep fines at the level of a reasonable cost of doing business, acts as a barrier to real reform of the financial markets. Why should investors push for reform when the industry watchdog punishes the occasional bad apple and guarantees that everything else is okay?
But the financial industry also has learned how to use the SECs regulatory process itself -- the dance of investigation, settlement and re-investigation -- as a way to slow the pace of change.
The ongoing investigation of the New York Stock Exchange and its floor traders and market makers is a sad example. In 1999 the SEC settled an investigation into the stock exchanges supervision of the traders who operated from the floor of the exchange from 1993 to1998. (Current SEC Chairman William Donaldson was chairman of the NYSE from 1991 through 1995.) The charges were extremely serious. For example, the SEC found that the NYSE suspended its routine surveillance of floor brokers for periods of up to two years. But the NYSEs punishment didnt even qualify as a slap on the wrist. The exchange promised to better supervise its floor orders with improved surveillance, a review of the rules and procedures, an electronic order trail, an education program, and quarterly audits. In 1999, then-NYSE Chairman Richard Grasso loudly proclaimed, We have zero tolerance for any member who does not fully comply with NYSE and SEC rules and regulations.
Of course, that compliance can take a while. In 2001, the SEC was still urging the NYSE to keep its regulatory staff on the trading floor during all trading hours. And the final tweak to the proposed system for creating an electronic order trail wasnt submitted to the SEC until April 2003.
By that time, the SEC had launched its current investigation into the NYSE floor operations by its market specialists.
Meantime, the specialists and market makers who play a key intermediary role in the NYSEs trading system continue raking in extra profits by routinely placing their orders ahead of those of customers. That enables them to trade on inside knowledge since they know, from their order books, where the market is going for a specific stock. A preliminary report from the SEC, leaked to the Wall Street Journal in early November, blasted the exchanges supervision and discipline of traders (again) for failing to punish even the most-blatant violations. The report put the costs to investors of this trading by specialists at $155 million over the last three years.
Window-dressing . . . and more window-dressing
None of the reforms proposed by SEC Chairman Donaldson in a Nov. 19 Senate hearing even begins to address the SECs role as an enabler of profits like those or to threaten the flow of those profits. Proposals to require that 75% of mutual fund directors be independent, up from the current 50%, is window-dressing, even if those independent directors get permission to hire their own staff, without making those directors fiduciaries legally accountable to mutual fund shareholders. The SECs proposal to end after-hours trading in mutual fund shares by requiring a firm 4 p.m. cutoff on buy and sell orders does nothing to fix the problem of stale pricing of mutual fund shares that makes after-market trading so profitable and tempting in the first place. (For an explanation of how these trades work, see my Nov. 18 column, We need a new guard dog at the SEC.)
A few humble suggestions to fix the problem
What would change my mind about the SEC and convince me that the agency was truly working for investors? Here are a few ideas:
- What about regulations that require fund companies to spend the money to install systems that would minimize stale pricing of mutual fund shares?
- What about regulations that require not just disclosure of all fees but that require mutual fund companies to roll all fees and expenses, including everything they spend on marketing and on commission incentives and on research, into one easily compared and fully disclosed number?
- What about putting an end to the price improvement monopoly at the NYSE that turns exchange specialists into traders with inside information?
- What about increasing the SEC budget by charging financial firms for the inspections and audits that give them a government seal of approval -- so that the SEC has enough staff to actually know if a financial company is actually honest -- and put those fees on a sliding scale so that companies that violate SEC regulations pay more?
Do I expect any of this from the current SEC?
Nah. What Ive proposed would actually cut into profits at too many of the big and powerful financial companies that have captured the agency.
But, hey, Id love it if the SEC would prove me wrong.
Changes to Jubak's Picks
Sell Reliance Steel & Aluminum
Reliance Steel (RS, news, msgs) is bumping around just below my target price of $32 a share, and Im reluctant to raise my target price with the European Union and the United States playing chicken over steel tariffs. Adding to that reluctance, Reliance now trades at 28 times projected 2003 earnings per share, at the very high end of the stocks historic range for its price-to-earnings ratio. Im selling the shares with a 31% gain since I added it to Jubaks Picks on Sept. 5, 2003 at $23.22 a share.
Buy Western Digital
This buy of Western Digital (WDC, news, msgs) is an attempt to replay my successful May to July trade in disk-drive maker Seagate Technology (STX, news, msgs) with a Seagate competitor. That trade gained 45%, and all the fundamental factors that produced that gain are still working for the sector. Disk drives have gone from a PC-based commodity with the newest generation of high-capacity drives, and theyre showing up in more and more categories of consumer products. This time, I think the trade works better with Western Digital. The stock has pulled back about 22% from the 52-week high on troubles at competitor Seagate that include a Securities & Exchange Commission investigation but that dont really have anything to do with Western Digital. After the retreat, Western Digital shares sell at just 13 times projected fiscal 2004 earnings. Im adding the shares of Jubaks Picks with a target price of $18 by September 2004.
New developments on past columns
3 food stocks face a leaner, meaner world
On Nov. 20, Smithfield Foods (SFD, news, msgs) announced earnings of 33 cents per share for the second quarter of fiscal 2004. (The companys fiscal year ends in April.) That was above the Wall Street consensus projection of 31 cents a share and a big increase from the 4 cents a share the company earned in the same quarter last year. Much of the gain came from a surge in profit margins in the companys beef operations that more than offset declines in pork margins. In a conference call, Smithfield projected that its acquisition of Farmland Foods would be immediately accretive to earnings by as much as 20 cents a share over the next four quarters. As of Nov. 21, Im raising by target price for Smithfield Foods to $29 a share by May 2004. (Full disclosure: I own shares in Smithfield Foods.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Smithfield Foods. He does not own short positions in any stock mentioned in this column.
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