THE GREAT FINANCIAL SCANDAL OF 2003
(An Account by Charles T. Munger)
NOTE: This article was distributed at the 2001 Wesco annual meeting, as part of a package of materials entitled “Some Investment-Related Talks and Writings Made or Selected by Charles T. Munger”.
Unlike the other readings in this booklet, I don’t believe this has ever been published before. It details a hypothetical financial scandal in 2003 (so Munger is a little early), triggered by dishonest accounting, especially for options, at an imaginary tech company called Quant Tech (which appears to be a bit of Cisco, IBM and the like).
After 2003, people came to see the Quant Tech story as a sort of morality play, divided into two acts. Act One, the era of the great founding engineer, was seen as a golden age of sound values. Act Two, the era of the founder’s immediate successors, was seen as the age of false values with Quant Tech becoming, in the end, a sort of latter day Sodom or Gomorrah.
In fact, as this account will make clear, the change from good to evil did not occur all at once when Quant Tech’s founder died in 1982. Much good continued after 1982, and serious evil had existed for many years prior to 1982 in the financial culture in which Quant Tech had to operate.
The Quant Tech story is best understood as a classic sort of tragedy in which a single flaw is inexorably punished by remorseless Fate. The flaw was the country’s amazingly peculiar accounting treatment for employee stock options. The victims were Quant Tech and its country. The history of the Great Financial Scandal, as it actually happened, could have been written by Sophocles.
As his life ended in 1982, Albert Berzog Quant delivered to his successors and his Maker a wonderfully prosperous and useful company. The sole business of Quant Tech was designing, for fees, all over the world, a novel type of super-clean and super-efficient small power plant that improved electricity generation.
By 1982 Quant Tech had a dominant market share in its business and was earning $100 million on revenues of $1 billion. It’s costs were virtually all costs to compensate technical employees engaged in design work. Direct employee compensation cost amounted to 70% of revenues. Of this 70%, 30% was base salaries and 40% was incentive bonuses being paid out under an elaborate system designed by the founder. All compensation was paid in cash. There were no stock options because the old man had considered the accounting treatment required for stock options to be “weak, corrupt and contemptible,” and he no more wanted bad accounting in his business than he wanted bad engineering. Moreover, the old man believed in tailoring his huge incentive bonuses to precise performance standards established for individuals or small groups, instead of allowing what he considered undesirable compensation outcomes, both high and low, such as he believed occurred under other companies’ stock option plans.
Yet, even under the old man’s system, most of Quant Tech’s devoted longtime employees were becoming rich, or sure to get rich. This was happening because the employees were buying Quant Tech stock in the market, just like non-employee shareholders. The old man had always figured that people smart enough, and self-disciplined enough, to design power plants could reasonably be expected to take care of their own financial affairs in this way. He would sometimes advise an employee to buy Quant Tech stock, but more paternalistic than that he would not become.
By the time the founder died in 1982, Quant Tech was debt free and, except as a reputation-enhancer, really didn’t need any shareholders’ equity to run its business, no matter how fast revenues grew. However, the old man believed with Ben Franklin that “it is hard for an empty sack to stand upright,” and he wanted Quant Tech to stand upright. Moreover, he loved his business and his coworkers and always wanted to have on hand large amounts of cash equivalents so as to be able to maximize work-out or work-up chances if an unexpected adversity or opportunity came along. And so in 1982 Quant Tech had on hand $500 million in cash equivalents, amounting to 50% of revenues.
Possessing a strong balance sheet and a productive culture and also holding a critical mass of expertise in a rapidly changing and rapidly growing business, Quant Tech, using the old man’s methods, by 1982 was destined for 20 years ahead to maintain profits at 10% of revenues while revenues increased at 20% per year. After this 20 years, commencing in 2003, Quant Tech’s profit margin would hold for a very long time at 10% while revenue growth would slow down to 4% per year. But no one at Quant Tech knew precisely when its inevitable period of slow revenue growth would begin.
The old man’s dividend policy for Quant Tech was simplicity itself: He never paid a dividend. Instead, all earnings simply piled up in cash equivalents.
Every truly sophisticated investor in common stocks could see that the stock of cash-rich Quant Tech provided a splendid investment opportunity in 1982 when it sold at a mere 15 times earnings and, despite its brilliant prospects, had a market capitalization of only $1.5 billion. This low market capitalization, despite brilliant prospects, existed in 1982 because other wonderful common stocks were also then selling at 15 times earnings, or less, as a natural consequence of high interest rates then prevailing plus disappointing investment returns that had occurred over many previous years for holders of typical diversified portfolios of common stocks.
One result of Quant Tech’s low market capitalization in 1982 was that it made Quant Tech’s directors uneasy and dissatisfied right after the old man’s death. A wiser board would then have bought in Quant Tech’s stock very aggressively, using up all cash on hand and also borrowing funds to use in the same way. However, such a decision was not in accord with conventional corporate wisdom in 1982. And so the directors made a conventional decision. They recruited a new CEO and CFO from outside Quant Tech, in particular from a company that then had a conventional stock option plan for employees and also possessed a market capitalization at 20 times reported earnings, even though its balance sheet was weaker than Quant Tech’s and its earnings were growing more slowly than earnings at Quant Tech. Incident to the recruitment of the new executives, it was made plain that Quant Tech’s directors wanted a higher market capitalization, as soon as feasible.
The newly installed Quant Tech officers quickly realized that the company could not wisely either drive its revenues up at an annual rate higher than the rate in place or increase Quant Tech profit margin. The founder had plainly achieved an optimum in each case. Nor did the new officers dare tinker with an engineering culture that was working so well. Therefore, the new officers were attracted to employing what they called “modern financial engineering” which required prompt use of any and all arguably lawful methods for driving up reported earnings, with