Back on July 11th, we warned that Options were going to be a key trouble spot for stocks:
Options Options Options: Between the option backdating scandals, and more recently, "spring-loaded options,"
we haven’t even discussed the expensing of options. (Options expensing
are a large part of the reason tech stocks have gone nowhere). Options,
in all their myriad forms, are weighing on equity prices.
That seems to be playing out as pretty much as planned. The backdating scandal is more widespread than imagined (more than 2,000 public companies).
Ordinary options expensing is taking its toll also: Funny thing is, back in late 2004 I got into a debate with Cody on Options expensing, saying "Look out below:"
Look Out Below
12/16/04 3:19 PM ET
If you have been looking for an excuse to dump any Nasdaq issues, the new FASB rules on Stock options is it.
Regardless of your views on this rule, it now makes a slew of equities much much more pricey. All of your favorite former high flyers from the 1990s — it turns out that they were never really all that profitible — assuming they have to expense stock options like they are supposed to . . . -Barry Ritholtz
Confused by Post
12/16/04 3:32 PM ET
Hey, Barry, I’m confused by your post. Are you proclaiming the end of the tech bull run here? "Look out below"? I ask because I was under the impression that you’ve been bullish about tech and the markets in general, per your column the other day about all the money you see on the sidelines.
Color me still cautious but not because of some regulations about how to count numbers
No, not the end of the world
12/16/04 3:53 PM ET
Cody, There’s a reason that so many tech firms have been lobbying against this rule change. Many firms that managed to show profits in the 90’s turn out not to be so profitible after all, if you count what they spent on options / share repurchases.
Any of the firms (typically tech firms) that issue a lot of stock options are going to see their balance sheets get rather ugly next year. Taking these charges means a lot of companies that used to have reasonable P/Es will look far less cheap next year.
Stock options are no longer off balance sheet — they are an expense that must be fully and transparently accounted for . . . and that may leave a mark on quite a few balance sheets. -Barry Ritholtz
Dumping tech in 2004 turned out to be pretty good advice (not that the bulls would ever admit that).
If you want to see how disproportionately stock option issues have been hitting tech, today’s NYTimes has what is probably the best graphic depiction of the trouble as it applies to Silicon Valley in particular:
25 Tech Companies with Options Issues:
Graphic courtesy of the NYT
Consider the mass delusion of the period: It reveals how truly disconnected from reality even (supposedly) sober thoughtful professionals like Lawyers and Accountants became in the mania:
"The practice of backdating options dates to the early 1990’s but took on momentum during the frenzied days of the Internet era, when the competition for available talent was fierce. Numerous Silicon Valley insiders described the practice as routine — so much so that the universe of technology companies ultimately placed under the microscope may well far exceed the dozens already under scrutiny by the Justice Department or the Securities and Exchange Commission, if not both.
“People out there really duped themselves into thinking they were doing this for the benefit of stockholders when in reality they were defrauding them,” said Pearl Meyer, a managing partner at Steven Hall & Partners, a New York executive compensation firm that has worked with scores of Valley-based companies. “Talking to people out there, they clearly viewed this as a victimless crime.”
There is little doubt that Silicon Valley provided the perfect setting for cutting corners. The heady days of the tech boom gave many a sense of entitlement, if not also a sense that they were the primary force keeping America strong in the world economy. It was also a maverick culture where clever ways of gaming the system were admired rather than excoriated.
“There’s been a lot of stuff going on in the Valley since the 1990’s that has been pretty fast and loose,” said Michael S. Melbinger, an executive compensation lawyer at Winston & Strawn in Chicago. Compensation plans were adopted “during the dot-com boom and bust,” he said, “that were just sloppy at best.”
Few outsiders scrutinized these practices, though, and some were unaware of them.
Backdating was often “a client-driven strategy with the accounting firms saying, ‘Sounds O.K. to me,’ ” said Allan Koltin, the president of PDI Global, a consulting firm based in Chicago that works with many large accounting firms. “The client put the suggestion out there and the accounting firm, if they were smart enough and could figure out how to agree with the technology firm’s perspective, they pretty much won themselves a new client.”
Astonishing . . .
Silicon Valley Firms Scrutinized on Stock Option Policies
GARY RIVLIN and ERIC DASH and DAMON DARLING
NYTimes, July 22, 2006
Completely agree on the issue ….. But , that’s a lot of data mining if you use Dec 2004 through today ….. QQQQ has been everywhere in that time frame , anyone can use any time frame to make an argument …. could’ve used Oct 2004 until April 2006 for 40% gain …. everyone’s holding period is different ….. have you been short the QQQQ’s this whole time ??? I commend you if you have
The new FASB rules on Stock options weren’t announced until December 2004
And I was bullish on Tech in August 2004 — see this: Placing a Wager On the Chip Sector
while the rules weren’t announced until then , they had been discussed for many months prior to that … in fact , the SEC fought FASB not to pass those rules and Levitt was the main obstacle to FASB ….. and Joe Lieberman fought back in 1993 ( 11 years before ) to hold them back
now who’s data mining . . .
While commenting on backdating did you notice that Ben Stein has an eloquently column on post-911 options grants as well ? Worth noting and reading.
Two questions: 1) is the recent NDX an indicator (along with MSFT, Dell, et.al. results) that people are finally grasping that tech is a mature industry with no prospects of major growth on the horizon for many years ? 2) and when does, if ever, the equivalent realization set in regarding the old-line industries of the SP500 ?
Rather than celebrating low-growth prospects as indicators of rate increase cessations shouldn’t we be focused on low-growth as an indicator of low earnings and profits and thereby further price declines ? Not to mention the R word ?
You talk about this practice being blessed by the accounting firms. With the practice this widespread, I will be surprised if we don’t eventually find out that the accounting firms were the ones pushing the idea and making it more widespread than it otherwise would have been.
I note above (before the NYT excerpt):
This turned out to be another aspect of the bubble top . . .
I totally disagree with the new rules around option expensing. But, what’s new? I’ve lived through Sarbox and hate it too. If there are two professions we need less of, it is lawyers and accountants. FASB ensures the continued growth of its kind through ridiculous rules such as this just as lawyers do with complicated and increasing government regulation. (Not that both of these aren’t admirable professions. They are.)
This can be broken down into one simple issue. Will options expensing improve corporate governance? In my opinion, the answer is a clear no. Do we need more transparency? I say absolutely yes. But, I fail to see how this solves any problems at all. Ultimately, this change was meant to alter the behavior of cooking the books which results in inflated earnings. The reality is this will fail in any way to alter the behavior of a corrupt management team. We will always have murderers and the death penalty is not a deterrent. Ditto with corporate corruption. You simply cannot legislate morality. While this is a dire analogy, it makes a point. That point is there will always be murderers and there will always be corporate crooks. The laws we have in place work just fine when enforced. They’ve been refined over hundreds of years. Increased transparency does not mean new accounting methods are needed.
Investors should be more concerned about the lack of transparency in emerging markets where Jesse James and the Dalton Brothers roam free in the wild and wooly world of business corruption, nepotism and scams that are ingrained in their societies.
As someone who views my opportunities in the work place as a hired gun thanks to the lack of corporate commitment to its employees, I view options as a significant benefit and motivational tool to attract top talent. But, in a post Enron world, this is more misguided vomit companies have to choke down in the name of improved oversight and transparency. But, in the end I believe it fails the litmus test and at some point may be rolled back.
This is why we get seven hundred different types of earnings reports now. This is nothing more than a noncash journal entry leading to companies now reporting pro forma earnings.
Companies are always going to find ways to overstate their earnings. I think the best policy would be requiring companies to pay taxes based on the highest level of earnings they report for a given fiscal year and requiring companies to make their tax returns public. The IRS already puts a lot of effort into making sure people and companies don’t lie on their tax returns, so I would trust those numbers more than anything else the company reports. And it provides some balance on how companies want to lie about their income: they want to claim more profits to attract investors, but they also want to claim less profit to lower their taxes. It would also mean that people get to see what kinds of tax breaks companies are getting, which might cut back on corruption in the tax codes.