Thursday, December 02, 2010

Belshaw's World - ponzi schemes and the human wreckage left behind

Note to readers: This post appeared as a column in the Armidale Express on 24 November 2010. I am repeating the columns here with a lag because the Express columns are not on line. You can see all the columns by clicking here for 2009, here for 2010

I finished my last column by saying that by 1996 I was convinced that current management approaches could not work in the long term. They had, in fact, become a super Ponzi game.

To those who don’t know the term, Ponzi schemes are named after the US con man Charles Ponzi. Investors are attracted by offers of high returns. However, those returns come not from profits, but from the investor’s own money or that of subsequent investors.

A Ponzi scheme will eventually collapse under its own weight. However, that can take some time as demonstrated by the recent case of Bernard Madoff in the United States.

This was the largest investment fraud case in history.

By the time Madoff’s scheme collapsed, the combination of actual losses plus promised returns totaled a staggering $US64.8 billion. Actual cash losses totaled roughly $US21 billion. These are staggering numbers.

Not all Ponzi schemes begin as Ponzi schemes. Some start as legitimate investment schemes. They become Ponzi schemes if lower than expected returns are then topped up from investor’s money.

Now why did I compare current management approaches to Ponzi schemes? Surely that’s unfair?

Let’s start with current approaches to corporate reporting.

The progressive changes that have been made effectively require companies to report on the future. This includes a requirement to report on variations that might affect future profits in any material way.

These changes were intended to protect investors, while making for a more informed market. However, they also had the effect of linking share prices to prospective returns rather than the company’s track record.

You can see this in the changed treatment of price/earnings ratios. They used to be based on historical profits, now they are based on expected future profits.

Add performance pay arrangements linked to the achievement of targets that can include a range of variables including sales, profits, and share prices to the mix.

Growth is central to these targets, growth in sales, growth in profits, growth in share prices. What value are your share options, for example, if share prices don’t increase?

At individual firm level, this may sound fair enough. However, there is a problem.

Each business sets growth targets that then flow through to pay and reporting. But what happens if the totality of those targets is such that they are unachievable?

Keeping things simple, assume the economy grows at three per cent per annum. This means that the combined growth of all firms cannot exceed three per cent.

Yes, firms may increase profits by more than three per cent if the profit share of national income rises. Yes, firms may grow by more than three per cent if they can access international markets, although the trends I am talking about are global. All this said, growth in national income still provides the effective constraint on business growth as a whole.

If the combined growth targets set by businesses exceeds the growth capacity of the economy, then businesses as a whole cannot deliver on target.

Say the combined targets require a ten per cent increase in profits, a not unreasonable individual target, when the growth capacity of the economy is three per cent, then the gap is seven per cent. If the average target is twenty per cent, the gap rises to seventeen per cent.

We now have the precursor condition for a Ponzi scheme. Clearly not all businesses can achieve targets. A gap has opened between projected returns and the results that can be actually achieved.

In our performance based world, the pressures on boards and executives to achieve targets, to show growth, are substantial. Incomes and reputations depend upon it.

We saw the effects of this in the Global Financial Crisis. This was a Ponzi scheme on a large scale. However, there are far more invidious effects.

Operating in an environment where combined targets cannot be met but individual targets must be met, firms focus on actions that will increase short term profits. In practical terms, this means cost cutting.

It is generally possible for a firm to meet short term profit targets by cuts to activities that do not immediately affect profitability. Too often, however, those cuts affect later profits. You are, in fact, operating a Ponzi scheme.

As with all Ponzi schemes, investor desire for above average returns makes the whole thing possible. The markets reward the short term.

Working as an outplacement consultant I saw the immediate results in the human debris that passed through our office. However, I had also seen it in my work as a management consultant.

Still, I should perhaps deal with this in a later column.

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