The Number by Alex Berenson
The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America
by Alex Berenson
Random House. 274 pp. $24.95
The assumption underlying this book is that numerous investors are still trying to figure out what hit them. Given the $8-trillion loss in stock-market valuations during the past three years, it seems a reasonable assumption. And Alex Berenson seems a plausible candidate to explain the calamity. A New York Times business writer specializing in “financial investigative reporting” (to quote the dust jacket), Berenson has thrice been named “one of the top 30 business reporters under the age of thirty” (to quote the dust jacket again, while wondering whether awards in the journalism industry have proliferated out of control).
Today’s standard view of the crash is that it was inevitable—that the explosive rise in stock prices during the 1990’s became a “bubble” driven by what the Federal Reserve chairman Alan Greenspan famously characterized as “irrational exuberance.” But one can embrace this premise, as Berenson does, and still sense a need to address other major mysteries about the boom and bust.
For openers, why did investors suddenly turn irrational? It is plainly not adequate to posit that they were hypnotized by the “new era” promise of the Internet/telecom sector, since the familiar old blue chips in the Dow Jones Industrial Average also rose vigorously (about fourfold) during the decade—if, to be sure, nowhere near so vigorously as the high-tech Nasdaq index (up about tenfold at its peak).
Additional unanswered questions pertain to the pervasiveness of fraud. To what extent were investors bamboozled by accountants beholden to their corporate employers? By securities analysts pressured to deliver affirmative judgments on stocks underwritten by their own firms’ investment bankers? By executives willing to lie, cheat, and steal to boost the value of their stock options?
We have all read the avalanche of news stories about bad behavior at Arthur Andersen, Enron, WorldCom, Tyco, and other enterprises that commanded unquestioned respect only a few years ago. It is still not quite clear whether we should think of this highly publicized venality as representing a small basket of bad apples or as betokening disastrous systemic corruption of our financial markets. Berenson does not squarely address this distinction, but as his subtitle foreshadows, the book tilts unmistakably toward the systemic view.
The “number” referred to in his title is quarterly earnings per share, and readers are told repeatedly that the “cult of the number” is what has been distorting reality on Wall Street. “The number is a lie,” says a characteristically heavy-breathing passage in the book’s final chapter. “We need it; we can’t avoid it. But it’s still a lie. And as long as investors remain too focused on the number, companies will find ways to manipulate it.”
The Number is organized as an extended chronological tour of the stock market, beginning with the boom of the 1920’s and ending, in a chapter titled “Truth,” with the post-boom reckonings of today. In the early chapters, recurring themes are the federal government’s uneven efforts to create a regulatory framework, to establish standards for accountants, and to increase financial disclosure. Incredible as it seems today, no earnings reports at all were required before passage of the 1933 Securities Act. The quarterly statements that contain “the number” were not even required by the Securities and Exchange Commission (SEC) until 1970.
In an important but strangely muddled chapter titled “The Number Is Born,” Berenson tells us that to understand the frenzied market of the late 1990’s, you have to know about a prior sequence: the fifteen-year breakdown of integrity in investment research. Until 1975, he writes, the commissions that brokers earned from trading shares were fixed by the New York Stock Exchange. In the absence of price competition, brokers competed on the strength of their research efforts, which, in Berenson’s judgment, reached an all-time qualitative peak in the late 1960’s and early 1970’s. In those days, he adds, “Institutional investors used commissions to support more than $100 million in research a year.”
But all this changed after Wall Street’s “May Day”—May 1, 1975. That was the day on which a Justice Department antitrust action finally brought an end to fixed commissions, ushering in the age of discount brokers and with it, inevitably, lower trading profits. When the market moved up solidly in the early 1980’s, brokerage firms had less money to spend on research. Furthermore, the big bucks were now being made in leveraged buyouts and sundry other deal-making, and so the research that did get done was increasingly tailored to those purposes. Everything was a “buy,” and investors were being snookered: “By the mid-1980’s, complaints about the quality of Wall Street research were endemic among professional investors.”
It is a tidy story line, but Berenson has trouble sticking with it. First, he feels obliged to note that even before May Day, investment research was fundamentally dishonest. “Then, as now,” he writes, “analysts who wrote negative reports risked being ostracized.” More seriously undermining the chapter’s main point is a lengthy and sensible footnote that stretches over the bottom halves of three pages, constituting a kind of running argument with the text above it. While the text is going on about deceived investors, the footnote is reminding us that investment research, before and after May Day, was largely unread and generally useless except in the rare instances where the findings were unique and proprietary. The conflict between the two views is never ironed out.
As The Number draws closer to the 1990’s, it offers a more detailed look at the market’s fraud-related problems. We learn that “the sudden drop in corporate ethics” can be explained in two words: stock options. Stock options—the right to buy a given number of a company’s shares at a given price after a specified date—have of course been around for a long time, but Berenson argues persuasively that the “mega-options” increasingly surfacing in the 1990’s critically changed the perspective of the corporate officers who were being granted them. In opening up the possibility of vast wealth to be created through short-term price movements, options offered perverse new incentives for senior executives to cheat on the numbers.
Also getting expansive treatment is the transformation of the once-genteel accounting profession into a serious profit-seeking business, and the two big issues that have endlessly swirled about the business: (1) to what extent should accountants be held responsible for inaccurate financial statements, and (2) should they be allowed to sell consulting services to the companies they audit? Here and elsewhere, Berenson comes across as a regulatory hard-liner. He wants the SEC to address both issues by cracking down much more severely on the accountants, and he repeatedly rues the commission’s inadequate budget and inability to bring more charges. Knowingly, he informs his readers that President Bush “began to gut” the oversight board created by last year’s Sarbanes-Oxley legislation as soon as the media’s attention was diverted to Iraq.
At one level, The Number is a decent summary of what has happened lately to investors. But it is a fairly low level. Very little of what Berenson puts forward is based on data that will look new or original to ordinary readers of the business pages. Berenson believes that small investors need some higher level of federal protection against fraud, but he also believes that small investors are capable of boundless irrationality. This leaves one wondering why he thinks the protection would do much good. In any case, it is always worth reminding oneself that stock valuations are set not by irrational small investors but by well-heeled, sophisticated institutions. Exactly what many of these institutions saw in the overpriced markets of the late 1990’s is a mystery unanalyzed by Berenson and still to be explored.
The Number surely aligns itself with the majority in viewing the trajectory of stock prices in the 1990’s as a “bubble,” but the book never gets around to defining this amorphous concept, which appears to involve a phenomenon identifiable only after the event, and which endlessly confounds the world’s smartest financial analysts. As of late February, the Dow was still about 1,500 points higher than when Alan Greenspan proclaimed a bubble in December 1996. There is a case for banning the term.
At the end of his long chapter on the 1990’s (titled “Frenzy”), Berenson notes despairingly, or perhaps gleefully, that when the market was topping out in March 2000, 75 percent of analysts’ recommendations were still “buys” or “strong buys,” and only 0.7 percent were “sells” or “strong sells.” This advice, he adds dramatically, was being given “at the worst moment to buy stocks in seventy years.”
All of which led me to look up what a certain award-winning business writer was telling his own readers in March 2000. Despairingly, or perhaps gleefully, I must report that Berenson did not mention it was sell-off time. Indeed, on March 18, he was telling readers of the New York Times that the Dow’s recent sharp rise—it had been up 499 points two days earlier—“augurs well for investors over the next few months.” Citing research that linked such extreme one-day gains to strong positive results over the ensuing six months, he urged that it was time to buy. “The statistics,” he wrote, “are unambiguous.”