Recently, we’ve learned that Steve Jobs had liver transplant surgery in Tennessee two months ago.  This has led to a public debate about whether or not Apple’s board should have revealed the extent and significance of Steve’s ongoing health issues.

On the one side are professional investors, such as Warren Buffett, who say the information is material, and therefor should have been revealed.

On the other side is Apple’s Board, supported by many members of the public, who say Steve’s health issues are a personal and private matter, and really nobody’s business.  It’s a compelling argument, and is consistent with most people’s beliefs that health matters should always be private.

But they are wrong.

The issue here is one of fiduciary duty in the face of material information.  Fiduciary duty is a concept that most people in the public are unfamiliar with.  But anyone who has served as a board member, or as a senior officer of a company (such as a CEO, CFO, etc), has had to grapple with it.

In essence, a fiduciary is supposed to put the needs of their beneficiary ahead of their own – much the way a parent often puts their child’s needs ahead of their own.  It is a unique relationship in business and in law, and the normal rules of the business world do not apply in a fiduciary relationship.

“Material information” is simply information that a typical investor would be likely to include in a decision of whether to buy or sell a company’s stock.

In this case, it’s really impossible to argue that Steve Jobs’ health is not material information.  There are many, many people who would include Steve’s health in their decision to buy or sell Apple stock.

And because he is CEO (even if on leave), he is a fiduciary.  That means he is obligated to put the needs of the shareholders ahead of his own.  There are no exceptions to that rule for health, or privacy, or anything else.

I realize this has to be a personally difficult time for Steve and his family.  So it may be difficult for him to keep a clear focus on such abstract concepts.  But that’s where Apple’s board has failed.

Apple’s board members are also fiduciaries for the shareholders.  They have monitored his progress, and have had an ongoing obligation to report his condition to the shareholders.

And they have failed spectacularly.

What’s worse, they have actually argued that they have an obligation to keep Steve’s personal health information private.  But they do not.  When they joined Apple’s board, each of them willingly took on the role of a fiduciary.  These are sophisticated business people, who understood that role (or ought to).  To argue as they have that their primary obligation is to Steve, and not the Apple shareholders, is really abhorent.

We seem to be living in a time when people are confused about the fiduciary relationship.  And yet it was that very breakdown in the fiduciary concept that caused such enormous problems at companies like Enron, Worldcom, and even HP, which resulted in the backlash of Sarbanes-Oxley.

I have admired the business decisions Apple has made over the past decade.  They have shown a great deal of vision, and have revolutionized multiple markets.  It’s been a joy to watch them grow, both as a shareholder and as a consumer.  And I wish Steve the best in his health struggles.

But I do hope that the Apple board is held accountable for this clear breach of their fundamental fiduciary duty.  Because ultimately, that will make Apple stronger, and will send a message to other boards in the marketplace that they need to respect their primary obligation to the shareholders above all others.

The 2000 film Boiler Room depicts the seedy world of the “pump-and-dump” scam.  In it, a broker purchases a large block of public stock in a shell (i.e. empty) company.  The firm then calls potential clients to pitch them the same stock.  This drives up (“pumps”) the price, making it appear to be a runaway stock, thus attracting more buyers and driving the price higher.

When the price is high enough, the broker “dumps” their own shares at a huge profit and walks away.  The result is that the buyers are left holding stock in a worthless, basically non-existent company, which promptly falls back to zero, wiping out the investors.

Which brings us to Silicon Valley.  Over the past decade or so, Silicon Valley has morphed from a region that was the builder of great companies (Apple, HP, Intuit, Cisco, Oracle, etc), into perhaps the greatest generator of “pump and dump” stocks.

Many people who live in Silicon Valley have complained about the changes that have taken place over the past decade.  Venture Capitalists still like to claim that their primary interest is building great companies. Many of  Silicon Valley’s founding VCs (Art Rock, Tom Perkins, etc) used to believe that if they built great companies, the money would follow.  So they focused on building great companies.

But now it s

eems the VC community is more interested in pumping up their companies, getting “an exit” (i.e. dumping), and moving on.  Today, if they happen to buil

d a great company along the way, that’s terrific.  But it is far from the primary motivation.

Any entrepreneur can tell you about the emphasis VCs place on having a solid “exit strategy.”  But while VCs will sometimes ask about a “business model” how many ask about the company’s “business strategy?”  (Answer: None.)  And no, a business model is not a business strategy, any more than an exit model is an exit strategy.  The model is just the form it will take, such as “selling tickets”, while the strategy is how you are going to go about doing it successfully (e.g. “door-to-door with a fleet of hourly workers familiar with the people who live in the neighborhood, hired from local churches.”)

And the entrepreneurs aren’t much better.  Although many entrepreneurs are still driven by a desire to see their products come to market, the reality is that, faced with a potential multi-million dollar lottery win, most entrepreneurs will abandon the dream in a heartbeat.

I have a little more sympathy for the entrepreneurs as they often don’t have much money, so the temptation has got to be big.  By contrast, a successful VC typically has a much larger personal net worth, and has made a decision to pursue this business model.  Of course, their decision must recognize the difficulty of raising follow-on funds if their prior fund shows sub-standard results.  So the focus on financial results is understandable.

But the net result is an emphasis in Silicon Valley that has moved from building great companies, to pumping up new companies or technologies just long enough to gather a large user base, show a potential for greatness (but not actual greatness), then dumping the technology or company on the highest paying buyers they can find, regardless of long-term value.

And that’s a shame.  Because it makes a few people very wealthy, but at the expense of the system that allowed them to get there.  And in the end, is there any moral difference between them and the seedy brokers in Boiler Room?

]]> http://www.economicsforone.com/blog/2009/04/21/high-tech-boiler-room/feed/ 0 http://www.economicsforone.com/blog/2009/03/21/the-well-of-infinite-depth/ http://www.economicsforone.com/blog/2009/03/21/the-well-of-infinite-depth/#comments Sat, 21 Mar 2009 17:29:02 +0000 rick http://www.economicsforone.com/blog/?p=104 In high school calculus I remember learning about an equation for a 3-dimensional shape whose walls stretch to infinite, but whose volume is limited. Imagine that! It’s like a flower vase that stretches from the earth to the moon, and off to the stars, but which only holds a cup of water.

It’s really neat in theory.  But it doesn’t hold up in the real world.

A lot of economic theories are like that.  They assume that the financial world is infinitely deep, and that their actions are just a tiny part of that. And they may even work—so long as most people don’t use them.

One example is index funds.  Index funds attempt to mirror the market by holding a set of securities in the same proportions as the market.  The theory is that the market incorporates all known information, and represents the best understanding of relative values, and so you cannot own any better portfolio than the overall market.  (The counter-argument is that the market really represents a voting system, and often includes a great deal of emotion.  And there are plenty of examples of stocks rising or falling for reasons that have nothing to do with the underlying value of the stock.)

But if everyone owned index funds, who would be left to set the relative prices?  As more and more people subscribe to index funds, the number of people who are setting the prices goes down, until eventually (in the absurd) a single person is setting relative prices while the rest of the world just follows that person’s allocation.

There are many more examples of financial theories that break down as their adoption rate goes up.  And it’s worse for the better theories.  When people realize they can get an edge, their method, theory, or whatever, quickly spreads through the financial community, thus violating the premise that most of the market is not using it.

So what is the solution?  Two parts:

1. Don’t rely on theories that require you to be a small part of the market.  Instead use approaches that are independent of how much of the stock or how much of the market you own.
2. If you do find a trading edge that requires you to own a small part of the market — keep it to yourself!

And finally, if you find that the market is following a theory like this, be prepared for a breakdown, and position to take advantage of it.

It reminds me of the early 1990′s.  A lot of uncertainty.  A lot of opportunity.  Prices fluctuating.  Irrationality in some areas, but not across the board, much like during the peak of the bubble from 1999 to 2000.

There are some great opportunities in equities right now.  Some long — some short.

I’ve been heavily weighted in energy stocks for the past 3 years, and it’s been a great ride.  But oil won’t go up forever.  The upstream oil producers have benefited from the high price of oil, and they will suffer when it goes down.  And down it will go; despite the claims of increasing demand in China and India, there really is no fundamental justification for the current high price of oil.  It’s a bubble, and it’s clear the large oil producers understand that.

Likewise the ongoing, slow-motion real estate collapse has created some impressive possibilities.  Who is going to buy up all that foreclosed real estate?  And what about the houses that are not in foreclosure?  They may be perfectly good homes, but they won’t be able to command their previous prices.  When prices get irrational–and they will!–gobble them up while you can!  Rent them out and hold onto them.

And watch out for the financial sector.  A lot of companies got caught up in the chase for a quick buck, and are over-dependent on the real estate market.  As that bubble collapses, it’s likely to have a devastating effect on some banks.  The only financials I’m holding onto are Goldman Sachs, Bank of America, and a small position in Schwab.  I also think Wells Fargo remains pretty good.  But these stocks need to be monitored closely, as they are decent issues sitting in the middle of a minefield.

I don’t tend to do a lot of short selling–but there may be some great short opportunities in the financial sector now.