Management Integrity

June 26, 2002

As the morals of this world continue to careen downhill like a hippopotamus on Rollerblades attempting to negotiate Lombard Street in the dark, one can only thank one's lucky stars that those beacons of probity and virtue, CEOs of public companies, are in a position of prominence to illuminate the road for us and keep the rest of us from veering off the right path!

Okay, maybe not.

As we have learned from recent headlines, corporate managers are often more interested in lining their own pockets with the shareholders' money than they are in placing the shareholders' interests ahead of their own -- the definition of fiduciary duty.

And thus, we as investors are having to re-learn one of the things taught to us by Warren Buffett, and by Phil Fisher before him. Namely:

The integrity of management will have more to do with the value of your investment than just about anything else, and yet almost no one pays any attention to it.

At least until now. Now it has become obvious that the integrity of management can drastically affect your investments. As Jeff Skilling, Bernie Ebbers, Gary Winnick, Dennis Kozlowski, et al, have quickly moved from the status of deified heroes to pilfering chumps, all investors have had their eyes re-opened to the importance of management integrity.

But rather than simply do post-mortems, I'd like to give two real-time examples of what I deem to be good and bad management. In the process it will allow me to write a brief obituary for a man I never knew, but still trusted. After that, I'll have a few more brief things to say about investing.

A Tale of Two Companies

Over the past couple of years as the markets have been wildly overpriced, one of the few areas where I've been able to find any halfway decent investment ideas has been in the area of extremely small companies. They have no analyst coverage and therefore far less competition. Even though the following two companies are very small, I think they provide an excellent example for learning. This is not investment advice. This is for illustrative purposes only. It is only my opinion.

The two examples below both appear to be "value" stocks. I believe that only one of them is, and the other is potentially a value-trap, because of management. With the wrong management, an apparent margin of safety . . . . often isn't.

Let's start with the positive.

Dewey Electronics [Symbol: DEWY.OB]

Dewey Electronics is primarily a defense contractor. The company is the exclusive manufacturer of 2kw tactical generator sets for the US Army and other branches of the military. Revenues have declined somewhat recently, mainly due to timing issues as their old defense contract was coming to an end. However, the company was recently awarded a new 10-year contract. The company has won awards for quality and value as a defense contractor. The company is trading at about $4.00-4.50. It has an approximate trailing P/E of 5. It has over $2.50 per share in cash. The Current Ratio is about 6:1. ROA and ROE are excellent.

The only sizeable debt the company has is a mortgage on its 49,200 square foot manufacturing facility, which it owns. (The company has been making early principal repayments on the debt. A few years ago the debt was more than $2 million, now it is about $900,000.) The building sits on 90 acres of land that the company owns adjacent to a full interchange of Interstate 287 and Muller Road in Oakland, New Jersey. The current market value of the land is not reflected on the balance sheet. The company has publicly stated that they are seeking alternatives for the land in an effort to increase shareholder value. The company only needs about 20 acres for its operations, so the other 70 acres is free to do with as they please. The company has less than 1.4 million shares outstanding. I don't know what 70 acres right off the Interstate is worth in Oakland, NJ, but I'm hoping it's more than zero (yes, I've owned shares in this company for some time). The auditor is Deloitte & Touche.

Factoring in the low P/E, the cash, the land, the exclusivity of the military contract for tactical generators, especially in light of the war on terrorism, etc., I don't claim to know exactly what the company is worth, but I like the margin of safety.

But as nice as all of that sounds and as much as there appears to be a margin of safety, the only reason I was willing to touch it was because I trusted the management.

Dewey Electronics is a family business. Gordon C. Dewey founded the company in 1955. His wife, Frances, is a Director and Secretary of the company, and his son John is also a Director. The Dewey's own about 40% of the stock, with Gordon owning most of it. So let's face it, Gordon Dewey could run this company any way he wanted. If he wanted to rip-off shareholders, he easily could have done so.

Yet he didn't.

I always felt like Mr. Dewey and I were partners. He payed himself a reasonable salary of $144,000; it's been the same for the last three years. In the years when the business's performance warranted it, he received reasonable bonuses -- in cash, not stock. He did not take additional compensation for being a member of the board. There has been very, very little in the way of stock options. Hardly any dilution over the last several years. The only related party transaction is $200,000 owed to Mr. Dewey at 9% per annum. Mr. Dewey lent the money to the company, unsecured, in 1988 when the company's fortunes were far different. It was essentially a venture capital loan. The company could easily have paid it off, but I have no problem with a venture capitalist being rewarded with a 9% return. He deserves it. In my opinion, it is all the more testament to Mr. Dewey's rectitude that he did not garner more shares for himself, via purchasing equity, rather than making a very reasonable loan.

Gordon C. Dewey died recently. I did not know him. I do not know his family. I do not know anyone at the company. All the information I gleaned is from public documents. I spoke to Mr. Dewey only twice on the phone -- briefly both times, to ask some questions about the business. And both times I got the impression he wanted to get back to work. He was in his late 70's and worked in the office until the end. Condolences to his family.

What we have here is an example of how the public capital markets can benefit us all. They allow investors to partner with businesspeople hundreds or thousands of miles away. We can take advantage of the business acumen of others, even if we don't have those abilities ourselves. Together we can produce valuable products that are needed in the marketplace -- in the case of Dewey Electronics, valuable military equipment for our fighting men and women. And with honest people running the show and instilling a similar culture, there can be an enduring legacy that benefits shareholders, employees and customers alike, even when the original founders have passed on.

This is the way the system should work, and integrity is the keystone.

Now let's examine the ugly side of the system and see why the morals of management must be the investor's first consideration, even ahead of an apparent "margin of safety."

National Auto Credit [NAKD.OB]

Again, this is a very small company -- total market cap is about $1.5 million. Yes, extremely small, but still a valuable lesson can be learned here. The company didn't used to be small; this used to be a NYSE-listed company. So it's an example of the type of thing we may be seeing much more of in the future. (Incidentally, the links provided herein are so you can verify the information if you like.)

Arguably, this company has an even greater apparent margin of safety than Dewey Electronics. But I would not touch it with a ten-foot pole so long as current management is in place, because as a shareholder I would have absolutely no confidence that I would ever see any of that value. Everything has been going to insiders. (I hold no position -- long or short -- in this company, and I do not know anyone at the company.)

Some companies puff up earnings or use flaky accounting gimmicks to make it seem like they are making more money than they are, or to make their assets appear more valuable than they really are. National Auto Credit (NAC, for short) is somewhat different. It actually does have substantial assets and book value. . . . . . . and the insiders are making a killing off those assets.

The company is currently trading for about $.15 (yes, 15 cents) per share. According to the latest 10-K (filed 5-15-02), the company had 8,641,754 shares outstanding as of May 10, 2002. NAC also had over $7 million in cash and marketable securities. It also owns half of the Angelika Film Center in Soho, New York City. Total stockholders' equity is shown as more than $16 million, and that figure may be fairly accurate. (Since I began writing this piece--I've been piecemealing it together whenever I have a few minutes--NAC has filed their latest 10-Q and cash, marketable securities, and shareholders equity have all declined.)

As I said, this company used to be listed on the NYSE. It was a sub-prime auto lender. (The company has hopped in and out of various ventures since then.) In 1998, the auditors, Deloitte and Touche, resigned because they said they could not rely on management representations. After that, there were investigations by the SEC, the FBI, etc. Shareholders sued and finally things were settled.

The company then bought back the shares of the previous Chairman on Nov. 3, 2000, and James McNamara, the current CEO (who just happened to be brought in by the previous Chairman), was named to replace the then CEO who resigned on the day of the buyout. At about the same time, the Directors salaries went up by about five times. All of that looks very suspicious to me. The old management made out fine and the new CEO, Mr. McNamara, signed a huge contract with a $750,000 signing bonus, $500,000 a year salary (plus bonuses), and all sorts of perks, options, maximum parachutes, etc. And before becoming an employee, he was allegedly an outside director who was independent. (In fact, he was on the special audit committee to investigate the abuses of prior management!)

There have been numerous related party transactions for large amounts. The whole thing is disgusting. And shareholders know it. A number of shareholder suits were filed against NAC shortly after Mr. McNamara and his cronies received their sweetheart deals. But the court system moves too slowly. Perhaps the worst part of all of this is that Mr. McNamara (whose previous claim to fame is having run two other companies into the ground), is now personally buying the stock for pennies. His actions have caused the price to plummet (did he do that on purpose?) and now he is using some of the cash from his ridiculous salary to buy shares from other investors. After all, once all the cash is gone, there will still be the theatre assets. Why not grab those too? After just a couple of years, he now controls over 20% of the company. Now, even if the company is liquidated (which would probably be a good thing), his poor management will have benefited him, and it will be at the expense of the shareholders who sold to him.

NAC currently has no operating business. The company just hired a new CFO for $240,000 per year, plus bonuses (latest 10-K). That's right, the top two guys are sucking out at least $740,000 per year. Non-employee Directors pull down $55,000 per year, plus expenses. All this while the company currently has no operating business. Plus, management is using company funds to defend what appear to be very legitimate shareholder suits, so more money is going out the window. They have also instituted a poison pill to discourage any would-be acquirers.

Management appears to be working against the shareholders, rather than for them. The book value is more than ten times the current share price. But as an investor, how do you know you will ever see any of it? What if the company announced that the Board had approved a management-led buyout at a few cents above the current share price? What would you do? Depend on the court system? What if management just milks the thing for several more years, collecting salaries and using company funds to thwart shareholder suits?

NAC has also repeatedly had trouble filing its SEC documents on time. The company last filed a proxy statement on 8-23-99. Has the company even been holding elections? Where is the SEC?

Lessons To Be Learned?

What we should learn from all of this is that there is the theoretical world -- often filled with rules, legalese, the courts, government regulators, and rosy ideals -- and then there is the practical, real world. As an investor, you should never count on the theoretical world to save you.

Public Companies In Theory

In theory, a public company is a democratically run organization. The shareholders, by a vote, determine who will run the company. An independently elected Board of Directors serves as a check-and-balance on management. Audit Committees and Compensation Committees made up of independent Directors also serve to keep management honest and keep salaries reasonable on behalf of all shareholders.

But that is not reality.

May I Enter Your Kingdom, Please?

In the real world, when you invest in a public company you are voluntarily agreeing to have your money ruled over by a king: the CEO. Remember here, I'm not talking about how we'd like things to be, or how the laws are written up. . . . . I'm talking about reality. And you don't have to take my word for it. Warren Buffett and Charlie Munger both recently said that they (Warren Buffett and Charlie Munger!) have very little influence over the Boards they sit on. And they said that, for the most part, what the CEO wants the CEO gets. (Buffett also said of his Fruit of The Loom purchase, "It was made-to-order for us, but only with present management. If we'd had to buy it with previous management, we wouldn't have paid $1 for it." Keep that statement in mind the next time you think about buying a company because it's cheap, even though you're leery of management.)

The idea of independent Directors sounds great in theory. But "independent" doesn't mean that these people are complete strangers who have come in off the street. "Independent Directors" are nearly always going to be friends of the CEO and/or other Board members. After all, they have to get nominated somehow.

As to voting, and the idea that "the shareholders elected the Board," this is true but misleading. The shareholders don't have an opposition slate of Directors that they can vote for, as we do in, say, a national election for President of the U.S. The truth is it takes a huge amount of money to propose an alternate Board that truly has a chance of winning. This takes a huge grass roots effort because most investors do not have a large enough position to justify taking on the cost of such a proxy battle themselves. Plus, management proxies are worded such that if they are not returned, then they are counted as votes FOR the proposals suggested by current management. Most investors don't have the time to get involved to the degree necessary for these proxy efforts, because, after all, they wanted a passive investment in the first place. So it is very difficult to get an opposition Board elected. There are many strikes against such an effort right from the start.

But, this process allows a convenient way for management to deflect any questions about their integrity. Whether it be salary, golden parachutes, signing bonuses, stock option plans, or whatever, the CEO can simply say "the Board, as elected by the shareholders, approved it."

"The Board" often serves as nothing more than a convenient rubber-stamp for the CEO, and at the same time allows the CEO to pretend that "the shareholders approved it." His hands are clean, you see, because the Board makes those decisions, not him.

So essentially, this is very much like a kingdom where the king can abuse his subjects, little by little, because the subjects hold very little power, have other things to do, and can't rise up in anger about every little thing. Taking 10% of a public company each year via stock options, for example, is really just the modern-day version of coin clipping. The subjects don't like it, but what can they really do about it? Only when things get unbelievably egregious will the subjects gather together to form a grassroots movement, devise a plan, decide on a leader, and storm the castle. And even then the King may already have absconded with most of the gold.

Too often, managements are working against shareholders rather than for them. It is far easier to take, than to produce. Your best bet is simply to stay away from such managements. You don't have to participate. And if you find yourself holding shares of a company where the management is dishonest, run. This is one area where I agree with Jim Cramer:

Accounting Irregularities = SELL

But I go even further than that. Here is my rule:Accounting Irregularities, or SEC Investigations, or FBI Investigations, etc., all of them = SELL . . . .and don't go back.

Companies Develop A Culture

The reason I don't go back is because honest people tend to surround themselves with honest people and slime balls tend to hang around slime balls. A company develops a culture of honesty or dishonesty. And it tends to carry on. If you're a swindler trying to cook the books, what are you going to do if someone starts to question the way things are being done? Fire him. You don't want a squealer in your midst. Other employees with integrity will also leave, as they won't like what's going on. Pretty soon, you're left with nothing but (or at least a majority of) corrupt people. Conversely, if you're an honest CEO and you detect someone in your organization is trying to embezzle or mislead, what do you do? Fire him. You don't want that kind of filth in your organization. People of integrity will want to work for you, even if it's for less money. They want to be able to look themselves in the mirror.

Therefore, it's been my experience that the group of managers at the top tend to be of a similar mindset. And that's why I don't go back. A poor manager is one thing, a dishonest management team is another. If sweeping changes are made, or if you are overseeing management changes, obviously that can be different. Otherwise, removing one person doesn't change all the other corrupt people who are left.

I believe it's Jim Chanos who likes to say that when management chicanery exists, it's always worse than it looks. Always.

Proposed Rule Changes

I don't have much faith in them. I suppose allowing shareholders to vote on option plans is better than nothing, but I'm becoming more and more of the opinion that options should not be allowed at all for public companies. There are simply too many ways for dishonest managers to drive up the share price in the short term by making things look better than they are. Cookie jar reserves, channel stuffing, the "assumptive troika" of pension smoothing, gain-on-sale accounting, and mark-to-market accounting all allow managers to make whatever assumptions they want in order to "manufacture" whatever earnings they want. (Who says manufacturing is in a recession!) At the very least, options must be fully expensed.

As discussed above, "Independent Boards" are never going to be truly independent. It doesn't matter how many rules you put in place. New rules may only end up hurting the honest companies by forcing them to jump through new hoops when they weren't cheating anyone anyway. Do you really think a swindler is going to be stopped by an "independent" Board? A CEO is either going to have integrity or not. We all know we're not supposed to lie, cheat, or steal. There's no news flash here. We don't need more rules. Are we really going to stop the dishonest people with new rules, or are we just going to increase the costs on the honest guys?

Rules often inadvertently encourage the very behavior they are attempting to prevent. Rules can be worked around, principles cannot. Perhaps we should approach enforcement and accountability on the basis of overriding principles rather than trying to come up with, and enforce, specific rules to cover every possible eventuality (the IRS tax code comes to mind). A little more Andy Taylor, a little less Barney Fife.

Think of it this way, if someone on the streets of New York City is offering you a game of Three Card Monte, is an oversight committee going to make him honest? Especially when he's choosing the committee members? How about if the committee members met independently, would that help? Even if you got to choose the "independent oversight committee" yourself, do you think he couldn't fool them too? The hand is quicker than the eye and these are pros. Just vow to yourself not to play Three Card Monte -- you cannot win. Don't let your greed get to you.

What A Waste

Additionally, all these rule changes, regulations, etc., are huge wastes of time and productivity. It really is in all of our best interests to act with character and virtue. For a short period of time it may seem like the scoundrel's way of life is better. But is it really? Would you want to be Jeff Skilling or Andy Fastow of Enron right now, regardless of how many millions they have? They are social outcasts. They face years of legal hassles, broken families, lost friends, dead friends by way of suicide, etc. Would you want to be Dennis Kozlowski right now?

And what of the brokers and analysts who thought they were so smart by selling shares of "crap" to the public? They, too, face years of lawsuits and will probably have to give most of the money back when all is said and done. Giving it back immediately would be the best thing. It would save everybody time. But it won't happen. Years of unproductive time will be wasted in court, and then they'll be forced to settle.

My guess is that when this entire maniacal speculative episode is over, nearly everyone will wish it had never happened. It will have been a huge, huge waste of time and resources for society as a whole. Like saying, "Hey, maybe we can steal from ourselves and not get caught."

How Bad Is It?

Just how much management deception and chicanery has there been? I keep hearing the TV folks say, "When will investors stop distrusting management? That's like asking, "When are people going to stop believing that there's oil in Saudi Arabia?"

The implied comment in such a question is that investors have simply been mistaken and none of this management deception and/or corruption has occurred. Or if it did, foolish investors are simply overreacting, we're told.

It's no big secret that tons of companies have been juicing things with pro-forma earnings. The SEC knew it and didn't stop it. Investors were fine with it because their stocks were going up. Reporters simply reported these earnings as though they were real. They weren't. I remember Ellen Hancock of Exodus Communications (remember that one?) stating with a straight face that her company had reached EBITDA profitability, as though there really were such a thing. (That was before the bankruptcy).

Companies have been fibbing. It's that simple. Fibbing to drive up their share prices. They just never thought the day of reckoning would come. Perhaps, much like Enron, these companies just thought they could always come up with another accounting gimmick to keep the game going. They never thought it would end.

And in the overall market, I don't think it's going to change. I think it will only end when there are no more sheep to be sheared -- when investors have lost all they can stand to lose. The Three Card Monte guy goes out of business when he can no longer entice anyone to play. So while the con man is certainly not to be let off the hook, investor greed played a large part in all of this. Investors thought they could get rich for doing no work. They wanted the phony earnings if it meant their stocks would go up. Like an infinite sponge, management chicanery will expand to sop up whatever amount of investor greed that exists.

"These Are Just Isolated Cases"

Let's take just one example of deception: revenue swapping. When a couple of dot-coms were caught swapping ad revenue, we were told those were isolated cases, remember that? As it turns out, nearly all of them were doing it. "Well, that's those twentysomethings who never should have been in charge in the first place. Thank goodness the dotcoms are gone now."

But wait, then the big telecom companies were caught "round-tripping" their revenue. Many of them are now hanging on for dear life. "Well, that was all that New Era stuff. Thank goodness all that's gone now."

And now we come to find out that nearly the entire energy sector was doing the same thing. We haven't been provided too many convenient excuses here. These were old-line companies in a supposedly conservative industry. They weren't supposed to be involved in this type of thing. They all claimed to be making "trading profits." Do you know how tough it is too make trading profits? And yet, according to the energy execs, nearly everybody in the industry was making trading profits. But now they've had to "write-down" all of those profits.

Three very different industries were all doing the same thing.

So here we have Larry Mondello, the Beaver, and Wally all getting caught red-handed eating Mrs. Cleaver's freshly baked cake. And yet the instigator of it all, Eddie Haskell, is standing over in the corner with his hands in his pockets, whistling, and looking up at the ceiling, as if to say, "Don't mind me, no need to look over here." Even as he's got frosting all over his face, he says, "Mrs. Cleaver, I'm shocked at what these boys have been doing!"

A few weeks ago we got just such a speech from Henry Paulson of Goldman Sachs, decrying the activities of those other boys. Investment bankers are the Eddie Haskell of Wall Street. They're the instigators. They're the ones who, either directly or indirectly, set up all these structures that allow for trading profits, derivative profits, gain-on-sale profits, mark-to-market profits, off-balance-sheet nonsense, structured finance products of all kind, etc. Many of these banks are leveraged black boxes. And I'm guessing that when the cover is eventually taken off those boxes, we will be absolutely appalled at what we find.

Naive investors lost a lot of money in Goldman Sachs IPOs that never should have come public. Goldman Sachs did plenty to abuse the public trust by bringing such companies public. These were all "Enrons" for somebody. Perhaps Mr. Paulson needs to be reminded of a few IPO names where his firm was the Lead Underwriter and the company is now either bankrupt or the shares are down more than 90% from the opening price: Exodus Communications, Inktomi, iVillage, Portal Software, Northpoint Communications,, Nextcard, Etoys, Starmedia Network, Viant, E-Loan, Backweb Technologies, Convergent Communications, Insweb, Engage Technologies, Looksmart, Netzero, Webvan, Freemarkets, Classic Communications, Palm, Net2000 Communications, Saba Software, 360networks, Blue Martini Software, Storage Networks, Corio, Resonate, Crosswave Communications, Equinix, Cosine Communications . . . . and that's not a complete list. (Source:

When I was a teenager, my friends and I would often cruise around town. One of us would usually have access to a parent's car, and the four of us would drive around, going nowhere in particular. At some point during the trip, a flatulent aroma would begin wafting throughout the interior of the vehicle. Invariably, somebody would say, "Oh MAN!! Who did THAT?!" We would then grab our throats in mock-suffocation, gasp for breath, cough spastically, and eventually roll down the windows so we could jam our heads out of the car to get some fresh air. As one became more experienced in this ritual, one began to realize that indeed the accuser himself was most often the culprit as well. The transgressor would make a proactive accusation in order to divert attention away from himself. A bold and cunning move.

It was a lovely speech Mr. Paulson, but something smells.


Tim Picks
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