SACRAMENTO, Calif. - Corporate America's accounting scandals are "a new form of terrorism," said CalPERS' investment chief Mark J.P. Anson.
Mr. Anson said the lack of confidence investors have in corporate America's financial statements has heightened dramatically the risk premium they expect to earn from stocks, thus depressing stock prices. And it may take a year or two to restore investors' faith in financial data, he added.
"If you cannot trust the accounting statements, that goes to the very heart of fundamental equity analysis and fundamental bond analysis," Mr. Anson said in the first lengthy interview he has granted since becoming chief investment officer last December of the $136 billion California Public Employees' Retirement System, Sacramento, the nation's largest pension fund.
In the short term, the equity risk premium - the price that investors demand to compensate them for the additional risk of holding equities vs. long-term government bonds - has ballooned to the 5-5.5 percentage point range, he said. In the longer run, Mr. Anson predicts the premium has shrunk to the 2.7 to 2.8 percentage points, well short of the historical premium of 5.25 percentage points, as measured by Ibbotson Associates Inc., Chicago. The bottom line: investors will get rewarded far less for taking the risk of owning their stocks than they would have historically.
Subject of debate
The size of the equity risk premium has become a huge subject of debate within institutional investment circles. In late 2000, Robert D. Arnott, managing partner of First Quadrant LP, Pasadena, Calif., and Ronald J. Ryan, president of Ryan Labs Inc., New York, projected that the premium could be zero or negative in coming years (Pensions & Investments, Nov. 13, 2000).
In response, Roger G. Ibbotson, the highly regarded finance professor at Yale University's School of Management, New Haven, Conn., and chairman of Ibbotson Associates, together with Peng Chen, Ibbotson's vice president-research, said the equity risk premium was alive and well. However, they projected the premium would be 3.96 to 4.25 percentage points over bonds, about 1 to 1.25 percentage points below the historical average (P&I, June 11, 2001).
More recently, Mr. Arnott and Peter L. Bernstein, president of Peter L. Bernstein Inc., New York, wrote in the Financial Analysts Journal that the "normal" risk premium - defined as what investors might have expected from stock investments - is 2.4 percentage points or less.
"I fall clearly onto the side of the Arnott divide," Mr. Anson said in the interview.
Mr. Anson drew a comparison with the days immediately following the Sept. 11 terrorist attacks on the World Trade Center and the Pentagon, when the nation's stock markets closed for six days.
"Right after 9/11, people's investment horizons collapsed. Rather than looking out to the next quarter, next year, next five years, people were truly concerned. What's going to happen tomorrow? Will there be another terrorist attack? Is the stock exchange going to open up? Do we even have liquidity in the Treasury bond market? So investment horizons ... actually collapsed on a day-to-day basis," he said.
As a result, the equity risk premium shot up to about 5 percentage points, and global stock markets plunged by nearly 20%.
New form of terrorism
There were no additional strike following the Sept. 11 attacks, and President Bush built up a coalition of support before attacking Afghanistan. "People started to expand their investment horizons again, out to a week, a month, to next year," Mr. Anson said. The risk premium fell, and the market rallied in the fourth quarter.
By the beginning of this year, however, Enron Corp.'s accounting manipulations became apparent, followed by similar problems at WorldCom Inc., Global Crossing Ltd., Qwest Communications International Inc. and other companies.
"And the same thing happened: Equity risk premiums expanded, somewhere in the range of 5 to 5.5 (percentage points)," he said. "People's investment horizons have shrunk. If you can't trust accounting statements today, how can you even begin to forecast out next year, or the year after that, or five years into the future?
"So we have a new form of terrorism, if you can call it that, in the United States. It's not coming from outside our borders, it's coming from within our borders, and it's the lack of confidence that we as investors have in corporate America and the validity and the accuracy of the financial information that they have provided us."
The question is how long this uncertainty will last. "First, we have to see how the Sarbanes bill (the Sarbanes-Oxley Act of 2002, reforming accounting oversight and corporate governance rules) is applied. We need to put together the new Public Company Accounting Oversight Board. We need to see who's going to be on the board, what steps they're going to take. We need to watch a full year of corporate executives certifying the accuracy of their financial statements," Mr. Anson said.
"So it's going to take time for investor confidence to come back to this market. It's not going to happen overnight. It could be a year, it could take two years, but we're moving in the right direction."
Not there yet
While corporate governance has enjoyed a renaissance following the accounting revelations, Mr. Anson thinks executives have a ways to go to embrace the shift in attitudes.
Not only do chief executives and chief financial officers have to certify their corporate financial data, but Mr. Anson thinks they will begin to police themselves more heavily.
"If I were the chief executive officer of a public corporation right now and I knew the stock market was suspicious or suspect of the information I was releasing, I would go out of my way to implement strong corporate governance principles - not only to protect my shareholders but also, from a selfish perspective, to enhance my own compensation," he said.
"So I think right now corporate governance is nicely aligned with capitalism."