DRAWN AND QUARTERED

SYNOPSIS: 'Markets are stupid' is not a valid investment strategy

Devotees of good bad movies fondly recall that very 60's spy spoof "The President's Analyst." The protagonist was pursued by various powerful, sinister organizations, including the government of Canada. But the most powerful of all was T.P.C. The Phone Company.

That was then. Now what's left of AT&T, reduced by legislation and competition to at best first among equals in the telecommunications industry, has declared that it will split itself again. The dream of rebuilding AT&T's empire in the new worlds of the new economy has been abandoned.

What's peculiar about this move is that the company has hardly bothered to offer a conventional business justification for breaking itself up.

Other things being equal, a company that straddles several related lines of business ought to reap important advantages. Of course, other things are not always equal: a company that is too sprawling becomes unfocused. Finding the right scope making the best tradeoff between the synergy that comes from being in several related businesses and the disadvantages of a scattered focus is famously difficult.

But today's AT&T does not look like an unwieldy, unfocused conglomerate. On the contrary, there ought to be considerable advantages to having the same company offer long-distance service, wireless service and broadband access to the Internet. AT&T executives say the new entities will be more "nimble"; why, exactly? And the breakup itself will be costly and disruptive. Why are they doing this?

The answer, it seems, is that AT&T thinks that the financial markets are stupid.

AT&T management apparently believes that if it spins off its "new economy" operations wireless and broadband the stocks of those operations will sell at such high prices that the overall market value of the company's constituent parts will rise, even if the combined profits from those parts decline. This can only be true if today's company is severely undervalued, or if AT&T-in-pieces will be severely overvalued, or both. So you have to believe that the markets can't see that the sum of the parts is no more, and probably less, than the whole.

Now markets do go wrong. When investors were in the grip of dot-com mania, companies that spun off their techier parts did, temporarily, create stockholder value out of thin air. But that was a short-lived bubble; it seems much less likely that such financial razzle-dazzle would work now. Anyway, should the management of a major U.S. corporation base its long-run business strategy on the belief that markets will consistently be stupid?

But then, should the U.S. government base its long-term Social Security strategy on the same belief?

For what struck me about the dubious premise behind the AT&T breakup is that a similar premise underlies many proposals for privatizing Social Security. George W. Bush's proposal, admittedly, does not count on the stupidity of markets. Instead, he trusts the people: voters are not supposed to notice that the same pool of money is promised to two different groups of recipients.

But the real plan, the one that gets announced after the election, would probably involve sharply reducing the benefits promised to workers, in return for the right to invest their Social Security taxes in stocks. And they will be assured that stocks are such a good investment a far higher yield than you get on bonds, with hardly any risk that it's a great deal.

The question you should ask is: If stocks are really such a good investment, why does anyone buy bonds? The market must be stupid, consistently pricing stocks too low. And there is some evidence that in the past stocks often were underpriced. But that past underpricing does not mean that you should believe that stocks will always be underpriced. Markets go wrong, but they aren't predictably stupid. Indeed, one way to interpret the great bull market of the 90's is that it involved a correction of that previous underpricing. If so, the era of high returns with low risk is already over and basing national policy on the assumption that it will continue is as silly as basing corporate strategy on the belief that the dot-com bubble will rise again.

It's a shame to see one of America's corporate icons broken up on the basis of a dubious financial theory. But if the same happens to one of our most crucial social programs, it won't be a shame it will be a tragedy.

Originally published in The New York Times, 10.29.00