Government regulations are usually enacted in response to an event or to solve a problem. For example, Sarbanes-Oxley was in response to several corporate scandals, such as the Enron bankruptcy in 2001 - followed by the WorldCom bankruptcy a year later. The Act included some very tough penalties, both civil and criminal, for inaccurate reporting of earnings. The regulation did a lot to improve reporting standards in the US. This improvement has not come without cost, which is more easily borne by the largest corporations. An unintended consequence may be that every year since its passage, there has been a reduction in the number of publically traded companies in the US.
In recent years there have been many more regulations. The Dodd-Frank Act, to mention only one, has yet to be fully written. Dodd-Frank was a response to the banking and credit crisis associated with a collapse in the real estate market and in the value of collateralized loan obligations. Regulators must be working overtime to assess the consequences of this complex law.
The Finance Executives International (FEI) conducts an annual survey on the costs of section 404, which requires extensive audits of internal controls. Legal and accounting fees have increased as have compliance costs as companies have adopted ethics codes and processes for executive certification of their financial statements. In the 2006 FEI survey, only 22% of companies responded that the benefits outweighed the costs. These costs are particularly burdensome on small and mid-sized companies (there are exemptions for companies with market capitalizations under $75 million).
The Volker Rule, a component of the Act, bans proprietary trading by the nation’s banks. One regional bank said the Volker Rule will cost the company $385 million to eliminate the prohibited holdings. The American Bankers Association estimates that it will take 6.6 million hours of work to implement the law and an additional 1.8 million hours a year for enforcement. Furthermore, the banks would have to hire more than 3,000 employees to remain in compliance.
We think this sets the stage for more mergers and acquisitions. In a slow growth environment, costs are an important motivator for consolidation. What is the best way to take advantage of merger and acquisition opportunities? Trying to determine what firms may be take-over candidates is a challenge in a concentrated portfolio. We adhere to the philosophy that during a gold rush, it is better to sell shovels than dig for gold. For those who have individual stock portfolios, we have invested in select names that facilitate and profit from M&A activity in the financial arena.
John Hess 
Falgun Jariwala 
Managing Principal Managing Director
jhess@nsinvestors.com fjariwala@nsinvestors.com
www.nsinvestors.com www.nsinvestors.com
- The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. They are those of the authors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you consult your financial advisor.
- Investing involves risk, including loss of principal.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Investing in a specific sector involves additional risk and can be subject to more volatility than investing more broadly.