How to Turn Stock Speculators into Investors

Imagine opening a bakery with your cousins. You work 18-hour days to build a loyal following of bread-and-pastry connoisseurs—only to discover that cousin Joey is treating his partnership shares like a roulette wheel. He pulls out cash when the bakery is under stress, instead of pulling together with the family to save the business. He pledges his shares to a competitor to buy a boat. Then Joey repurchases them in time to vote cousin Eddie out of the kitchen.

No one in their right mind would tolerate this kind of behavior, even from your favorite aunt's son. But it's standard operating procedure in the public stock market, where far too many investors behave like cousin Joey, caring more about lining their own pockets than building valuable companies.

How can we turn speculators back into investors?

The wrong way is to impose additional market circuit breakers, as was recommended last month by the "Flash Crash" panel of the U.S. Commodity Futures Trading Commission and the Securities and Exchange Commission. The same goes for further trading-disclosure rules. And bonus restrictions and salary caps. These treat symptoms, not the root cause, which is an imbalance between stockholder and company financial-value systems. The solution can better be secured by treating public stock ownership more like a private investment.

Companies Serve Three Vital Masters

All companies serve three masters: their investors, their customers, and their employees. All are essential in their own way. Without customers, you have no revenue. Without employees, there are no products or future profits. Without shareholders, there's no capital or liquidity.

Without a doubt, private shareholders deserve a seat at the table. Their cash, expertise, and patience provide companies with the time and resources to succeed. In the last few decades, however, the period for which the average public stockholder hangs on to shares has dropped from around seven years to just a few months. Like Joey, these "investors" aren't loyal to the company, its employees, or its customers. They care only about its stock price. They seek all the gain with none of the responsibilities. Why should they dominate our economic system?

Even after the financial system meltdown, I still believe in open markets. But as a matter of public policy and wise economic stewardship there is no reason to treat drive-by investors any better, say, than we treat gamblers at the track. We must encourage investors to carefully evaluate the long-term prospects of a company—before they invest—so the stock price will reflect its true enterprise value, uncolored by speculation.

Issue Long-Term and Speculative Stock

How? Create two classes of shares for all listed public companies. Class A shares would have to be held for at least one year after purchase. Class B shares could be traded freely.

Only Class A shares would qualify for long-term capital gains treatment. (Granted, active traders in B shares would rarely qualify for long-term gains, but this distinction would mark a bright line between the classes.) Since market cycles often run for five years, and companies value stable financing during hard times, I'd prorate the long-term capital gains tax from 20 percent (at one year) to 5 percent (if held five years or longer).

Second, only Class A shares would qualify to receive dividends. If you're not investing in the long-term health of a company, you don't deserve a share of its long-term accumulated wealth.

Third, only Class A shares could vote.

Write Off "B" Losses as Gamblers Must

Finally, Class B capital losses would be treated as gambling debts are—deductible only in the current year and only against other short-term Class B gains. If you are rolling the dice on stocks more frequently than once a year, you are gambling with the shares, not investing in the strength of the American economy.

Given today's modern financial platforms, the exchange of stock into these two classes could be completed within three years. The changes would be minor, at best, if the body politic were willing. A simplified version of the existing Rule 144 applies to Class A restricted stock. And with the SEC's universal cost-basis tracking mandate (section 6045) phasing in starting this year, capital gains calculations will be nearly automatic. New listings might choose to issue only Class A shares, letting Class B shares wither away. I bet Google (GOOG)—among other big-name initial public offerings—would have joined the "A" camp.

It's time for Joey to class up or get out of the kitchen.

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