240 Years After the Crash: Lessons from the English East India Company
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During this month 240 years ago, one of the most influential corporations in world history was forced to beg the English Parliament for an emergency loan to prevent its imminent collapse. But many Britons hated the company not for high prices, low quality, or poor service, but for the humanitarian crisis they had caused halfway around the world.
The English East India Company is a topic that does not get much play in American history textbooks. Not many Americans could tell you what it did aside from selling the tea that was dumped into Boston Harbor. But the history of the Company, why is succeeded and why it failed, can help even an investor in the twenty-first century spot both opportunity and red flags in a company before or after investing.
A Powerful Trade Monopoly
One of the key reasons for the East India Company's success as a trading company, was its lack of competition from other English companies. While the Company literally fought other foreign trading companies, only the EIC was allowed to sell goods brought from India in Britain for much of its existence. Because of this privilege, the EIC was able to pay shareholders a healthy dividend while generally growing shareholder value over the decades between 1700 and 1750. The Company was a monopoly and was able to deliver on the promise of long term growth for shareholders.
In modern capitalism, unregulated monopolies are usually frowned upon. In fact, the Department of Justice is charged with reviewing merger deals to prevent such monopolies from forming. Under these circumstances, one can look for companies with a dominating market share instead. Companies like Google (NASDAQ: GOOG) control such a large share of the market that their names become known to everyone. Google has even become a verb added to the English language.
While always under the watch of regulators, Google still has the advantage that serious advertisers will want to deal with the best in the business. And in Internet advertising, Google is king. Marketing groups, advertisers, and PR firms all want to get their message across and Google gets them to pony up the cash. The company had a net income of $2.8 billion in its most recent quarter and is still expanding into other areas including social networking and smartphones. With its huge market presence, the future looks bright for Google, a company that can continue to use its cash reserves to grow and expand into new areas or even begin paying a dividend to its now wealthy shareholders.
Corrupt Compensation
The place of the East India Company in history is not just as a trading enterprise, but as a creator of a system of colonial administration. Through military conquest, the Company's army took over Bengal in 1757 and created a system of government administrated for corporate profit.
"Yet this was a corporate revolution, designed to acquire the riches of an entire people for the benefit of a single company" says Nick Robins, author of The Corporation that Changed the World. He goes on to say that "even [the Company's] own deputy-chairman Laurence Sulivan confessed that this was a situation 'monstrous in reason'" (Robins 80). Company officials used their power to take what they could for themselves. They were first, the Company was second.
Today, investors must watch for executives taking advantage of their companies for personal gain. While many firms pay their executives large salaries and bonuses to retain them, other policies implemented by these companies can be detrimental to shareholders.
A common practice inside large companies is giving executives stock option compensation to try to give them some skin in the game. But too often the options have a low strike price or are later adjusted to allow incompetent executives to profit nonetheless. One should realize that stock options cost the shareholder directly through share dilution and many executives simply turn around and sell the shares after exercising the options thereby increasing selling pressure on the stock. Making it worse, many companies burn cash to initiate share buybacks which are publicized as reducing the share count, but in reality often only balance out their firm's executive options.
I chose not to mention any particular companies in this section because executives taking advantage of their companies and stockholders is a problem among so many companies that it would be unfair to single any particular one out. Nothing is immune from executive exploitation, whether it's the financial institutions where executives made short-sighted decisions to temporally drive up their stock price, retailers who are burning cash to balance out buybacks while shutting stores at the same time, or penny stock companies where insiders dilute shareholders into oblivion and make money by pump and dumping the shares.
Crash and Burn
When most companies today fail, shareholders lose their investments and unfortunate employees lose their jobs. But as a colonial administrator, the East India Company's negligence and failure of management cost the lives of over a million.
According to Nick Robins, the famine was a problem for India for thousands of years. But the local rulers and nobles would assist the poor and, in turn, make famine less damaging. Harsh punishments were instituted, including that "if merchants were found to have short-changed peasants during famines, then an equivalent weight in human flesh would be taken from them in exchange" (Robins 91). But under East India Company rule, these laws no longer applied to Company officials. Prices skyrocketed as famine ensued, but officials were bidding up the price of food for their own gain. Nobles who normally would have ample supplies ran low on reserves and could not give nearly enough food to the poor. Accounts of peasants and urban workers crawling to die on the grounds of the East India Company reached London, and Londoners were appalled by the humanitarian crisis the EIC had caused.
But the EIC was sick as well. With the tea boycott in the Americas and a financial depression, the company was taking loans from its own officials. When the depression worsened, the Company could no longer obtain private financing and went to Parliament for a £1 million loan (keep in mind this was in 1772 money) and relief from the taxes they owed.
When companies neglect their business fundamentals and do not prepare for the possibility of a market downturn, disaster can strike them and their shareholders. Investors who owned AIG (NYSE: AIG) before the 2008 crash know this all too well. When the company moved from being a standard insurance company to insuring sub prime mortgages as one of their primary sources of income, the company fell apart and, much like the EIC, was forced to lobby its government for a bailout. The EIC used to make its money from trade, much the same way as AIG made money through standard insurance, but the EIC rapidly expanded into a colonial administrator and began to derive its revenues from the taxes collected in India. The EIC sucked the region dry as corrupt officials took over the trade for themselves. This mirrors the way AIG officials profited immensely during the good times while the company traded in sub-prime mortgage insurance and the company, and its shareholders, were left holding the bag when the scheme blew up. Not to say AIG was the only company with this problem. Many other firms fell apart after taking on dangerous trading practices and while the executives made money, the shareholders got burned.
A Centuries Old Lesson
There is one huge lesson that shareholders of modern public companies can take from this imperialistic trading corporation from 240 years ago: Always know what is happening inside your companies. As the fundamentals were decaying away at the East India Company, share prices still offered investors an opportunity to sell. Savvy investors could have seen what was happening and got out before the crash. Shareholders who know executives are exploiting their company for personal gain should voice their opinions or sell their shares before the system comes crashing down. But don't be afraid of something new. The Company made significant returns for its investors while it was a trading company because it filled a niche in Britain. So make good investments and continue to watch them. Not for quick trading purposes, but to make sure your investment is still what you meant to invest in. If it's not, reevaluate, is the new style of business what you want? If you don't like it, sell your shares. There are likely plenty of other buyers looking for the shares who may or may not fully understand what they are buying. But as a diligent investor, you have an advantage: You do know.
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