It’s been four years since the Sarbanes-Oxley Act (SOX) went into effect. Enacted partly in response to the Enron and WorldCom debacles, SOX is universally seen as the most sweeping legislation to affect public accounting since the 1933-34 securities acts. While its reach is enormous, the impact of this sweeping reform is having some surprising effects, both direct and indirect, on the stock market.

There was ample evidence that before SOX was passed, companies with better governance structures enjoyed higher stock returns. A study performed by Paul Gompers and others at Harvard Business School (see the February 2003 Quarterly Journal of Economics) showed that in the 1990s, firms that scored in the highest decile of shareholder rights earned abnormal returns of 8.5% per year, enjoyed higher profits and sales growth, and made fewer corporate acquisitions.

After SOX, the tables seem to have turned. Faced with this pending legislation, investors actually bid up the stock prices of firms with weaker shareholder rights, as reported by Melissa Frye and Minhua Yang in the January 2006 issue of the Quarterly Review of Economics and Finance, seemingly expecting the new legislation would force management to clean up their act.

A less direct but equally effective way that SOX raised stock prices was by forcing many smaller firms to go private. Faced with mounting costs for following the new laws, a significant number of firms decided de-listing was a more cost-effective solution. This reduction in the supply of publicly traded stocks naturally resulted in upward pressures in valuation.

Although some may scoff at SOX by pointing to the onerous costs to comply, it has been estimated that the Fortune 1000 have only spent a combined $2.5 billion per year to meet the terms of the new law. This isn’t chump change, of course, but compared to the $70 billion lost to Enron shareholders alone, it’s strikes me as a pretty good deal. Although it didn’t prevent the current backdated options scandal, SOX is beneficial to shareholders and represents an effective deterrent to corporate malfeasance.

The Monthly Index Report for September 2006

Index

Aug-06

QTD

YTD

Description
S&P 500 Index*

2.13%

2.65%

4.45%

Large-cap stocks
DJIA*

1.75%

2.08%

6.19%

Large-cap stocks
Nasdaq Comp.*

4.41%

0.54%

-0.98%

Large-cap tech stocks
Russell 1000 Growth

3.06%

1.10%

0.15%

Large-cap growth stocks
Russell 1000 Value

1.71%

4.18%

11.01%

Large-cap value stocks
Russell 2000 Growth

2.99%

-2.36%

3.57%

Small-cap growth stocks
Russell 2000 Value

2.94%

1.51%

12.10%

Small-cap value stocks
EAFE

2.78%

3.81%

14.71%

Europe, Australasia & Far East Index
Lehman Aggregate

1.53%

2.90%

2.16%

U.S. Government Bonds
Lehman High Yield

1.62%

2.62%

5.84%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

-0.08%

-2.26%

-0.15%

Managed Futures
3-month Treasury Bill

4.40%

All returns are estimates as of August 31, 2006. *Return numbers do not include dividends. ** Returns are estimates as of August 30, 2006.

Searching for Alpha

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.