Friday, July 19, 2013

John Kay on Equity Markets: Exit, Voice, and Short-termism

A year ago, John Kay produced what can only be described as a rather long report focused on, among other things, the reduction in long-term oriented behavior among UK equity market participants and corporate decision-makers.

Kay's work more than implies that the fault lies both with shareholders and company decision-makers alike. Naturally, the behavior of owners (and, too often, what amounts to "renters" of stock) influence how the board and senior management behaves and vice versa.

The Kay Review of UK Equity Markets and Long-Term Decision Making

Increasingly, business executives, for a variety of reasons, too often end up focused on shorter term outcomes and quick fixes.

From the report:

"Short-termism, or myopic behaviour, is the natural human tendency to make decisions in search of immediate gratification at the expense of future returns..."

Longer tenure among competent senior executives and the right kind of compensation systems would certainly help. The CEO with a short tenure and lots of pressure to perform quarter-to-quarter is less likely think and act longer term. Few would seem likely to focus on long-term effects if the prevailing pay systems, in combination with shorter in duration tenure, frequently reward the next person who gets the job.

A system that tends to reward the next CEO for the long-term decision-making of the current CEO is a system destined to fail.

As far as short-termism goes it's not just executives, of course.

Corporate boards, regulators, and market participants all play a role.

John Kay makes it rather clear nothing short of a major cultural shift is required. That's unlikely to happen quickly under the best of circumstances.

Market participants have shorter time horizons by almost any standard these days; and it is not just the high frequency trading types.

It's an increased number fund managers and other participants who increasingly emphasize shorter term price action and outcomes in markets (w/holding periods maybe not measured in seconds or less but still hardly investing with long-term effects mostly in mind).

Also, the layers of middle men -- investment consultants and financial advisors among others -- not only tend to add frictional costs, but also increasingly create a buffer between those who've invested the capital at some risk and the companies they partially own.

This reduces shareholder engagement.

"Short-termism can also manifest itself in hyperactivity."

Well, as the report points out, individuals that are hyperactive generally "fail to give sustained attention to tasks" but what does this hyperactivity mean for the corporate sector?

"In the corporate sector, hyperactivity can be seen in frequent internal reorganisation, corporate strategies designed around extensive mergers and acquisitions, and financial re-engineering which may preoccupy senior management but have little relevance to the capabilities of the underlying business."

The civilized world has for a very long time attempted "to construct devices and institutions to combat our instinctive short-termism. The central question for this Review is whether capital markets in Britain today dissuade or stimulate the search for instant gratification in the corporate sector."

 In fact, as Kay notes, attempts to combat this instinct can even be found in the epic story of Ulysses.

"The outcome, not the process, is what matters, and that perspective has been central to this Review. From the outset, we have emphasised that the goals of equity markets are to operate and sustain high performing companies and to earn good returns..."

It's important to note that the report is focused on the more established relatively large public companies that are traded in London (see bottom of page 15). Of course, smaller, less mature, and not quite as established businesses will require very different things from the capital markets. Many will need efficient access to capital to build their businesses and generally have had more difficulty accessing funding since the financial crisis. Yet, much like the more established businesses, they'd still benefit from a reduced culture of short-termism.

Larger and smaller businesses have that in common even if their needs are otherwise rather different.

Business investment has declined in the past decade in the UK, but it's not because the larger companies are lacking funds.

"Quoted companies, both taken as a whole and in most individual cases, generate more cash from operations than they use for investment. They are not short of cash; they are awash with it. The value of the cash holdings of British business today is larger than the value of its plant and machinery."

And it's not necessarily just about encouraging more shareholder engagement...

"Shareholder engagement is neither good nor bad in itself: it is the character and quality of that engagement that matters."

Exit and Voice
The report also refers to "economist Albert Hirschman's famous distinction between the courses of action available to buyers when the quality of a relationship is inadequate: 'voice' – attempting to improve outcomes within the context of the market relationship; and 'exit' – withdrawal from the market relationship*. These alternatives apply just as much to a shareholder concerned with corporate governance or company performance as to a customer dissatisfied with the produce at the local supermarket. The unhappy shopper can complain to the management, or go elsewhere. And so can the contemporary shareholder."

The problem is that structure and regulation have the emphasis wrong.

"...the structure and regulation of equity markets today overwhelmingly emphasise exit over voice and this has often led to shareholder engagement of superficial character and low quality. We believe equity markets will function more effectively if there are more trust relationships which are based on voice and fewer trading relationships emphasising exit.

The focus of the report is on the UK equity markets but the problems, as well as potential solutions, seem likely to be more similar than different for the United States.

Kay rightly criticizes the hyperactive behavior of senior management and market participants who pursue "immediate gratification". Well, behavior that is longer term oriented is more likely to follow if the right incentives are put in place and enough conflicts of interest can be eliminated.

Considering this apparent attention deficit for anything but what can deliver the quickest rewards, it seems unlikely that this not at all short report will even reach enough of its target audience in the first place (never mind get the focused attention it deserves).

This report -- and the subject more generally -- certainly requires that the reader not have such a deficit.

So, in contrast to short-termism, no quick payback or reward will be found in reading Kay's report. It's certainly a worthwhile read for those who'd like to see long run systemic improvements; it's a worthwhile read for those less conflicted (or, at least those who can mostly set conflicts of interest aside for the bigger picture), less susceptible to short-termism, and willing to invest some time to seriously consider what really needs to be changed.
(Though, of course, it's not as if Kay's work could possibly provide all the answers.)

Changes that might make equity markets better serve their purpose for existing in the first place. In reality, nothing appears likely to be fixed anytime soon. The conflicts of interest, wrong incentives, and embedded industry cultural forces are just too powerful.

It's still worth better understanding how the status quo might be failing us.


Related post:
Buffett & Bogle: Overcoming Short-termism

* Hirschman, A. (1970), Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States, Harvard University Press
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