Tuesday, 20 March 2007

Long and short

There's been a sprinkling of comment pieces appearing about short/long-termism in the investment markets. Some of it was in response to Al Gore's speech at the NAPF last week which, appropriately enough, drew heavily on recycled material (is anyone not aware that the average length of time shares are held has gone down?). For example there was this piece (scroll down a bit) in the Telegraph which is a pretty superficial take on the issues at hand.

More interesting is this piece by Tony Jackson in the FT yesterday (you'll need a sub I think). Here's a chunky excerpt:

The most obvious weakness is the so-called agency problem, whereby managers have a different set of incentives from the owners. One response to that was the rise of value-based management in the 1990s. Executive rewards should depend on results as measured by the shareholders. Of course, it did not work. Rewards went up a lot faster than the stock indices. And when stock options lost their value in the bear market, they were often repriced. Executives still marched to a different drum and they still called the shots.

Other basic drawbacks have more to do with behaviour than rewards. For instance, boards can work badly because of clashes of personality or ambition. The non-executive chairman – if there is one – may not be able to handle this.

The obvious people to sort it out are the owners. That is fine if this is a small group of insiders, as in private equity. But in public companies they are a leaderless army.

Behavioural theory also suggests that executives cannot always analyse the mass of data in front of them. They respond by going for a safe solution.

This may partly account for the way most public companies today are reluctant to leverage their balance sheets as much as shareholders want. It may also explain their reluctance to go for radical strategies unless pushed by an aggressive shareholder.

Take Cadbury Schweppes of the UK, which last week abruptly agreed to demerge, having publicly dismissed the notion less than a month before. This was a virtually instant response to the appearance of the US activist Nelson Peltz on the share register.

At this point, companies will point the finger of blame at shareholders. The market, they say, is obsessed with quarterly earnings.

If an otherwise sensible long-term strategy would hit those earnings, forget it. But shareholders also press for big moves such as mergers and demergers. Where is the consistency?

Even if true, that is not strictly relevant. What matters is not who is to blame, but whether the system works as a whole.

If it induces irrational behaviour in both owners and managers, so much the worse.

This reminded me of a fantastic essay Alfred Rappaport wrote about investors' fixation with short-term earnings. This article is buzzing with ideas, which I'll try and summarise in another post at a later date. One key insight that I drew from it was the idea that stockmarkets can be 'efficient' (or not) in more than one sense. Markets might exhibit ‘informational’ efficiency, with all known information factored into share prices, in turn meaning investors are unable to outperform the market over a prolonged period. But the market may also demonstrate ‘allocative’ inefficiency because decisions regarding capital allocation are not being made on the basis of sound valuations.

Think of this in terms of the tech stock bubble of the late 90s early noughties. Share prices were informationally efficient - because they reflected all available public information and market views - but were allocativley inefficient because the valuations were way out of line with the reality of the underlying businesses.

PS. I posted a few days back about the loyalty dividend proposed by Dutch business DSM including the possibility that they might get sued. Well it looks like that might just happen according to Reuters.

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