Thursday, 8 August 2013

Bundled choices, exit, voice etc

When an investor buys and holds a share they are making a kind of bundled choice - all things considered, this company's shares are worth owning. This decision may encompass a whole range of factors - expectations of future performance, views on quality of management, concerns about governance, social and environmental management, even psychological biases! But it is, in essence, a kind of bundled choice. On the face of it buying or holding the shares represents 'support' for the company, but this position is an aggregate one.

Historically asset managers have used the bundled choice nature of holding a company's shares as a reason for not challenging investee companies. This can take two forms. One the one hand asset managers have sometimes sought to downplay the significance of issues beyond financial returns - if we really didn't like the company's management, or they were that bad, we wouldn't hold the shares etc. Ergo our decision to hold shares means that we have decided other issues are relegated. On the other hand they have sometimes used the argument that you can't really unbundle the choice, much as you might like to - eg. we agree that the company's governance is  poor, but if we challenge them this could make the situation worse (see, for example, reluctance to challenge James Murdoch's continued presence on the BSkyB board).

Companies have exploited this too, for example seeking to portray challenges to board structure as a referendum on the leadership of the company (see JP Morgan recently), and making the point that if you don't like how they generate their returns then alternatives are available (see Rupert Murdoch ahead of last year's News Corp AGM).

And one might also make the case that calls by campaign groups for disinvestment from certain stocks are built on the idea of a bundled choice - if you don't like what the company is doing, you shouldn't be holding its shares. (I have some sympathy with this view in a limited number of cases.)  

If the last 20 odd years of corporate governance activism by shareholders have been about anything, it is legitimizing 'voice' as an alternative to 'exit'. With such a mindset we can take the approach that we might like the company in general, and rate its prospects, but we think that it could still, say, improve its governance. So we'll continue to hold your shares, but seek to encourage you to make changes too. This represents, in my opinion, an attempt to unbundle some of the decisions that are made in relation to equity investing. Trying to remove a poor director, or opposing a pay proposal, can be combined with continuing to rate the company, and a wish to remain invested.

Even taking an optimistic view of things, I can only describe this as having been marginally successful so far. In fact, if anything, I see signs of a counter-revolution. For example, 'integration' in the responsible investment community is, it seems to me, something of a sacred cow. This perspective argues that any concerns about "ESG" issues should be tied into the investment process as much as possible and, ultimately, inform investment decisions. The logic of this is that market signals (ie buy/sell decisions) are event more powerful than the exercise of ownership rights.

But, if you follow this through, this could take us back to the situation we were in about 20 years ago. Imagine you really can quantify the financial materiality of, say, respect for freedom of association and it isn't really material. Presumably then no investment decision would be affected by it as an issue, and no market signal would be sent. Essentially the message to companies would be: freedom of association will never be important enough an issue for us to sell your stock. Alternatively, you might discover that something more mainstream, like board independence in small caps, is very material. But then if this is integrated into your investment decision this points to selling out (or never buying in). I know in reality those who advocate integration would now doubt try to exercise voice as well, but I think the fact that integration could emphasize "exit" over "voice" goes curiously unremarked.

In the same territory, the argument that asset owners should leave 'ownership' issues up to asset managers seems to be resurgent. In a sense this, too, is a logical follow on from the perspective adopted by advocates of 'integration' . If you pick an asset manager to select stocks for you, why would you take responsibility for voting and engagement away from them? These should be tied up with the investment decision, if we really believe in integration, so leave responsibility with those picking the stocks. It is again in essence an argument for bundled choices, after a long period in which the emphasis has been on trying to allow asset owners to have both access to the financial returns from a given investee company and be able to influence it over ESG issues, even if the intermediary didn't agree.  

Put these things together and you can see a scenario in which responsibility for oversight of ESG issues at PLCs falls largely to specialist staff within asset managers. These are organisations that live or die by their ability to marginally outperform each other over relatively short periods of time. So it's quite possible that issues which we might consider important, but which are not financially material, end up rarely, if ever, getting raised in the company-shareholder dialogue, certainly at a senior level. You can hear in the discussions around the Stewardship Code, for example, the intention to emphasize that this is not about responsible investment. Once the CIO level people are involved this is too "soft", and instead the focus is solidly on financial returns (linked, of course, to issues like strategy etc).

Needless to say, there are big issue at stake here. In the UK economy PLCs are a very important element. Publicly-traded companies dominate fields like transport, finance and so on. Under our corporate governance model, formal accountability is to shareholders and no-one else. In practice clearly relationships with the state, regulators, customers, suppliers etc are also very important, but only shareholders are afforded control rights. Yet the ideas that are articulated in this area continue to emphasize the right, even desirability, of 'owners' backing out when they see things they really don't like, or choosing to overlook things that they might think are wrong but don't hurt returns.

Expressed in those terms it doesn't look like a great model, does it? And this might explain the desire of some to explicitly move away from it.

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