In these articles, Barton and Wiseman outline their view that the short-term approaches to managing and investing in companies, approaches which were responsible for the financial crisis, still exist.
Public trust in business and the capitalist system is at a low, driven by rising income inequality, high unemployment, and growing budget deficits, while governments feel increasingly compelled to intervene in the business environment. Major investors could help to restore faith in capitalism and promote a longer-term approach that would benefit both business and society.
Barton describes three key changes that are needed to shift from “quarterly capitalism” to “long-term capitalism”: a shift from short-term to long-term focus in business and investment, a broader focus on the interests of all corporate stakeholders, not only shareholders, and improving the effectiveness of corporate boards. Barton and Wiseman also outline four practical changes that institutional investors can make to their investment approach to support these systemic changes.
Refocus corporations on long-term issues
Business executives need to focus on the long-term issues to achieve long-term success, yet there is disproportionate pressure on company management to focus on the shortterm. Average Western CEO tenure has dropped from 10 to six years since 1995 despite the complexity and size of companies growing, and the average holding period for U.S. equities was about seven years in the 1970s; today it is “more like seven months”.
Such short term outlooks have consequences. Executives focus their efforts on short-term targets despite the majority of equity value derived by analysts being based on assumptions of longer-term cash flows. Asset owners, the pension funds, insurance companies, mutual funds, and sovereign wealth funds who hold roughly 35% of the world’s financial assets, should have an interest in long-term value creation for their beneficiaries. However, their approach to hiring and assessing fund managers exacerbates the short-term focus through short-term contracts and performance targets. Stewardship advocates suggest big funds should set targets for the number of holdings and rates of turnover as well as performance based targets in their mandates, promoting a longer-term approach and improving asset owners’ ability to be more involved business owners.
Serve the interests of all stakeholders, not only shareholders
Serving the interests of all stakeholders – employees, suppliers, customers, creditors, communities, the environment – is critical to maximising both long-term corporate and shareholder value. A McKinsey study in 2010 found that a majority of business executives and investors believe that environmental, social, and governance (ESG) initiatives create corporate value in the long-term, but most executives do not act on this belief out of fear that the financial markets will penalise their efforts. The outcome is that businesses are losing public trust, particularly in Western countries. The importance of this trend should not be ignored, as capitalism depends on public trust for its legitimacy and therefore its survival.
Improve boards’ ability to govern like owners
Studies based on family-owned companies suggest that the most effective ownership structure tends to combine some exposure to public markets (for the discipline it engenders and capital access) with a committed, long-term major shareholder. Most large public companies have extremely fragmented ownership, and boards that are unwilling or unable to perform the single-owner-proxy role. As a result, CEOs are influenced by the stakeholders who make the most noise, not those with the long-term interests of the company at heart.
An “ownership-based” approach to corporate governance requires three things: more effective boards, more sensible CEO remuneration, and a new vision of shareholder democracy.
1. More-effective boards
Non-executive board directors of public companies often spend as little as 12 days a year working with the company, while as many as 80% of non-executive directors lack industry-specific experience. To be effective, boards need to spend more time with the company and have relevant experience and knowledge to help them identify opportunities and reduce risks. In addition, boards need more-effective committee structures and resources to allow them to form independent views on strategy, risk, and performance. In essence, effective non-executive boards must be more professional and have a more meaningful strategic partnership with top management than they currently do.
2. More-sensible CEO pay
There is often a disconnect between CEO pay and performance, contributing to the decline in public esteem for business. In the past stock options were thought to incentivise CEOs to act like owners but in practice short-dated options lead to a focus on meeting quarterly earnings estimates. On the other hand, even longer dated options (vesting after three years or more) can reward managers for simply riding industry- or economy-wide trends. In addition, few compensation schemes carry consequences for failure. Three key changes are needed:
- link compensation to the drivers of long-term value such as innovation and efficiency, not only to long term share price;
- extend the time frame for executive performance evaluations, e.g. rolling three-yearly;
- create downside risk for executives e.g. by requiring significant personal investment in the company through personal share ownership.
3. Redefined shareholder “democracy”
The increase in equity turnover in recent years has resulted in a situation whereby at any given annual meeting, a large proportion of voters may soon no longer be shareholders. It may be time for the “one share, one vote” principle of governance to give way to new rules that give greater weight to long-term owners, such as the rule in some French companies that gives two votes to shares held longer than a year, or to assign voting rights based on the average turnover of an investor’s portfolio.
Practical approaches for asset owners
Many large owners have the scale and resources to influence the leaders of the businesses they invest in, but often they do not act like business owners. Instead, they delegate responsibility to consultants and allow investors with shorter time horizons to set equity prices in the public market. Barton and Wiseman suggest four steps that asset owners can take to promote a long-term approach to capitalism that benefits both business and society.
1. Define long-term objectives and risk tolerance
Asset owners should have a strategic plan defining their investment horizon, and acceptable downside risk and variation from benchmarks during this time period. The portfolio should be invested according to these criteria (which, in practice, is likely to mean greater allocations to illiquid asset classes such as infrastructure), and short-term underperformance tolerated if the long-term investment outlook remains good. Fund manager compensation structures should also be reviewed to reward long term performance, such as lower base fees, longer commitment periods and deferred performance-based fees.
2. Active ownership of companies and markets
Engaging with company management on their long-term strategy can unlock greater value than simply selling an under-performing stock. Some evidence suggests that active ownership is more effective when done privately, though when public pressure is required to effect change large asset owners can play a leading role. Such asset owners should also participate in regulating and managing the financial markets, promoting financial reform in the best interests of their beneficiaries.
3. Focus on long-term economic not short-term accounting value
Asset owners should encourage companies to share measures that truly reflect their long-term economic value, such as 10-year economic value added, and multiyear return of capital investments, and insist that their portfolio managers and analysts actually use this data to facilitate investment decision-making rather than focussing on standard accounting metrics and quarterly guidance.
4. Internal governance structures supporting long-term approach
Asset owners must lead by example and align their own structure with a long-term approach, including experienced and effective boards, and internal policies that reduce shortterm pressure and promote long-term interests.
RI Quarterly Vol. 3: Long-termism in financial markets
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