SRI Notes

The Owner vs. The Boss

Who controls the corporation?  Most economists and investors would say "the shareholders."  Even proponents of stakeholder theory agree that shareholders should have a significant say in how a firm conducts itself.  In 2005 Jean-Paul Page wrote an excellent little book entitled Corporate Governance and Value Creation for the CFA Research Institute.  It's a think piece on the role of corporations in society, written from first principles ("corporate governance begins with power") and a deep awareness of the contending schools of thought in the field.  After much deliberation Page concludes that this should be the first commandment of corporate governance: 

The ultimate power in a company must rest with its shareholders.

It's not hard to come up with an illustration for why this must be so:

Let's say you own an apartment building, and have hired a management company to run it.  You're planning to sell the building in a year or so, so you decide to only do cosmetic maintenance.  You authorize minimal repairs, but instruct the manager to put off major issues, if possible, for the next owner to deal with.  Seeing this, the management company decides to hold back a portion of the rent payments you receive and 1) gives itself a raise and 2) begins managing the property as if they, not you, were the owner.

What would you do in this situation? 

It is not an academic or hypothetical example.  It is an almost exact description of what is happening in corporate America today.  Enthused by the prospects of a sale (to private equity, perhaps), and pressured by performance-driven compensation structures, shareholders are becoming more short term-oriented than ever.  As discussed many times here, time horizons have shortened to microscopic levels - the average turnover on the New York Stock Exchange is 100%, suggesting the average investor is looking out about one-year.  Since many shares never trade (think of all that low cost-basis stock in bank trust accounts), the de facto time horizon for a given trade is even shorter than that.  People don't own stocks anymore, they rent them.

And the managers hired to run the business are increasingly treating the owners like tenants.  Let me rephrase the story I just told you:

Let's say you manage an apartment building for an absentee landlord.  Inattentive, fickle, and unsophisticated, this person is trying to sell the building for a quick profit.  You've been authorized to do only cosmetic maintenance - putting off major issues for the next owner to deal with.  After thinking it over, you decide to hold back a portion of the rent payments you receive and 1) give yourself a raise (you need to get more money up front - who knows what the next owner will think of you?) and 2) begin managing the property from a longer-term perspective (the owner may not care if the building falls down the day after the sale, but you do).

In the latest Business Week, Clayton Christensen and Scott Anthony present the clearest defense I have seen of management's perspective ("Put Investors in Their Place").  "Why," they ask, should management "pander to people who now hold shares, on average, less than 10 months?  Should managers really regard such investors, whose investment horizons are shorter than the most nearsighted of managers, as stakeholders whose value they ought to maximize?"

Well, game on.  The battle for control of the corporation is now clearly out in the open.  Large pools of equity capital, sophisticated investment banks, and leading management consultants are offering alternatives to the longstanding model of public ownership of U.S. corporations.  If that model cannot be fixed, and soon, society will face a significant loss of corporate transparency and accountability, as companies are taken private.  Christensen and Anthony point out that companies in Asia, such as Tata (India) and Li & Fung (Hong Kong) are doing exceptionally well without the help of day traders and corporate governance activists. 

Christensen and Anthony argue that this will come with social benefits.  Their script for managers reads:  "Our responsibility is to maximize the long-term value of this company.  We will therefore act in the interest of those whose interests coincide with our long-term prospects, namely employees, customers, the communities in which our employees live, and the minority of investors who plan to hold our securities for several years."

It is a noble goal.  But the choice is not a simple one.  Should social investors be prepared to sign away Page's "ultimate power" to get the social benefits (which, after all, are just a promise)?  Or is it time to start looking for a new management company?

Private Equity and SRI

Michael Lewis has a dark article today ("Coach Class of Capitalism") about how the growth of private equity is affecting the structure of the investment world.  There are two kinds of investors today, he says - regular people, who get mutual funds that have average return prospects, and the very rich, who get private equity with outstanding return prospects.  His commentary comes as private equity funds continue to set records for both fund size and deal size.

Social investors shouldn't be thrilled with the rise of private equity, simply because these investments move the corporate world toward less disclosure and less transparency.  Social research depends heavily on required corporate disclosures, such as 10-K and 10-Q reports - these go away when companies go private.  Shareholder activism depends on the shareholder resolution process in place at public companies - there is no comparable forum for engagement with private firms.

From the private equity investor's perspective, that's all good.  One of the key benefits of doing an LBO is strategic flexibility.  In theory, at least, management can escape the constraints of public ownership and simply do what needs to be done to maximize the value of the business.  (In practice the short-term accountability often just transfers from stock investors to bond investors, as the company piles on leverage to finance the deal.)

Lewis sees all of this as just another way for the rich to circumvent rules, but I think it's a little more complex than that.  This surge in private equity would not be possible without attractively-priced stocks.  There can't be a big LBO industry unless a lot of stocks are too cheap.

So who is selling?  Well, mutual funds managers and institutions, mostly.  The typical private equity deal takes years to work out - the returns will be there, on average, but you have to live with illiquidity and 'dead money' for awhile.  By contrast, the typical money manager is measured quarterly and operates on a horizon of perhaps a year (as discussed here many times). 

In a world where 5-star funds attract most of the investment flows, few mutual fund managers feel they can afford the luxury of long-term investments.  So they sell 'dead money' investments to private equity investors, who resuscitate them and, after a decent interval, sell them back.

This seems to be another manifestation of the disease described by Hawley and Williams in The Rise of Fiduciary Capitalism.  Individual investors have hired intermediaries (mutual fund managers and pension funds) to manage their wealth, and the evaluation/compensation cycle for these intermediaries turns out to be far shorter than that of the investors themselves.  All this would imply that speculators could arbitrage time horizons, buying long-term investments at good prices.  And that seems to be exactly what's happening.

Certainly a long-term orientation is no guarantee of success.  It is a kind of a curse among my hedge fund friends - for them an investment is a trade that didn't work out.  At dinner the other night one denounced a stock idea I presented on the grounds that "it hasn't worked all year."

And bad investors learn quickly to point to the long term.  If you're a bad investor you want to be sure to convince your client of the merits of a long-term outlook because the sooner she evaluates you, the sooner you'll be fired. 

Still, if you look at who's been successful in markets over the decades, my impression is that the long-term types have gotten a disproportionate share of the spoils:

• David Swensen at Yale posted a terrific track record over the past decade, partly by collecting liquidity premiums on 'alternative' investments such as timber and private equity.
• Warren Buffett has become the world's 2nd-richest man while maintaining a core equity strategy that has extremely low turnover.  In his 1987 Chairman's Letter, he wrote:  "Of Wall Street maxims the most foolish may be "You can't go broke taking a profit...  We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business."  Buffett is widely-read and many people say this, but it is completely incompatible with the kind of trading most managers actually do.
• The Dodge & Cox Stock Fund has managed to build a 5-star track record with 11% annual turnover. 
• Even index funds based on the S&P 500 have performed quite well, despite portfolio turnover of less than 10% per year.  Historically, the majority of mutual fund managers have not been able to keep up with this index, despite all their trading.

So the fault is not in our stars, but ourselves.  When yours or my mutual fund gets behind, we tend to go hunting for one that's working better.  The fund managers know they need good numbers to raise money, so they do something - anything - to get back on track quickly.  Since about half of them are screwing up at any given time, there's a crowd at the exit and a lot of competition for hot new ideas.  The net result is too much trading, too much renting of stocks, and not enough ownership. 

I'm not thrilled about the rise private equity, but I think it's a symptom of a much deeper illness.  If we were doing a better job of being owners, there'd be no need for private equity to step in and do the job for us.

By the way, friends tell me Lewis's latest book, The Blind Side, is an excellent read.

Conference on Long-Term Investing

Cynthia Williams of the University of Illinois College of Law has organized what looks like an excellent conference this week on the impact of short-term pressures on capital markets and corporate governance, with many heavyweight presenters.  Full info on the conference is here.

I am re-posting their background reading links here:

• The New York Sun: "Is It   Time To Ban Earnings Guidance?"
• The McKinsey Quarterly: "How to Escape the Short-Term Trap"
• Financial Times: "Activism is good for all shareholders"
• Michael Jensen: "Agency Costs of Overvalued Equity"

Thanks to Michael Kane for the heads-up.

Something to Think About

Reuters reports that, in a speech at Columbia Tuesday night, Former ExxonMobil CEO Lee Raymond said:

"People don't understand the time frame that we operate in. We operate in terms of 10-, 20-, 30-, 40-year cycles and to put that in context, that's 20 (U.S.) Congresses. A single quarter or a single year, which may mean everything from a political circus point of view, is not really all that significant in the time frame that we operate in."

Social investors, and anyone interested in the interaction of governments, markets, and society, should think hard about that statement.

Short-Termism Makes Strange Bedfellows

U.S. Chamber of Commerce President Tom Donohue will speak November 30th at the Wall Street Analyst Forum in New York (details here).  According to an e-mail I received today, "Tom will challenge analysts, investors, and senior management to end the era of quarterly earnings guidance and the damaging short term outlook they encourage and instead move toward a system that more accurately values businesses and encourages long-term growth plans..."

I point this out because short-termism is one of the recurring themes of this blog (it recurs here, here, and here...), and also because Donohue is no friend of social investors and governance activists (last year he criticized CalPERS for its activism and was on the receiving end of criticism as well).

That Donohue and social investors see the same problem strongly suggests to me that it really is a problem.

The Best of All Possible Worlds?

I've written before about the short time horizons prevalent today.  Now there is a study suggesting that the best traders are likely to be, well, psychopaths.

This brings many thoughts to mind.  It certainly is consistent with the increased use of computers in finance, especially for shorter-term trading.  We've seen a parallel in chess, where computers can now beat the best grandmasters (although a computer plus a human is stronger than either alone).

But I cannot shake the feeling that we are getting it wrong.  Capital allocation is one of the most important tasks in our society.  I find it hard to believe that a group of psychopaths operating on a short time horizon are going to do it in the best possible way.

More on Time Horizons

Social investors are not the only ones concerned about Wall Street's increasingly short-term outlook.  Alfred Rappaport of Northwestern's Kellogg School of Management has written an interesting article on short-termism.

Rappaport is one of the foremost teachers of discounted cash flow analysis (he wrote the book), but finds in his review of the literature that its use is limited.  Instead, investors seem to prefer earnings-based indicators, like P/E and earnings surprise.  He believes the "root cause of recent corporate scandals [is] the widespread obsession with short-term performance.  There is no greater impediment to good corporate governance and long-term value creation than earning obsession."

It is a remarkable state of affairs when economists like Cameron Hepburn argue that DCF analysis is too short term-oriented, at the same time the chief proponent of DCF says it is under-used because it is not short-term enough!

What everyone seems to agree on is that Wall Street's concern is with the next 20 minutes.  If you're looking for someone to worry about the next 20 years, you've come to the wrong place.

Today I read a similar sentiment from a very different source.  Terrence Deal and Allan Kennedy wrote the influential Corporate Cultures in the early 80's, and updated their work with The New Corporate Cultures, which came out in 2000.  The latter book ends with this comment:

"We are optimistic enough to think that we may be nearing the end of a cycle emphasizing the short term over the long term and shareholders over all other valid claimants for their share of the corporate pie.  As this troublesome cycle abates, management decisions will show more balance, shaking off some of the recent excesses."

Discounting the Future

One longstanding concern of mine has been that Wall Street and most investors focus on the short-term, while social and environmental issues typically play out over long (sometimes multigenerational) time horizons. It's hard to believe that analytical techniques that are designed for short-term trading will be equally optimal for long-term decision-making.

It turns out that there is a growing academic debate around this question, particularly over the use of discount rates. The process of discounting has been cricized by some as understating the value of future environmental cleanups and other socially beneficial activities. Martin Weitzman, a professor of Economics at Harvard, has said "to think about the distant future in terms of standard discounting is to have an uneasy intuitive feeling that something is wrong somewhere."

This documentary on the BBC's Radio 4 does a nice job outlining the issues.  Pay particular attention to the comments of economist Cameron Hepburn.  I'm not usually a fan of theoretical economics, but this stuff is really good - Hepburn co-authored a very interesting paper on this that is worth looking at.