Proper rewards for loyalty
“To value stocks, markets primarily focus on the long term and not short term economic fundamentals. Although some managers may believe that missing short term earnings per share (EPS) targets always has devastating share price implications, the evidence shows that share price depends on long term returns, not short term EPS performance itself.” Koller, Goedhart and Wessels, “Valuation: Measuring and Managing the Value of Companies”.
Readers of this magazine will be familiar with the view that the long term rate of return is the single most important factor by which to judge the success of a pension plan. The key driver of investment decision making, therefore, should not be immediate investment returns, but long term viability and profitability. It can be argued that many funds can afford to be fairly tolerant of the short term volatility exhibited by assets which, over a longer period, offer the greatest likelihood of return.
However, despite a significant volume of evidence which supports this approach, management and investment performance still tends to be measured on a very short term time scale (typically quarterly), which arguably may deter managers from focusing on longer term value. While the financial crisis has prompted a shift in CEO incentives towards more long term performance, by putting in place longer vesting periods and instituting claw-back provisions, shareholders’ short-termist orientation tends to remain unchanged. The average holding period for a share is now seven months, down from several years in the 1990s, with high frequency trading accounting for 70% of US turnover.
Over the past few years, a number of companies have attempted to motivate investors to hold on to their shares for longer by issuing so-called “loyalty shares”. These are shares that pay out more to investors that have owned them continuously for a minimum period, typically two years. According to Professor Patrick Bolton at Columbia Business School, “the idea is to reverse what has been a secular trend since World War II of shorter and shorter holding periods and much more churning going on in the markets”. This would allow company management some breathing space to focus more on long term strategy and sustainable value creation.
Bolton proposed the creation of “L-shares” that offer a special call warrant (the right to buy a set number of new shares at a set price), but the concept could be implemented in other ways. In May of this year, French cosmetics company L’Oréal began paying an extraordinary 10% “loyalty” bonus dividend to shareholders who have held the stock for at least two years. L’Oréal reports that several thousand shareholders have registered their shares to take advantage of the new programme.
Corporate loyalty shares have tended to be a European phenomenon, with other big issuers including tire maker Michelin, which was one of the first issuers in 1991. Michelin’s CEO explained the move, which followed a dividend cut, as allowing “long term oriented shareholders, who hold on to their shares during the difficult but critical time the company is facing” to be rewarded. Air Liquide offered both a dividend and share bonus to shareholders who kept their shares for at least two years, and several demutualised UK life insurance companies and building societies have also granted loyalty bonuses.
In Asia, loyalty shares have been linked to government privatisations. In Singapore, for example, CPF members were able to buy discounted Singapore Telecom shares in 1993 and 1996, which entitled them to loyalty shares on the first, second, fourth and sixth anniversaries of the share offers. Similarly, in Hong Kong, investors in the government’s Tracker Fund in 1999 were offered extra units for free if they held their original shares for a year or more.
Problems with implementation
While the idea that longer term shareholding makes better capital budgeting and investment decisions possible, the concept of creating loyalty shares to achieve this may present problems. Rewarding longer ownership would require new legislation, particularly to apply it to existing firms, and companies would need to adapt their share registers to indicate how long shareholders have held stock.
Some investors, especially in the US, are actively hostile to the concept, arguing that it would mean that shareholders would not be treated equally. For example, in 2007, after Dutch chemicals company Royal DSM announced plans to offer loyalty shares, American asset manager Franklin Templeton Investments sued on the grounds of discrimination against shareholders.
Incentivising fund managers
It could be argued, indeed, that such schemes distort the market and that it is not the role of companies to provide enticements to fund managers not to sell their stock. Another way to encourage a longer term approach could be to examine the financial incentives given to managers by their clients – that is, the pension funds. In many cases, despite the fact that pension liabilities are of very long duration, managers are still paid for short term financial results.
This could be detrimental to the asset owner’s interests in a number of ways. Seeking maximum return in a short time period may lead to an unnecessary level of turnover in the portfolio, which increases costs, and may discourage fund managers from using contrarian investment styles, which might have the potential to outperform. Corporate governance - by necessity a long term activity – may be de-emphasised, and managers unwilling to engage with company boards in any activism agenda. There is a risk that this itself may reduce returns to shareholders over the long term.
A solution, perhaps, could be to consider constructing much longer term mandates for fund managers, including appropriate financial incentives which reward the manager for consistent behaviour. These might incorporate an absolute return approach to allow the manager more freedom to pursue returns over a longer time frame and avoid the constraints associated with following an index.
This approach might be welcomed by company CEOs, like Paul Polman of Unilever, who firmly express a preference for shareholders who will support the company’s development over time. Last year, he criticised the short term behaviour of investors and appealed directly to them: “If you buy into this long term value creation model, which is equitable, which is shared, which is sustainable, then come and invest with us. If you don’t buy into this, I respect you as a human being, but don’t put your money in our company.”