With 78% of pension funds considering themselves long-term investors in an IPE Focus Group survey, it would be tempting to believe that dramatic progress had been made towards achieving the objectives of the Kay Review on UK equity markets. Indeed, it would fully justify the enthusiastic spin of ‘Building a Culture of Long-term Investment: Implementation of The Kay Review’, the progress report put out by the UK Department of Business, Innovation and Skills (BIS) this October.
However, a quarter of those surveyed believed that the ‘long term’ was three to five years, and the companion paper to the BIS report, entitled “metrics and models used to assess company and investment performance” is fixated on short-term price effects.
Still, there are pearls among the comments offered by the IPE Focus Group: “The idea that long-term investment should be public-market inherently seems to be at odds with long-term investing”; “Public markets are driven by short-term liquidity and [mark-to-market] ideology, which is anathema to long-term investing, which is about long-term, sustainable cash flows”.
One way of defining long term is in terms of the flows of liquidity arising from the securities held, their coupons, dividends and maturing proceeds. When these, rather than changes in market price, dominate investment returns, we are in the long term.
Incredible though it may seem, the BIS paper does not consider what constitutes the long term, either theoretically, or in the opinions of the numerous interviewees, leaving any discussion with no frame of reference.
The discussion of liquidity is concerned only with market liquidity and advocates changes in market microstructure to increase this. This fails to take account of the fact that liquidity has a cost – if it did not, all assets would be perfectly liquid. It also means that the most liquid stocks are the most expensive; government debt offices systematically profit from the cost of liquidity by issuing large benchmark issues. There is a mistaken belief that the most highly traded equities are those closest to their fundamental value. In fact, it is the least liquid where this is more true, since the investors here are more likely to be just that – investors – who have conducted their due diligence and analysis.
The BIS report cites one asset manager observing that “prices are 13 times more volatile than fundamentals”.
It is worth unpacking this comment.
Markets are games against nature, against exogenous factors described as fundamentals. This is the basis for long-term investment. However, financial markets are dominated by an endogenous game against others, the hyperactive trading of which John Kay was so contemptuous. This is the land of speculation, where price performance is all-important. Of course, in the long term this speculation washes out, leaving only the returns and volatility of fundamentals.
The process is not some arbitrary mean reversion, but convergence to economic reality; returns must ultimately reflect realised profits. The returns in any year are dominated by price movements, but over the long term, they are time-serially independent. Capital gain is an insignificant part of long-term returns. By contrast, dividends (and their growth) are the dominant source of long-term returns, and they are predictable over years. In this regard, the stickiness of dividends is a positive attribute for long-term investors.
Dividends warrant an entire chapter, which should not surprise, as the right to dividends is one of the few property rights associated with ownership that shareholders possess.
However, the view taken is strange: “The principal-agent relationship is a key driver of demand for dividends as this helps investors to sift companies for potential agency problems”. There is no principal-agent relation between investors and either the management or the board of a company. Equally odd are the assertions that “Taxation of dividends has reduced the level of interest in finding high yield and in holding investments for a longer time period”; and that “Companies have responded with remuneration incentives weighted to capital gain rather than dividends and cash flow”.
When not focused upon the short-term market price effects of dividend cuts, the paper adopts the implicit view that growth must be a perpetual objective for a company and that the payment of dividends, where it limits further growth investment, is misconceived. The paper is inconsistent. Earlier it supports the payment of dividends as a mechanism to limit management diversions and wasteful empire building. Under that view, the company may raise new funds for new investments. So why not here?
It is disappointing that the paper contains no discussion of the return of capital to shareholders by share buyback rather than special dividend, where management incentives are central to the analysis. The suggestion that dividends should be distributed as core and fluctuating components only prompts the question: if this is a good idea, why has it not already emerged as market practice?
For reasons not at all obvious in a report concerned with metrics and models, there is an extended discussion of earnings guidance. Incentives figure large, but there is no recognition that the existence of an incentive does not ensure an outcome, least of all when that outcome is morally questionable.
In light of the Focus Group survey result that investors regard regulation as the primary impediment to long-term investment by institutions, the discussion of regulation in the research paper is narrow, covering only the question of “suitability” and retail investment.
One of the more bizarre suggestions is that the management of a company should conduct exit interviews with investors who have divested their holdings. Quite apart from the sheer impracticability, it is motivated by concerns with share price performance – short-termism writ large. If we are long-term investors, then we are most likely also investors in the future, and that is a future in which we would like prices to be low and prospective investment returns high. The long term can be a very strange place in many ways.
Con Keating is head of research at BrightonRock Group and a member of the steering committee of the financial econometrics research centre at the University of Warwick