Adam Smith reckoned that division of labour in a pin factory boosted productivity 4,800-fold: in manufacturing, division of labour led to a collapse in the cost of labour. Similarly, diversity in the intermediation of capital in equity markets - between high and low-frequency traders and investors with various time horizons - should reduce the cost of capital.
But Al Gore of Generation Investment Management, speaks against this diversity. “Three-quarters of the value of the average firm builds up over [….] 7-8 years,” he said recently, presenting Generation’s ideas about ‘Sustainable Capitalism’. “It’s a fair question if that’s really investing, if you are focused on a tiny fraction of [that] period.”
Sure enough, Generation’s recommendations include incorporating risks from “stranded assets” that would be impacted by an increase in the cost of say, carbon or water, and its broader arguments - especially in favour of ‘loyalty dividends’ - appear to assume that capital is undervalued in the same sense as carbon. If the carbon price corrects, a coal-fired power station might be a stranded asset; if the cost of capital increases, it would be company equity.
Imagine a stock with a three-year loyalty dividend. If certain investors couldn’t bid for it because three years is outside their risk tolerances it would trade at a discount, which might attract investors whose horizons are currently too short for their own risk tolerances. That’s fine, but it also raises the issuer’s cost of capital. That could remain unchanged only if the arbitrage tempted investors to extend horizons beyond their risk tolerances - which would be no better than shortening them beyond their tolerances. (By contrast, market forces that incentivise shaving milliseconds off of a high frequency trader’s horizon, for example, mitigate the HFT’s risk, but tighter bid-ask spreads also attract more capital, which reduces the cost of capital.)
Generation thinks equity issuers would pay more for capital if it brought savers’ time horizons closer to their own. John Kay, in his interim report on ‘UK Equity Markets and Long-term Decision Making’, reminds us that such analogies between companies’ time horizons and investors’ are entirely “naïve”: “The basic historical function” of equity markets is to “allow for the different time horizons of companies and savers,” he writes, and the fact that “different agents employ different time horizons, and that many of these are short, is not in itself evidence of a problem”.
Respondents to Kay’s consultation were concerned that savers’ time horizons are much shorter than optimal for their objectives. But the problem is not that some horizons are too short, but that many are too similar: savers’ idiosyncratic and complementary risks get lumped together by behavioural biases (savers are all human) and regulation (which treats all savings institutions as if they were the same); capital gets withdrawn from equity markets due to frustration at low returns or incompatibility with regulatory risk budgets; and its cost for businesses goes up.
Let’s not add more perverse and costly incentives: if we want to sustain a low cost of capital in our economies, we should aim to diversify savers’ time horizons - not necessarily lengthen them.