Andy Haldene is bothered that as dividends have risen, profits retained by quoted companies for reinvestment have fallen from 90% in 1970 to about 35% today, leaving firms with far less money for growth-boosting invetment and risking "eating themselves". This is bad for the long term health of UK Plc.
As Terry Smith lucidly explained in a recent FT article, a firm with a 20% return on capital that reinvests 100% of profits will grow by about 4000% over 20 years. If the same firm reinvests only 10%, its 20 year, growth will not even reach 1000% over the period. This matters to long term investors such as the many saving for a pension in 20 to 40 years. It also matters to governments since a growing economy means more money to spend without increasing tax rates.
It is a subject that Anthony Hilton raised in 2012. He aired Andrew Smithers' concern that the 'craze' for trying to align CEOs' incentives with their company's interests by paying 'massive' bonuses linked to measures like earnings per share and return on equity gives CEOs corresponding incentives to cook the books by using share buy-backs as a quick-and-easy way to improve earnings per share. Reinvesting earnings to promote longer term growth takes time to produce results and tends to depress share prices in the short term. So CEOs with short term bonus schemes (and in this context three to five years is short term) are systematically tempted to shun what is better for the long term good of the company in favour of the short term good of their wallets.
You might think that boards are to blame for this. After all, they design and set bonus systems with 'long-term' targets including relatively short-term returns on equity. This despite (in the UK) the Corporate Governance Code, whose opening words are:
"The purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company."
But things are not that simple.
Incentives set for professional asset managers are usually mis-matched to the decades-long horizons of the many future pensioners investing their funds; and investment managers can be influential in the appointment of boards.
These managers' incentives usually mean they get bigger bonuses if boards deliver short term gains. Anthony Hilton recently reported the egregious case of an otherwise successful chief executive who was told by a senior shareholder that an unexpected rights issue and subsequent share-price drop had robbed him of his performance bonus and he would have his revenge. The CEO was out soon after.
This mis-match is widely recognised. In his review of UK equity Markets, John Kay wrote that:
"short-termism is a problem in UK equity markets, and that the principal causes are the decline of trust and the misalignment of incentives throughout the equity investment chain."
But Con Keating has recently pointed out that there is another layer of complexity. As he puts it:
"Shareholders are not a homogenous group; their motivations and strategies can vary significantly. Some have even developed strategies, such as the “washing machine”, where engagement and activism seek to achieve short-term gains before the manager then moves on to the next. Heterogeneity among shareholders will tend to reinforce collective preferences for the short-term. In times of corporate action, such as hostile take-overs, groups of activist short-term shareholders, often hedge funds, do have a tendency to arise naturally, through self-interest, without any formal co-ordination or collusion. By contrast, when engagement is concerned with the long-term, formal co-ordination through bodies such as the Investors Forum is deemed advisable or even necessary"With such a range of shareholder motivatations, Keating believes the short-termists win; and since the long term is a series of short terms, long-termists are also likely to lose in the long run.
Keating toys with weakening the power of shareholders. This is a tricky approach since if shareholders are unable to hold a board to account, who is left to prevent a malign or incompetent board from wreaking damage?
To escape this conundrum, Keating asks whether a system that discriminates between short- and long-term shareholders might give boards greater practical power to put the long term interests of the company ahead of the shorter term interests of shareholders. France has attempted to do this with the Loi Florange part of which may have made it easier for shareholders who have held a company’s shares for more than two years to claim double-voting rights.
States have a huge interest in promoting the long term health of enterprises in their economies. They have also given enterprises the precious ability to limit their liability, invest collectively on huge scales and overcome mortality. Is it unreasonable for States to insist on measures that discourage short-termism from ovewhelming the long term succcess of enterprises on which long term national prosperity depends?
And if it is reasonable, what is the best solution? Loi Florange is one approach that has gained some support, but Sherlock Holmes would recognise this another three pipe problem.