The disciplines of the Stock Market keep managers honest and improve corporate performance.
The City of London financial markets represent a huge investment in expertise and analysis - a lot of which is dedicated to scrutinising the strategies, leaders and performance of large quoted companies - and attempting to predict future profits and cash flows.
The bulk of the analysis of companies is conducted by Sell-side Analysts, who generally work for the brokerage arms of investment banks, Buy-side analysts, who work for the investment companies, and a polyglot mixture of investment managers, specialist independent analysts and the pundits of the financial press.
Vast sums of money are spent tracking the doings of top managers and their companies. External analysis is supplemented by constant conversations with CEO's and finance directors. The whole lot is topped off by regular formal presentations made by top managers to the investment institutions - at least one a year for larger companies. This all has a manifest impact on managers, some of whom estimate that they spend 40% of their time on City-related matters. Studies by Judge Business School and Cranfield University give sharp insights to the beliefs of managers about what has the most impact on their careers.
(Life and Times of the CEO. Harrington and Steele, Cranfield University, 1999.
In the Mirror of the Market. Roberts et al, Judge Business school , University of Cambridge, 2005.)
All this analysis, scrutiny and constant speculation on the activities of companies and their likely performance should have a positive impact, should it not?
Some of the best brains in the world are deployed to ensure that they act in the shareholder interest, and if shareholders are satisfied, then so should the rest of us - after all, many of us are in fact shareholders through our pension schemes and savings?
Well, here are some opinions and facts - judge for yourselves......
What managers really think:
Sir Richard Sykes, ex-CEO of Glaxo, chaired a weighty enquiry into 21st Century Investment manned by a galaxy of managerial and City talent. Sir Richard said in his opening speech introducing the findings:
"A casual observer of the financial scene could be forgiven for thinking that the whole investment system is fatally flawed or irreparably broken. Advisers and fund managers failing to help savers and institutions starving UK industry and commerce of their life blood"
(Restoring Trust, Investment in the Twenty-First Century. To-morrows Company, 2005.
Niall Fitzgerald, retiring chairman of Anglo-Dutch consumer goods company Unilever said, shortly after his retirement: The short-term nature of the way in which investor decisions are made has always been an issue, but I think that it is now much more serious and potentially destructive. More and more, there is the danger that decisions will be taken with a two-year time horizon at most, probably with a three month time horizon.......Decisions need to be made about investment in ideas, in science, in people, in opening up new markets.
Sir Michael Perry did not have to wait for his retirement as chairman of Centrica to say: A combination of corporate greed, abuse of power, short-termism and erosion of mutuality in industrial relations has dented public confidence.....
Bertrand Collomb, President of Lafarge, SA and a top European businessman with experience stretching from the UK, through France and Germany to the USA, said: You describe very well the pressure exerted by the City on its companies, and on managers who forget that a company's future lies first in its people and operations! ....But everywhere the aims of the financial players are different from what makes a successful and sustainable business....What to do about it is a tough issue. And unfortunately nobody seems to have any interest in dealing with the issue....
These are not chance remarks made by a few mavericks, but most managers do not wish to speak in public - they believe that such opinions will be career limiting. In more than 100 interviews of top managers, there was hardly a voice that believed the scrutiny and pressures exercised by the markets and press was anything other than negative on companies' long-term prospects.
The Role of the Board in creating high performing organisations. Dr John Roberts and Don Young, PARC 2005.
Julie Froud, Professor Karel Williams and colleagues from the University of Manchester have conducted a major study into the behaviour and performance of the largest companies.
Financialisation and Strategy, Narrative and Numbers. Froud et al, Routledge, 2006.
They describe massive changes in the nature of giant companies' corporate strategies that have occurred over the last 20 years.
Intense pressures from the capital markets have caused companies to focus mainly on how to satisfy investors. In turn, this has changed the character of corporate strategy, which has become, in essence, the production of numbers for the markets, supported by a 'narrative' that supports the numbers.
More important than this, the primary role of the corporate office is now to support top managers in their transactions with the financial markets, which are now estimated to take up about one third of CEOs' time.
This finding is supported by much corroborative research and evidence.
Corporate offices of many FTSE 100 companies have therefore become mirror images of the financial markets. The effect of this and the pressures for narrow corporate governance have been to distance boards from the businesses and organisations they are supposed to lead. This leaves corporate managers with a limited range of 'levers' that they can use to improve the business. A short tenure CEO is most likely to resort to transactional means to improve performance and impress the financial markets - thus the massive dependence on corporate restructuring and mergers and acquisitions - neither of which have been demonstrated to have the desired long-term effects.
The quality of City analysis and understanding of companies
Professor Andrew Tylecote and Dr Paulina Ramirez, conducted a long-term study into the characteristics of the UK investment markets.
'UK Corporate Governance and Innovation.' Professor Andrew Tylecote, University of Sheffield Business School and Dr Paulina Ramirez, Centre on Innovation and Structural Change, University of Ireland, Galway.
They concluded that UK investors, whilst they might understand industries and technologies at a theoretical level, had little understanding or interest in how individual enterprises actually functioned
To sum up the gist of the research: The UK has an investment system that is dominated to a greater degree than any other country by impersonal institutions that are obsessed with short-term returns and do not care for or have much interest in, individual companies in which they invest. (Our words, conclusion endorsed by the researchers).
Their first instinct in the case of any trouble is to sell the shares, their second is to try to cause a takeover, and only as a last resort will they engage the management. When they do, the fact that they understand little of how companies really work, because engagement is not their natural style, and their people are not trained or experienced to do so, makes the outcomes rather uncertain.
By contrast, many US investment institutions have much more company-specific expertise and a significant proportion of investors tend to seek long-term and engaged relationships with the companies in which they invest.
Most important,Tylecote and Ramirez concluded that the UK stock markets actively discouraged investment by companies in innovation, R&D and long-term development of complex technologies.
What investors want
The lack of in-depth understanding of how businesses really work is not surprising when it is realised that investment institutions do not generally value 'soft' data - they want the 'Numbers', because that is what people with accounting, banking and Business School backgrounds understand.
This bias has been recognised by a number of investors, who are dissatisfied by the quality of brokers' analysis and launched what they described as the 'Enhanced Analytics Initiative'.
Mâns Lönnroth, CEO of Mistra investors, expressed their views succinctly:
"On the basis of what we have learned from our research into sustainable development, we believe that there is an urgent need to understand and incorporate non-financial issues into the investment process much more broadly than is currently common practice".
However, most investors are of a more speculative bent - they see their jobs as taking punts on short time-horizon share price movements and care not a jot for the companies whose shares they buy and sell.
Here are some of the factors that institutional investors like, according to our interviewees and writers such as Tony Golding, who wrote a seminal book, 'The City':
- Focus and commitment to a core business. Therefore, 'non-core' activities should be de-merged, spun off or carved out. Not so long ago, a degree of diversification was approved of. Fashions change.
- Managers who manage their business portfolios like they manage an equity portfolio. In effect, this means a high degree of corporate activity, and particularly, regarding the enterprise that they lead as group of "assets" that can be shuffled, bought and sold.
- 'Biddable' companies. They intensely dislike anything that might prevent a company from being acquired, and like to feel that there could always be a bid for their holding in a company.
- A clear 'strategy'. This means an understandable way of keeping future earnings moving ahead. We have previously mentioned a distinct liking for a high level of M&A activity as part of a good strategy. Strictly speaking, large acquisitions ought to be regarded with suspicion by institutional investors, not only because of their value destructive history, but also because if new shares are issued, there is a risk that future earnings per share may be "diluted" (bad word). However, it is at this stage that "synergy", (good word), can come to the rescue.
Companies planning a big acquisition will invariably issue a list of expected merger synergies, and investors will usually vote in favour. Acceptance will be made easier in large integrated investment banks, because the investment banking and stock broking arms will benefit from acquisition-generated fees.
- Moving on and forgetting yesterday. This factor means that investors tend to have very short memories and are always looking for the next opportunity. It also means a very distinct preference for dealing with problems by transactional means. It is regarded as better to divest or close a troublesome business than to enter a lengthy process of improvement.
The City, Tony Golding, Financial Times/Prentice Hall, 2001.
Facts and Statistics
So far we have dealt with 'soft' data and peoples' opinions and experience, the summation of which seems to be that the City wants managers to behave as though they were agents of shareholders, manage their companies to maximise short-term returns, regard their enterprises as a collection of assets that can be acquired and disposed of at will and put dividends and investor returns ahead of long-term investment in the business.
Most rational people would say that following this recipe is unlikely to result in long-term high performance.
Do the Facts and Research bear out this conclusion?
Here are some:
Tylecote and Ramirez concluded that the UK system of investment was actively discouraging of long-term investment in technology and innovation.
Here's what the OECD data indicated:
Only the UK amongst OECD countries had a lower share of GDP spent on R&D in 2000 than in 1981. In Britain, in 2000, it was 1.9%, in the US, 2.7% and Germany, 2.5% (OECD). In 2005, the investment in R&D by Britain's 750 top-spending companies decreased by 0.5%. Most tellingly, this decline was driven by a 3% decrease by foreign-owned companies - deepening the concern that foreign companies are likely to 'offshore' research and innovation, whilst maintaining investment in productivity-enhancing capital expenditure. Thus, burgeoning foreign ownership is likely to decrease the creation of 'break-through' and advanced knowledge creation in UK industry.
This lack of investment has had a profound effect on the make-up of the FTSE 100, Britain's largest companies:
- In 2005, the top 750 'British' R&D-intensive companies spent £17 billion (240 of these 750 were foreign-owned and overall reduced their UK R&D spending).
- By comparison, FTSE 100 companies spent £39 billion on mergers and acquisitions in 2003 - and £306 billion in 2000. It is very well known that M&A destroys far more value than it creates. So 'buy, not create', seems to be the order of the day.
- The 'spread' of FTSE 100 companies across industrial sectors is hardly that of a high-tech economy:
|Sector||Number of Companies|
|Banking and Financial Services||24|
|Media and Entertainment||14|
|Food, Drink, Tobacco||12|
|Mining and Resources||8|
|Transport and Distribution||1|
|Aerospace, Engineering, Materials||5|
Of this listing, only the last two, making up 9% of the FTSE 100, could be regarded as genuine creators of science and technology-based products.
If long-term investment suffers as a result of investor pressure for performance, then surely financial results will be enhanced?
Here are the long-term results of the top 100 UK companies, the FTSE 100:
FTSE 100 Performance
Annualised Percentage Increases 1983 to 2002
|FTSE 100||S&P 500 (US)|
|Profit Before Tax||2.7||1.5|
|Return on Capital (2002)||3.6||1.3|
|Dividends/R&D spend (2005)||162.0%||48.0%|
|(Germany and Japan, 19%)|
|Directors' Pay||26.2||N/A (very large)|
|CEOs' Pay as multiple|
of average pay (2003)
Most data drawn from: Financialisation and Strategy, Froud et al, Routledge, 2006.
- The rate of sales and profit growth in both FTSE 100 and S&P 500 is not significantly greater than the underlying economic growth rate. Thus despite the attentions of the full weight of the City and very expensive top managers, the biggest companies have simply grown at or below the rates of the underlying economies.
- In UK companies, the rate of dividend growth far exceeds the rate of underlying growth in profits. This has supported share prices, (and directors' pay), but is probably an important driver of a generally low rate of investment in Research and Development (R&D) and capital expenditure.
- The increases in top managers' pay are totally detached from company performance.
There is no evidence that the investment markets in their current form have beneficial effects on companies - in fact there is ample evidence that the opposite is the case. Looked at from the standpoint of larger companies, it is clear that better means of investing are needed that will support rather than destroy. Looked at from the standpoint of the public interest, the current system encourages underperformance, stagnation, inequality and exploitation.
More fundamentally, it is becoming clear that a system of ownership and investment that was originally devised to fund the first industrial revolution does not have much relevance in the information age.
In to-day's businesses, customers and employees must come first and different forms of organisation that will encourage collaboration between companies, customers, suppliers and outsourced supporters will become common. A domineering financial system that insists that its rights are paramount will become an anachronism. New forms of ownership are needed.