The constant chase for a quick profit in equities offers dim prospects for growth
At its height, the British empire was one of the largest in the world, with less than 1per cent of the population controlling one-fifth of the world's land area. One reason for the empire's longevity was its ability to adapt to changing conditions through an objective feedback mechanism. Whenever the government got into trouble, it would establish a royal commission or invite a prominent person to head a committee to review what had happened. It would normally be independent of the civil service and vested interests.
The best part about such an inquiry is the official deniability - the recommendations are those of the experts, not necessarily the government. If the public liked the recommendations, the government could adopt them; if the public didn't, they would be shelved.
In the wake of the global financial crisis, the British government invited London School of Economics professor John Kay to review the British equity market and its impact on the governance of UK-listed companies. The report, published last month, holds many lessons for Asian stock markets.
Stock markets play an important role in the economy by enabling listed companies to raise capital. They also price shares, help manage risks at the corporate and national level and exercise discipline on the governance and performance of listed companies.
The Asian financial crisis in the 1990s, the tech bubble in 2000 and the current crisis all questioned whether stock markets perform well in practice. In advanced markets like London, companies hardly raise primary capital through initial public offerings, since most established companies are cash-rich. Stock market volatility is very high. The impact on corporate governance has been questionable, because it was found that retail investors are too small to influence corporate behaviour, and large institutional investors tend to sell out rather than exercise their voting power to change corporate behaviour.
Kay's study suggested that short-termism is a fundamental problem in British equity markets and that the principal reasons are a decline in trust and the misalignment of incentives throughout the equity investment chain. These underlying trends are reflected in facts about the UK equity market. British companies are investing less in the real economy and their research and development is the lowest when compared with that in the US, Germany and France.
In fact, new net equity issuance by British listed companies has been negative in the past decade, with the new stock sold offset by share buybacks and the acquisition of listed companies by cash. This is not only because listing costs are high, but also because the total return on listed shares has been disappointing.
The structure of share ownership has also changed drastically. In 2010, the share of retail investors in total UK equity market ownership was only 11.5per cent, compared to 54per cent in 1963. The proportion of insurance companies and pension fund ownership fell from 20.8per cent and 31.7per cent respectively in 1991 to 8.6per cent and 5.1per cent in 2010. What has grown in proportion are foreigners (global investors), accounting for 41.2per cent in 2010 and other investors (mostly professional London-based fund managers).
The Kay report is concerned about short-termism because, in Britain, hedge funds, high-frequency traders and proprietary traders account for 72per cent of market turnover, but roughly one-third of shareholding ownership. It is their short-term behaviour that drives prices, and there is concern that it creates bubbles far beyond fundamental value. During a crisis, this short-termism reduces liquidity and exacerbates stress.
Global demographics are changing the long-term investment strategy of retail investors. Throughout the advanced markets, baby boomers are reaching retirement age and are less interested in growth stocks and capital appreciation, and more concerned about capital preservation and strong dividend yields. Obviously, most investors in China, the US, Europe and Japan have not recovered their losses from the 2007 crash.
One basic thrust of the Kay report is that all participants in the equity investment chain should act according to the principle of stewardship, which is founded on trust. Hence, the report recommends that regulatory practice should favour investing over trading, not the other way round. In other words, the regulatory framework should enable and encourage companies, savers and intermediaries to adopt investment approaches that achieve long-term value.
In this current world of short-termism, this is easier said than done, since many financial intermediaries, especially investment banks, make more money from short-term trading than long-term investing. Interestingly, the report felt strongly enough about short-termism to recommend that mandatory quarterly reporting obligations be removed. This is music to the ears of corporate captains who feel they should be focused on building long-term value, rather than worrying about how the next quarterly report would depress stock prices.
The Kay report is a welcome review of how stock markets should help the real economy grow and create jobs for the long term. These are important lessons for Asian stock markets, investors and financial regulators.
Andrew Sheng is president of the Fung Global Institute
