Do Stock Markets Serve Investors?
At its height, the British Empire was the largest in history, ruling over one-fifth of the world’s people and one-quarter of its land area. One reason for the empire’s longevity was its ability to adapt to changing conditions and to have an objective feedback mechanism. Whenever a British government got into trouble, it would establish a royal commission of experts or simply invite a prominent person to head a committee to review what happened and make recommendations for change. This was normally independent of the civil service and vested interests.
The best part about such independent inquiries is official deniability. The recommendations are those of experts and not necessarily those of the government. If the public liked the recommendations, the government could adopt them and act quickly. But if the public did not support them, the report could quickly be shelved and not acted upon.
In the wake of the current economic crisis, the British government invited London School of Economics and Political Science (LSE) Professor John Kay to review investment in UK equity markets and its impact on the long-term performance and governance of British companies. The report, which was published on 23 July, has many lessons for Asia on the theory and practice of stock markets.
Stock markets play an important role in the economy. They enable companies to raise capital, improve the price discovery of shares, help in risk management at the corporate and national level and also exercise discipline on corporate governance and performance. The series of recent stock market crises – the Asian financial turmoil (1997-99), the tech bubble (2000) and the latest period of global volatility since 2007 – has raised questions about stock market performance in practice.
In advanced markets such as London, companies hardly raise primary capital through IPOs since most established companies have become cash rich. Stock market volatility remains very high, with prices crashing by up to 50-60 per cent from peak to trough over the recent crisis. The impact on corporate governance has been questionable because 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.
John Kay’s study suggests that “short-termism” is a fundamental problem in UK equity markets. The principal reasons are a decline in trust and the misalignment of incentives throughout the equity investment chain. These underlying trends are reflected in the fact that investments of British companies in the real economy over the past decade have fallen from over 13 per cent of GDP to less than 10 per cent of GDP. In addition, the UK invests a smaller percentage of its GDP on research and development than do its main competitors, the US, Germany and France.
In fact, new net equity issuance by British listed companies has been negative in the past decade, with new IPO capital offset by share buybacks and the acquisition of listed companies with cash. This is not only because listing costs are high but also because the total return on listed shares has been disappointing. At the end of June 2011, the total return on the FTSE All-Share Index was 4.5 per cent a year over the past five years and 4.8 per cent a year over the past decade.
The structure of ownership of shares has also changed drastically. In 2010, the share of retail investor ownership in the UK equity market was only 11.5 per cent, compared with 54 per cent in 1963. Ownership by insurance companies and pension funds fell from 20.8 per cent and 31.3 per cent, respectively, in 1991 to 8.6 per cent and 5.1 per cent, respectively, in 2010. Meanwhile, ownership by foreign investors rose to 41.2 per cent in 2010, up from just 7 per cent in 1963. (In 2010, other investors, mostly professional London-based fund managers, owned the remaining third of the shares in the market.)
In his report, Kay is concerned about short-termism because hedge funds, high-frequency traders and proprietary traders account for 72 per cent of UK market turnover but just roughly one third of shareholding ownership. It is their short-term behaviour that drives prices. The concern is that this short-termism creates bubbles far beyond fundamental value, while during crises it reduces liquidity and exacerbates stress.
Global demographics are changing the long-term investment strategy of retail investors. Throughout advanced markets, baby boomers (78 million people in the US alone) are reaching retirement age and are less interested in growth stocks and capital appreciation. Instead, they are more concerned about capital preservation and strong dividend yield to give them retirement income and cash flow. Since the crisis broke in 2007, most investors in China, the US, Europe and Japan have not recovered their losses from the crash. These four markets are down 65 per cent, 8 per cent, 34 per cent and 53 per cent, respectively. Some investors have fled to bond markets to seek capital preservation. Except for safe havens such as US and German sovereigns, bonds have generally lost their risk-free status because government debt in many developed markets exceeds 100 per cent of GDP.
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 from long-term investing. What is very interesting is that Kay felt strongly enough about short-termism to recommend that mandatory quarterly reporting obligations be removed. This should be music to the ears of corporate captains who believe that they should focus on building long-term value rather than worry about how the next quarterly report might depress stock prices.
The Kay Report is very much welcome as a fundamental review of how stock markets should perform their important function of helping the real economy grow, creating jobs for the long term. It holds important lessons for Asian stock markets, investors and financial regulators.