The collapse of Carillion has brought corporate governance back into the headlines and with it the perennial questions about the short-termist nature of British business. Merryn Somerset Webb was in fine form, having a go at managers, analysts and shareholders alike; “short-termism at its worst”.
The collapse of construction and support-services group Carillion has left a lot of people with a lot of explaining to do. First up, the UK’s equity analysts. Even in 2015, says the Financial Times, two-thirds rated Carillion’s shares a buy – despite warning signs in its accounts. The managers are also in the firing line. Why on earth were they taking huge bonuses in the face of a failure they surely saw coming? Why did they take on so much debt (if there is one lesson for investors here, it is to avoid companies with high levels of debt)? And why did they keep paying dividends, even as their cash-flow woes mounted?
The UK’s institutional shareholders are hardly blameless either. They bore on endlessly about how they take a long-term view – so why were they demanding those dividends from a firm that was clearly stressed? Short-termism at its worst (see this week’s cover story for more on firms who pay dividends that they probably shouldn’t).
The FT’s Capital Markets Editor Miles Johnson called it “a warning to dividend fetishists“. He too criticises analysts and Carillion’s bosses but points out that this is a symptom of a deeper problem:
Income investing has a long history in Europe, more so than in the US where investors are far more willing to support companies that pay no dividends at all. As a result, institutional shareholders in the UK have over generations created a culture of dividend worship that has pretensions to valuing long-term investment, but in fact frequently enables some of the worst forms of corporate short-termism and mismanagement.
This has led to a frequent pattern in the UK market, where companies will doggedly maintain their dividends even when their business models are under threat because of the knowledge that a cut will very frequently result in a chief executive being fired.
Over the years, a number of reports have made the link between the UK’s poor economic performance and the short-term focus of corporate executives and investors. One of the most comprehensive was John Kay’s review in 2012 which, as you might expect, met with mixed reviews from the investment industry.
It is certainly true that the UK has low levels of investment relative to other developed economies. In November, the Office for National Statistics reported that the UK was at the bottom of the OECD investment league and has been for most of the past two decades.
Looking back further, the UK’s investment relative to GDP began to fall away from that of other similar countries sometime around the early 1990s which, ironically, is when the first of a wave of corporate governance reports was produced and the framework which became our corporate governance code was created.
Source: World Bank Data
Chart: World Bank Data
Meanwhile, payments to shareholders have generally been higher in the UK than in other developed economies. Kyle Caldwell, the Telegraph’s personal finance reporter, remarked on this a couple of years ago, noting that payouts to shareholders as a percentage of company earnings were relatively generous. I have updated his chart with more recent data.
Apart from the recession period, UK firms have paid dividends at a higher rate than in other markets and considerably higher than in the US.
Furthermore, listed companies are a more significant part of the UK economy than most others. Market capitalisation is a crude measure as it fluctuates so much but, over time, the value of listed companies has been higher relative to GDP in the UK and US than in other large economies. (For some reason, the World Bank’s data on the UK stops at the recession. If anyone has the up-to-date figures please let me know.)
Chart: World Bank Data
The historic data on Page 15 of this University of Chicago paper suggest that a similar pattern held true for much of the last 100 years. Publicly traded companies have loomed larger in the UK economy than in most other developed economies for some time.
McKinsey’s report on short-termism in US firms last year found that those firms with a more short-term focus invested less and, over time, performed less well than those with a longer-term view. The study also found that a majority of executives believed the pressure to deliver short-term results was increasing. Andy Haldane, the Bank of England Chief Economist, reckons something similar is happening in the UK.
The other side of the coin to high pay-out ratios from internal funds is low investment. There is both direct and indirect evidence of investment having been adversely affected by short-termism on the part of either investors or managers or both.
Chart 6 shows some diagnostics for a matched sample of public and private UK companies (Davies et al (2014)). In line with US evidence, it suggests that investment is consistently and significantly higher among private than public companies with otherwise identical characteristics, relative to profits or turnover. In other words, shareholder short-termism may have had material costs for the economy, as well as for individual companies, by constraining investment.
Overall, then, there is some strong evidence that corporate short-termist behaviour is, in Andy Haldane’s words, “far from benign”. In the UK we seem to have a particularly severe case of it.
What I’m less convinced about, though, is whether corporate governance reform can do much to solve this. As Andy Haldane says, sometimes well-intentioned changes to corporate governance can have unintended consequences. The 1980s emphasis on shareholder value is a case in point:
[T]he shift to equity-based compensation practices in the 1980s and 1990s addressed one incentive friction – the principal/agent problem between shareholders and managers. But it may have done so at the expense of amplifying other incentives frictions – for example, it may have amplified risk-shifting incentives from shareholders to creditors and to wider society.
Linking the remuneration of corporate managers to shareholder value was supposed to have reduced the risk of executives managing companies for their own gain and aligned their interest with those of shareholders. Most observers now agree that it made the problem of short-termism worse and often didn’t work particularly well for shareholders. In 2009, Jack Welch, one of its early proponents called it “the dumbest idea in the world”.
Might something similar happen if corporate governance regime were altered to favour a broader range of stakeholders? As Stian Westlake said, reflecting on the Haldane speech, employees might prove risk-averse, preferring to save their jobs for the next few years rather than risk an investment that might only pay off years later. Likewise, customers might prefer continuity and low prices to the promise of innovative products in future.
Furthermore, while we often imagine shareholders to be individual investors, nowadays few of them are. Just as there is separation of ownership and control in companies, there is a separation of ownership and control in the investment and management of shares. Many investors have only a vague idea of which companies their fund managers are putting their money into. As the Kay review noted, in 1963 individual investors owned 54 per cent of UK firms. That figure is now around 12 percent.
The term“share ownership” is often used, but the word “ownership”must be used with care.It is necessary to distinguish:
- Whose name is on the share register? (often a nominee)
- For whose benefit are the shares held? (e.g. a pension fund trustee)
- Who makes the decision to buy or hold a particular stock? (normally an asset manager)
- Who effectively determines how the votes associated with a shareholding should be cast? (this might be an asset manager, a pension fund trustee, or a specialist proxy voting service); and
- Who holds the economic interest in the security? (i.e. who is the saver who bears the gains and losses from investment?)
It is possible, and in fact common, for each of these rights of ownership to be held by different people.
The Kay review emphasises the need for the long-term stewardship of companies and one of its recommendations, the abolition of quarterly reporting, has already been implemented. Even so, I wonder whether the engaged investor with a long-term interest in the company is a will o’ the wisp. Sure there are some but are there enough of them? This piece by corporate governance adviser Paul Frentrop summed up the problem:
Out in the open market, cold-hearted, distant investors count on liquidity to realise the ‘outperformance’ they promised their clients. And in this harsh climate, no steward can survive.
So, yes, we do seem to have a problem with short-termism in the UK that is affecting our wider economy and the country’s long-term prospects. Carillion was en extreme example of it. But I’m not convinced that changes to the corporate governance regime, even major ones, will make much difference. After all, we have implemented a new corporate governance code every few years for the last quarter century. OK, things might be been worse if we hadn’t but, whatever else it might have achieved, the overall long-term investment picture looks pretty much as it did 20 years ago. Even our 1990s and 2000s productivity catch up may turn out to be ephemeral.
Having said all that, I’m happy to be convinced otherwise. Answers in the usual place please.