One reason for the empire’s longevity was its ability to adapt to changing conditions and to have an objective feedback mechanism. Whenever the 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 had happened and make recommendations for change. This was normally independent of the civil service and vested interests.
The best part about such royal or independent inquiries was that there was official deniability – the recommendations were those of the experts, and not necessarily those of the government. If the public liked the recommendations, the government could adopt them and act quickly, whereas if the public did not like the recommendations, the report would quickly be shelved and not acted upon.
In the wake of the current crisis, the British government invited LSE professor John Kay to review the UK equity market and its impact on the governance of UK listed companies. The report was published on July 23 and has many lessons on the theory and practice of Asian stock markets.
Stock markets play an important role in the economy, by enabling listed 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 the corporate governance and performance of listed companies. The series of crises in stock markets in Asia (1997-99), the tech bubble (2000) and the current crisis (2007-2011) all question whether stock markets perform well in practice.
In advanced markets like London, UK companies hardly raise primary capital through IPOs, since most of the established companies have become cash rich. Stock market volatility remains very high – with prices crashing up to 50-60 per cent from peak to trough in the recent crisis. The impact on corporate governance has been questionable, because it has been discovered 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.
John Kay’s study suggested that short-termism is a fundamental problem in UK 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, their investments falling from over 13 per cent of GDP to less than 10 per cent of GDP, and their R&D is the lowest compared with US, Germany and France.
In fact, new net equity issuance by British listed companies has been negative in the last decade, with IPO new capital offset by share buybacks and acquisition of listed companies by cash. This is not only because listing costs are high, but also because the total return on listed shares have been disappointing – the FTSE all-share index returned 4.5 per cent per annum in the last decade.
The structure of ownership of shares has also changed drastically. In 2010, the share of retail investors in total UK equity market ownership was only 11.5 per cent, compared to 54 per cent in 1963. The proportion of insurance companies and pension funds ownership had fallen 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. What have grown in proportion are foreigners (global investors) accounting for 41.2 per cent in 2010 and other investors (mostly professional London-based fund managers).
The Kay Report is concerned about short-termism, because in the UK, hedge funds, high frequency traders and proprietary traders account for 72 per cent of market turnover, but roughly one-third of shareholding ownership. It is their short-term behaviour that drives prices, and there is concern whether their short-termism creates bubbles far beyond fundamental value. During crises, their 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 (in the US alone, 78 million people) are reaching retirement age and are less interested in growth stocks and capital appreciation, and more concerned about capital preservation and strong dividend yield to give them retirement income and cash flow. Obviously, the result of the 2007 crisis is that most investors in China, the US, Europe and Japan have not recovered their losses from the crash. These four markets have lost 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, but except in safe haven bonds such as US and German sovereign bonds, bond markets generally have lost their “risk free” status, as government debt in many OECD 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 the Kay Report felt strongly enough on short-termism to recommend that mandatory quarterly reporting obligations be removed. This is music to the ears of corporate captains who feel that they should be focused on building long-term value rather than worrying about how the next quarterly report will 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 and create jobs for the long-term. These are important lessons for Asian stock markets, investors and financial regulators.
Andrew Sheng is president of Fung Global Institute (www.fungglobalinstitute.org).
