Sunday, March 4, 2012

John Kay's review of equity markets and reporting

Led by Economist John Kay, the UK is undertaking a review of its equity markets looking at how to improve their performance.  Specifically, rebalancing the markets from their current bias towards short-term gratification and more towards long-term performance.

In her Guardian column, Heather Stewart discussed that old canard that transparency, as shown by quarterly reporting, is really the driver towards short-term gratification and that less frequent reporting might be beneficial.

When MPs call on shareholders to rein in runaway executive pay, and the public wonders in exasperation why investors in RBS didn't tame Fred Goodwin's overweening ambition ... they probably imagine a group of enlightened owners carefully shepherding the firms they control. 
The reality of today's equity markets is very different. Deep-seated structural forces favour hands-off ownership, short-term myopic decision-making and quick sell-outs....
According to Kay, there was a striking consensus among the hundreds of experts who responded to his review about the kind of role shareholders ought to play in UK plc – and similarly strong agreement that we are a very long way away from it.
To start her column, Ms. Stewart links the failure of RBS to the failure of the equity markets to take a long-term view.  In doing this, she and the interim report issued by Mr. Kay conveniently leave out the role played by the Board of Directors.

The Board of Directors exists to act as the group of enlightened owners carefully shepherding the firm.

It is their responsibility to oversee the selection and implementation of the firm's long-term business strategy.  It is their responsibility to be sure that management and employees are compensated in ways that create long-term value for the firm.

In theory, the Board of Directors is responsive to shareholders as shareholders can vote to replace them if the shareholders are dissatisfied with the performance of the firm.

In practice, this tends to not occur because many dissatisfied shareholders elect to sell their stock instead and invest in firms where they think long-term value is being created.

Ms. Stewart then moves on to lay out the case for why less frequent reporting might be beneficial.

The second, perhaps even more cherished, principle that Kay appears willing to ditch is quarterly reporting: the idea that companies, and the asset managers who buy and sell many of their shares, must produce a deluge of information every three months about their financial performance
In theory, quarterly reporting enhances transparency and focuses bosses' minds on the sacred idea of "shareholder value"....
In theory, quarterly reporting enhances transparency.

In practice, as the Bank of England's Andrew Haldane has observed by describing banks as 'black boxes', it does not.

Ms. Stewart then asserts that reporting is suppose to focus bosses' minds.

This is not true.  The reason that there is reporting is so that market participants will have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess the risk of each business and adjust the amount and price of their exposures accordingly.

The question that needs to be asked is does the current reporting achieve this goal.  Clearly, in the case of financial institutions, it does not.

If current reporting does not achieve this goal, then what would achieve this goal?

For financial institutions, what is needed is they must provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  It is only with this data that market participants can truly independently assess the risk of each firm.

Please note, reporting that provides ultra transparency for a utility (electric, gas,...) is likely to be different than for financial institutions as the utility business has different characteristics.  Fortunately, market participants are flexible enough to handle ultra transparency as it applies to different industries.
The tyranny of chasing the quarterly numbers can cloud more considered strategic thinking, and has helped to spawn the byzantine executive pay schemes that claim to align bosses' interests with those of the shareholders but can end up rewarding them handsomely for meaningless financial engineering, for instance tarting a firm up for sale to a ruthless foreign predator, or for driving their company to the edge of a cliff and baling out just in time. 
All of these are a symptom of the failure of Boards of Directors to do their job.
Even Jack Welch, the legendary GE boss regarded as the father of the idea of "shareholder value", has since disowned his offspring, telling theFT three years ago that he now regarded chasing quarterly returns as "the dumbest idea in the world".
"Shareholder value is a result, not a strategy," he said. "Your main constituencies are your employees, your customers and your products." 
However, that did not stop him, with the blessing of his Board of Directors, from putting out a quarterly earnings target that GE managed to consistently beat by 1 to 3 cents per share.

Please note, ultra transparency for GE would involve GE Capital and its corporate treasury disclosing on an on-going basis its current asset, liability and off-balance sheet exposure details.
Abandoning quarterly reporting would seem like a backward step if you assume that more information must always be a good thing; but short-term targets will inevitably distort decision-making. 
Actually, abandoning quarterly reporting is not a step backward if, and only if, what replaces it is reporting that meets the goal of providing market participants with all the useful, relevant information in an appropriate, timely manner.

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