Long-Term and Short Term Visions in the Financial World

Speaker A I think perhaps the best way that I can illustrate that is from a personal example. The firm that I worked for full time towards the end of my career, Consolidated Goal Fields, was under great threat from a takeover and we had a takeover battle in 19 88 80 lasted a year. I was, amongst other responsibilities, I was particularly charged with finding new projects and ideas to do. Demand for that kind of work died in the very first week of the takeover because people, the minute they weren't sure you'd be around in a year's time, never mind five or ten years time, people didn't want to talk to you. But that is understandable. But worse still was the fact that when you discussed the future of the firm with the fund managers and we met them every fortnight at least 20 or 30 of the top fund managers. I remember taking one of the sessions. Usually it was a finance director, but once it was me. And I remember pointing out how the company had grown in the last 20 years. It had increased in size four or five times in real terms, had a very good record and we expected to double in the next four to five years from the projects we'd identified and had in the pipeline. And I said no matter how high our stock is bid it would be very much better to hold on to it. I was received in total silence. Then when we had drinks and sort of buffet lunch afterwards, the senior fund manager came over to me and said, there's not a man in this room who doesn't agree with the assessment of you and your colleagues about how it would be better to hang on to the stock, and there isn't a man in this room who's going to do it. We can sell the stock at the price today's price or the price it will probably be bid up to. We can record a very, very good profit that will help our ratings and help us to renew fund management contracts with other people. And that was my road to Damascus. I began to realize that I could not look at long term net present value of projects anymore on their own. I had to take account of the fact we were now in a short term world. Why are we in a short term world? Well, there's two forces that cause this. One is corporate management and the other are the investment institutions. The investment institutions get most of their business from corporate management. They particularly get their pension fund business and they want to keep in with corporate management because that's the source of their business. They are not in the business of typically criticizing either their strategy, their takeovers, their pay, however outrageous and they only turn on managements at the last moment when it's clear the company is dying. As with Marconi or some such company or the Great American companies we know have been in that situation. They don't turn until that point, but equally because they are under instruction, really to perform well over at least two to three years, preferably to be in the top quartile or risk losing their mandates. Then they in turn put corporate managements in general under the same pressures. So CEOs in the major companies have an average tenure now something like three to four years. Many last as long as five or more. There's wonderful exceptions, but the expectation is that you've only got three to four years to perform in. You have mainly been rewarded by stock options. So the object becomes to drive the stock price up in your time of guaranteed tenure and cash your options. Something like 98% of all options are cashed within a month of being allowed to be cashed, both in Britain and North America, the fact they can be held for ten years doesn't come into it. So the two main actors, the investment institutions and the corporate managements, are each under great, almost irresistible pressure to perform in the shorter term. And only exceptional firms can resist it. Firms that are very big, we think of the General Electrics of this world, or the ExxonMobils, they have the freedom to do that. Whether they use it wisely, it's a different question, but they certainly have the freedom to do it. The other great exception are private equity firms, which, as we know, are making great strides in North America, in Britain and Europe, and they're getting bigger and bigger and bigger. They have the ability to give their managements something like five years plus and there is complete harmony between the management and the investors. But in Britain and North America, the underlying investors, you and I and everybody else in our tens of millions saving for retirement, we never have any influence with the investment institutions. They don't know who we are, we don't know what they've invested in. So there is absolutely zero contact between the underlying investors and the investment institutions. And the investment institutions themselves are under great pressure to conform to management. Now, if you're very bold, if you own, say, 2% of Shell and as a fund manager, and you decide to turn on Shell and put up the pressure, if you're successful, you will get precisely 2% of the benefits. You will also get 100% of the costs and you'll get 100% of the risks. And what is the risk? The risk is that you will have the name of being an awkward and difficult fund manager, not one that we want to entrust our pension fund to. So there is no incentive to be a conscientious fund manager because you're going to lose out to your competitors. So passive investment pays. Active investment, by and large, doesn't pay. The only exceptions we have to this are those institutions that are bold enough to take the long term view. The best known example is Warren buffet in his famous firm, Berkshire Hathaway, which for 35 years has outperformed the market over any period of a few years. But interestingly, I think you'll find in nine years out of ten, it has outperformed the market on a one year basis. So what is his secret? He looks for good firms with long term growth. He puts in a very substantial investment. He goes on the board. He's welcomed on the board the management, like a knowledgeable, committed investor who's, wise other investors, lap it up. So you have a very virtuous circle, but most fund managers do not have the luxury of being judged over periods of years the way Berkshire Hathaway is. It has earned that right, I hasten to add, but it's also always had very strong private shareholders, warren Buffet and his colleagues, who still own 40 or 50% of it. So you need committed, knowledgeable, long term owners who can hold management to account and give them the incentives for long term performance. That's what we lack.