04/08/2012 Do stock markets serve investors?

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Do stock markets serve investors?

AT its height, the British Empire was one of the largest in the world, with less than 1% of world

population controlling at its height one quarter of the world's population and one-fifth of the

world's land area.

One reason for the empire's longevity is 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 has happened and make recommendations for change. This is normally independent of the

civil service and vested interests.

The best part about such royal or independent inquiry is that there is official deniability the

recommendations are those of the experts, and not necessarily those of the government. If the

public liked the recommendations, the government could adopt these 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 Prof 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 questioned 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% from peak to trough in the recent crisis. The impact on

corporate governance has been questionable, because it was 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.

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

04/08/2012 Do stock markets serve investors?

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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% of GDP to less than 10% of GDP and their R&D is the lowest compared with the United

States, 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 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%, compared to 54% in 1963. The

proportion of insurance companies and pension funds ownership had fallen from 20.8% and

31.3% respectively in 1991 to 8.6% and 5.1% respectively in 2010. What have grown in

proportion are foreigners (global investors) accounting for 41.2% 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% 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 create bubbles far beyond fundamental value. During crises,

their short-termism reduce liquidity and exacerbate 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 United States, Europe

and Japan have not recovered their losses from the crash. These four markets have lost 65%,

8%, 34% and 53% 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

exceed 100% 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

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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 would 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.

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