Corporate Governance: Cash in hand


IPE logoWhile there are signs that the world economy may finally be on the road to recovery after five years of financial crisis, that upturn has yet to hit full speed, partly because companies are reluctant to invest. Indeed, they seem happier to return money to shareholders than to put it to use themselves.


In the US, companies are spending more money on buying back their shares than at ºany time since 2008 – $448bn (€330bn) in the year to September, according to Factset. The 30 companies of the Dow Jones Industrial Average authorised $211bn in share buybacks in 2013, almost three times the amount they spent on research and development. And when they aren’t giving it away, companies are sitting on mountains of cash – according to the Federal Reserve, US-listed companies, excluding the banks and utilities that have mandated reserve limits, have some $1.7trn salted away.


So are these buybacks a good use of idle funds, or are businesses giving away money that would do more good for the sustainability of the business in the long-term by being reinvested? And further, is there a danger that a desire for the corporate-governance discipline of higher dividends and buybacks on the part of shareholders might be sapping companies – and the wider economy – of capital for productive investment?


“The real issue is does short-termism drive behaviours that are not in the long-term interests of the business?” says Rory Sullivan, strategic advisor to Sweden’s Ethix SRI Advisers.


Executives often act in ways that could damage the longer-term health of their businesses in order to meet or beat consensus estimates, argue Tim Koller, Rishi Raj and Abhishek Saxena in a 2013 McKinsey paper, Avoiding the Consenses-earnings Trap.


“Executives may forgo value-creating investments in favour of short-term results, or they might manage earnings inappropriately to create the illusion of stability,” they write.


Similiarly in The Economic Implications of Corporate Financial Reporting, published in the Journal of Accounting and Economics in 2005 by John Graham, Campbell Harvey and Shiva Rajgopal, a survey of 401 executives and 20 in-depth interviews found that “the majority” would avoid initiating a positive-NPV project if it meant falling short of the current quarter’s consensus earnings, and that three-quarters would give up economic value in exchange for smooth earnings.


“Managers believe that missing an earnings target or reporting volatile earnings reduces the predictability of earnings, which in turn reduces stock price because investors and analysts dislike uncertainty,” the authors wrote.


Markets respond adversely to spending if it is over a longer time scale than they are prepared to tolerate – but their time scale can rule out initiatives such as staff training and energy efficiency that are clearly good for the business, says Rob Lake, a responsible investment adviser who has worked for the UN Principles for Responsible Investment (PRI) initiative, the giant Dutch pension fund APG and Henderson Global investors. “CEOs take it for granted that markets are short term,” he adds.


The short-term focus of many investors is a major barrier to companies being able to invest for the future, says Georg Kell, executive director of the UN Global Compact, the voluntary corporate sustainability initiative. “It makes it difficult to justify investments such as long-term pollution controls, market building in emerging markets and long-term sustainability initiatives.”


The Prince of Wales recently reminded the industry that this is not just a technical issue – people’s ability to fund their retirement is at stake, he told a conference organised by the UK’s National Association of Pension Funds. “With an ageing population, and pension fund liabilities that are therefore stretching out for many decades, surely the current focus on ‘quarterly capitalism’ is becoming increasingly unfit for purpose?” he said.


If companies do have a short-term focus, “it starts at the top of the food chain” with the asset owners, says Jane Ambachtsheer, global head of responsible investment at the consultancy Mercer. “If you start with quarterly performance, you’re saying: ‘this is what we’re measuring – go get it’. It’s really challenging to change that.”


The issue affects all of the investment chain, says Robert Talbut, CIO at Royal London Asset Management. “Companies are more short-term in their outlook because of pressure from investors, and investors are more short-term because of pressure from asset owners,” he says.


“There is a demand for income from investors, in part due to the low interest rate environment,” says Alice Evans, fund manager, sustainable investment at F&C. “But there is a difference between investors in the true sense and traders. Over time, the number of real investors has diminished and that role has been taken by traders.”


These traders tend to shout a lot louder than longer-term shareholders and they do not hold securities long enough to see the fruits of any long-term investments. As a result, “there is a danger that the views of long-term investors will be squeezed out of the debate by the demands for short-term successes,” Talbut warns.


The irony is that missing earnings targets appears to make little difference to share prices. According to the McKinsey article, “a company’s performance relative to consensus-earnings estimates seems to matter only when it consistently misses them over several years”, so management teams “need not go to extremes to meet or beat analysts’ expectations if it means damaging the long-term prospects of the company”.


However, it is too simplistic to say that investors are therefore wrong to demand cash back from companies in all cases.


“Returning money to shareholders may not be the problem,” points out John Kay, whose government-sponsored review of the UK equity market drew attention to the short-termism issue in 2012. “We have all this cash piled up on corporate balance sheets for no evident purpose.”


In addition, there is a lot to be said for the discipline of paying a dividend, says Evans. “When you have no constraints on spending, it can be more difficult to make sensible decisions than if you have an ongoing commitment that you need to meet.”


Companies should be pressurised to distribute surplus cash if they cannot find a good investment destination for it, argues Talbut. “That is not short-termism,” he insists. “It is about the efficient allocation of capital. It is unsustainable for companies to sit on that money.”


In the oil and gas industry, investors are concerned about “the vast amounts of cash being pumped into large projects where the value has collapsed, with a detrimental effect on future growth and dividends,” says Jim Stride, head of UK equities at AXA Investment Managers. Some projects in the sector, such as investments in tar sands in Canada, “are on such a scale that if something goes wrong, there are going to be big problems”. The bigger the project, the greater the risk of cost overruns, he adds.


“These funds belong to shareholders and when there is excess capital, you have to ask who has more capacity to use the money – the company or its investors,” adds Shade Duffy, head of corporate governance for Axa IM. “If shareholders want to take capital out of a company, it does not mean they are only interested in the short term. Sometimes, it stops capital going to projects that would be detrimental to the survival of the company.”


The mining group Rio Tinto’s $38bn purchase of Canada’s Alcan in 2007 – since written down by more than $25bn and described by Dick Evans, the former Alcan CEO, as one of the “worst decisions ever” – is one example of where shareholders could have stepped in, she adds.


So how can we overcome this short-term bias in markets? One answer, Evans says, is for investors to focus more on environmental, social and governance (ESG) issues when they take investment decisions. “ESG investors are inherently long-term,” she points out.


This is becoming easier as more ESG information becomes available and that information improves in quality.


Investors also need to engage more with companies, says Sullivan, and not just at earnings time. “Because companies tend to engage during results season, the conversation is inevitably focused on the last quarter and the next quarter. Introducing anything longer-term sounds like an irrelevant distraction. But because investors don’t raise other issues, companies think they are only interested in the numbers. Companies and investors should try to meet at least once a year outside the annual meeting.”


From June, an Investors’ Forum, one of the recommendations of the Kay Review, will be up and running and will include foreign investors as well as those based in the UK. The Forum will allow investors to collaborate and give fragmented shareholder bases a stronger voice in their relationships with the companies they invest in. The December 2013 Report of the Collective Engagement Working Group set up to investigate the establishment of this Forum also endorsed the idea, suggested in the Kay Review, that companies should invite their major investors to dedicated annual strategy meetings.


“Companies need to build relationships with investors, rather than with ‘the market’ as a concept,” Evans says.


Companies can play their part, too. As well as that idea of the annual strategy review, some might follow the example set by Unilever, which famously eschewed quarterly earnings and profit reporting. To facilitate this, the UK has accelerated implementation of EU plans for a more relaxed reporting regime that will excuse firms from quarterly reporting. It is an approach backed up by recent research from Francois Brochet, Maria Loumioti and George Serafeim of Harvard Business School, ‘Short-termism, Investor Clientele, and Corporate Performance’, that suggests companies taking a long-term approach will attract investors with a similar perspective – and vice versa.


Yet while there has been progress, there is little evidence that a wholesale cultural change has happened. “We have not seen a systemic change towards longer-term investing,” Ambachtsheer says, while Lake adds that “there is still a very long way to go”.


However, Kay suggests that this merely requires patience.


“We are talking about making long-run cultural changes,” he says. “It is difficult to assess progress yet.”