Free Markets can Race to the Top: Adjustments to Investor Incentives Can Align Management with Long Term Profit
We can’t force corporate executives to make wise long term decisions. They already want to do the right thing, but are constrained by shareholders demands to make money fast. But if we can defend their efforts to optimize shareholder value over 5 years instead of three months, corporate profits will improve along with their social and environmental impact.
The required innovation briefly:
Institutions of capitalism can save themselves from destructive short-termism without government action. All that is required is that a small set of people, corporate executives, and large fund managers, resolve to make more money for their funds over the long-term.
Corporate executives can save themselves from the short-term bonus needs of the junior clerks that manage portfolios for big institutions – they can distribute dividends in the form of Loyalty-Shares as L’Oreal and Michelin have done in the past. Loyalty-Shares are simply the equivalent of a smart executive stock option plan — some call options with claw back in the event the owner sells before the required holding period, perhaps five-years. Institutions with long-term investment priorities could offer to buy such securities if they were created.
The US government could encourage this to be done by investing in pensions in long-term oriented funds that purchase loyalty shares. In private equity markets, incentives for long-term holding are already commonplace and in the public markets “Loyalty-Shares” have been distributed to reward shareholders for sticking it out through a downturn (See: L-Shares: Rewarding Long-Term Investors; Loyalty-Shares: Rewarding Long-Term Investors).
By making loyalty-shares distribution widespread, we can make long-term focused investment more prevalent. A government incentive or regulatory requirement for loyalty-shares distribution or ownership would be required to adjust the market to incorporate more long-term investments. While we cannot force people to be wise or selfless, when acting on behalf of corporations, we can make sure they need to do what their spreadsheet says is more profitable on a five-year basis rather than a three-month basis.
The main lesson Warren Buffett has been trying to teach us all these years is that a thoughtful strategy of “buy and hold” creates much better returns than Wall Street’s casino games, while generating real value for the economy. Modest changes in the way stock proceeds are distributed might be able to make thoughtful buy-and-hold strategies the most rewarding strategy. We need the increased diligence and attention to sound management that long-term owners require. We need more people investing like Warren Buffett, holding management accountable for long-term success, while protecting them from excessive stock market volatility unrelated to their business fundamentals.
Many authors have described American corporations obsession with quarterly numbers:
Alex Berenson and Mark Cuban: The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America
Michael Lewis: Boomerang: Travels in the New Third World
Justin Fox: The Atlantic- How Shareholders are Ruining American Business
It sometimes seems like America’s public companies are exclusively making short-term decisions wholly on the basis of “optics”– how they will look between now and the end of the current quarter. In the words of GB Trudeau’s faux businessman, “I don’t oppose sound climate policy because it’s flawed. I oppose it because I care MUCH more about my short-term economic interests than the future of the damn planet.” Short-term decision-making, with terrible long-term consequences, is a common cause of many of the afflictions ruining America, which include:
- The climate crisis.
- Widespread collapsing fraudulent banking practices.
- The flight of manufacturing from America.
- The dismantling of the US education system.
- Lack of disruptive, innovative engineering.
- Lack of investment in novel drug discovery.
- Terrible government regulation that stifles innovation.
- Low investment in technologies for avoiding oil spills that probably won’t be needed this quarter, in favor of avoiding trip-and-fall accidents that always affect the current quarter.
In this environment, even the most extreme example of short-term thinking, the classic Ponzi scheme, as implemented by Bernie Madoff and many imitators, garnered the approval of investors and the authorities who repeatedly investigated him.
The question of why Wall-street is so committed to short-term ploys and flamboyant PR, rather than real investment in growing businesses is puzzling. US corporations are competing against China, whose government and corporations make five-year plans and mostly stick to them. If we cannot invest in businesses that have a five-year payback, in five-years we will be permanently behind. We have a lot of advantages over China- if we do our job right we will be more than competitive again. Can we empower corporate leaders to make feasible five-year plans?
Parents of teenagers encourage their kids to delay gratification and work to accrue skills that create opportunity in the long-term. Can we get corporations to act like grown-ups too?
The Source of the Problem
Wall-street oriented CEOs care about the current quarter because they answer to boards that represent institutional shareholders. Institutional shareholders lack loyalty because they expect to use professional analyst information to be the first rats off the sinking ship, selling it to the public at a slight discount. But the public is running out of capacity to bail out the institutions as they run America’s greatest companies aground.
The conclusion of Michael Lewis’ The Big Short is that going public drove the investment banks crazy. The moment the investment banks themselves converted from partnerships to public companies besotted with bodacious bonuses, the public was doomed to be left holding the bag of disastrous assets. But can’t public companies, even investment banks, be run well? Should going public be the death-knell of an institution?
Why does Exxon’s CEO publicly entertain the delusion that the century-old understanding of CO2 and the greenhouse effect is unimportant? Perhaps because the Exxon Board pays him $34.9 million a year, much of which is a bonus based on the next couple quarters. That incentive undercuts careful long-term decision-making aligned with the long-term interests of shareholders.
What can we do about it?
Capitalism is a game of incentives, which can be aligned with smart long-term decision-making. Suppose we create a category of stock ownership, beneficial to individuals and institutions that provide a strong financial incentive for owning stock five-years. There are various formulations. They all would require legislation to be legal and universally applicable.
- A warrant could be delivered with every stock purchase that gives one the right to purchase stock at a 15% discount between five and six years hence while you still own the stock (the limited duration of the warrant is to reduce paperwork, and when executed brings in capital and possibly tax revenue.) Another five-year out warrant could be delivered with the stock when the current one is executed to avoid trades for that purpose.
- Dividends could also be used as the five-year incentive. Owners of stock for five-years or more could receive a kicker dividend.
- The GOP pushes for lower capital gains taxes. That could make the problem worse, if it helps accelerate random or predatory short-term trading. A preferential tax reduction that rewards long-term ownership could help quite a bit. Such a plan would also need to improve incentives for tax-free pension plans.
There are probably other ways to provide the incentive to individuals and institutions to plan to own stock five-years (or longer) and therefore will use their influence to make sure corporations are well managed for five-year capital growth.
Current “long-term” capital gains tax breaks don’t help much because they accrue in only one year and are irrelevant to tax-free institutional investors such as pension funds.
Long-term planning is what America needs to grow its economy and protect its natural wealth. When you are planning for five-years of survival, companies cannot afford to ignore the perils of climate change. Companies cannot ignore the economic impact of fraudulent collateralized debt obligations. Companies can’t hide debts in hidden subsidiaries and expect them to stay hidden for five-years. Business leaders will need to act like smart people who think ahead. Pump-and-dumpers will get the boot.
These incentives would not limit planning to five-years, or create a Chinese style five-year periodicity. Because there are always new shareholders, planning does not get foreshortened as the years pass. Companies will be obliged to maintain a well thought out five-year plan to encourage investment.
Making it Happen
To make this idea reality, there are many sub goals:
- Market Test loyalty-shares
- Simply find some CEO’s who want to offer loyalty-shares
- Fund managers who want to invest in them
- Create a fund managed in that way, buzz-worthy enough to attract sufficient investors if marketed right
- Find a fund whose long-term growth objectives support loyalty share investments
- Establish a track record over a year or so to induce others to try it
- There are a number of private companies facing a “valley of death” who would like public funding but who need investors tolerant of an incubation period. I think of SpaceX as one, which knows their mission to Mars will not be realized by a public management team. They may be willing to IPO with loyalty-shares.
- Well-referenced academic papers would have to be written or cataloged that make the case for the long-term capital owning incentive.
- Leaders would have to stand up for it.
- Bankers and securities lawyers would have to verify legal and fair ways of doing it.
- Companies would implement it on their own and demonstrate the (limited) benefits.
- Political forces would have to align around it.
- Political forces would have to succeed in making the change.
Fix the Securities and Exchange Commission (SEC)?
The institution charged with protecting the value of corporate shares (and therefore the value of corporations themselves) is the SEC. Unfortunately the SEC has been engineered to lack the capacity to protect the public and the values of shares. Unlike any real law-enforcement agency, the SEC throws out investigation files the moment it decides not to prosecute, keeping folks like Bernie Madoff from losing sleep. The SEC does not even employ accountants or actuaries who could understand turgid balance sheets and discover the rot within- they trust the accountants corporations are paying. The SEC doesn’t have the budget to hire enough people, despite the fact that they would be returning a great return on the taxpayer’s dollar in fines. The revolving door is in action- SEC executives and staff look forward to post-government jobs with the companies they regulate, having come from their ranks in the first place. The statutes and GAAP rules the SEC enforces are riddled with loopholes. We should make the SEC do its job, but that’s a tall order given the starting point. Congress seems unified in its opposition to investigating fraudulent short-term schemes that keep K street lobbyists fully funded. If Congress wanted to fight fraud and waste, it would fully fund the GAO (Government Accountability Office) and reap the rewards for the taxpayers of 87 times return on investment!
Instead of waiting for Congress to give law enforcement the tools to do its job correctly, we should create a market-based way of making corporations police themselves. That requires transparency of long-term planning to the owners of the company.
Fix the FBI’s White-Collar Crime Division?
It seems impractical to wait for the FBI to begin effective white-collar prosecution. Prosecuting fraud is essential to protect the value of institutions with real ROI. History shows few examples of effective prosecution of white-collar criminals with large liquid assets and the ability to mount a robust PR and legal defense. And the FBI isn’t at fighting strength- after 9/11 it reassigned 2000 of its 2500 white-collar crime investigators to anti-terrorism and they were never replaced. The 500 FBI agents left behind have failed to prosecute anyone involved in the collapse of the banking system, although investigative reporters have no trouble finding people willing to testify about former employer’s criminal activity.
Raise Trading Fees?
In times past, higher stock trading transaction fees punished rapid automated trading, and slightly favored buy-and-hold strategies. Instituting higher transaction fees has been proposed as a way to strengthen the economy. Our guess is that restoring the traditional trading fees would make the critical distinction, favoring decade scale investors over month scale investors. It can be argued that automated day trading is beneficial in many ways. Eliminating it would not significantly encourage long-term planning. It is not clear whether shutting down the high speed trading would redirect investors to long-term planning, or, some other more rapid-fire market.
Reduce or Eliminate Capital gains taxes, or create a new tax break for owning stock five-years?
Capital gains tax breaks do not apply to many big tax-free institutions such as pension plans, at the heart of the problem. A tax break won’t encourage them to adopt long-term planning. No capital gains tax reduction proposal to date has been designed to reward long-term planning- but it is not too late to propose one.
Create new taxes or fees for short-term investments?
While one can imagine government instituting penalties for short-term investments, it is really hard to imagine the politics coming together for a new fee or tax. In contrast, the Long-Term Incentive idea is viable because it creates a new type of financial instrument that no one had before, and doesn’t restrict people from doing what they want to with their money. It just denies an extra benefit to investors who cannot maintain an investment long-term.
It might be possible to institute a transaction fee that depended on the time a stock was held, starting at a considerable amount and trailing to nothing over five-years. But the value of such a fee must be a tiny fraction of the investment’s value, and would not be a consideration in the selling decision. In contrast, the non-transferable dividend or warrant we are talking about grows in value with a huge multiple as the stock price increases and the maturity approaches- its value cannot be ignored. It would also be hard to administer such a fee. In contrast the loyalty share is a combination of two well understood instruments, a share, and a call option, and will be easy to administer.
Background References – The Problem of Short-Term Corporate Governance:
Potential Torch Carriers
Patrick Bolton and Frederic Samama: L-Shares: Rewarding Long-term Investors
Al Gore: A Manifesto for Sustainable Capitalism
Bloomberg: ‘Gore Advocates ‘Sustainable Capitalism’ as Harvard Shows Return’
Hillary Clinton is making a campaign plank, without L-shares
Warren Buffet: Shareholder Letters
Charlie Munger: A Lesson on Elementary, Worldly Wisdom as it Relates to Investment Management and Business
Michael Lewis: The Big Short and Boomerang
Forbes: Peggey Noonan On Steve Jobs and Why Big Companies Die
New York Times: A Call for Corporations to Focus on the Long-Term
Washington Post: What caused the financial crisis? The Big Lie goes viral
Truth-out: Romney’s Success at Bain Capital: The Scam as Business Model
Economist…missing the point
UnitedRepublic.org – Josh Silvers