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Kay review thinks the unthinkable on the City’s inner workings

Treating shareholders differently and abandoning quarterly reporting could be effective ways of introducing more long-term thinking into equity markets

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, or block the American takeover of Cadbury, 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.

The interim report by the Kay review of Equity Markets, chaired by economist John Kay and published last week, set out the problem perfectly.

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.

In fact, as Kay explains, this idea of “stewardship” is far from the reality of today’s economy. Share ownership in UK plc is widely dispersed; a growing proportion of trades are executed automatically by computer; and fund managers often have to account for their performance each quarter, despite the fact many of their clients, not least pension fund members, are only interested in returns over a much longer period. All this tends to militate against investors spending time building up an intimate knowledge of the firms they own, and thinking about their long-term strategy.

As Kay says, some shareholders take a long-term perspective and are closely engaged with the companies they hold stakes in; many others are not. Tellingly, former Tesco boss Sir Terry Leahy told the review he had “missed the opportunity” for more constructive engagement with his shareholders.

David Swensen, who manages Yale University’s bn endowment fund, says he likes to “kick the tyres” of the businesses in which he takes a stake; but many fund managers go nowhere near the companies they invest in. The ultimate owners, often pension fund beneficiaries, are even more removed.

There are many reasons for the lack of a culture of stewardship by the owners of today’s companies; but Vince Cable, who commissioned the report, has rightly identified it as one of the bugbears of the British economy.

Kay takes aim at two of the treasured fixed beliefs of financial markets.

The first is the idea that investors must be treated equally. Firms with two classes of shareholders used to be common, and still exist in the US: for instance News International, where the Murdoch family holds a minority stake, but a majority of the so-called B shares that carry voting rights.

But in the UK, the notion of treating one group of shareholders differently has become anathema. Kay signals that it may be time for that to change. Perhaps, for example, the short-term “arbitrageurs” who pile into shares after a corporate bid is announced and can then help push through a takeover could be denied voting rights.

But as Kay suggests, “the principle of a qualifying period before voting rights are acquired might be applied generally, and not just in the context of a takeover.”

Placing short-term traders at a disadvantage to longer-term investors would be controversial; but it could start to sow the seeds of a cultural change in the City.

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”.

But as became clear during the credit crisis, what’s good for the share price in the short term isn’t necessarily to the benefit of the company, let alone the wider economy, in the long run.

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.

Even Jack Welch, the legendary GE boss regarded as the father of the idea of “shareholder value”, has since disowned his offspring, telling the FT 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.”

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. In the worst cases, as Enron’s sorry tale showed, the frenzied pursuit of “the number” can lead to outright fraud. But even in the best, it can lead to the corporate equivalent of the kind of initiative-itis that afflicts chancellors when there’s a budget in the offing.

Judging by these musings, Kay is ready to think the unthinkable about the inner workings of capitalism, UK style. The cult of boardroom excess that’s built up over 20 years, the desperate bailout of the financial sector that once accounted for a major chunk of FTSE100, and the sell-off of many of our proudest firms is ample evidence that such a fundamental rethink is long overdue. © 2012 Guardian News and Media Limited or its affiliated companies. All rights reserved. | Use of this content is subject to our Terms & Conditions | More Feeds