Note: I wrote this post back in 2012. I’ve refreshed it here because Hillary Clinton seems to have adopted this particular issue as her main bone of contention with Wall Street. Fun times!
Some graphs showing how long we tend to own a particular share:
Some potential conclusions to draw from those graphs:
- The big institutional investors, normally the long-term holders of shares, are now being completely out-traded by the speed with which small speculators and hedge funds are turning over their stock-holdings;
- There’s a formula error where short-selling is counted as a negative holding period (always possible);
- Big institutional investors can lower costs by trading in derivatives linked to shares, rather than the shares themselves; or
- Some other explanation that I haven’t thought of.
Look, clearly, a big part of the reduction is the growth in high frequency trading – because those traders buy and sell so rapidly that they’ll certainly be skewing the holding period downwards. And they’re not buying the share for value – they’re buying the share for arbitrage – so they really shouldn’t count. That said, I’m going to discount them from the equation because these trends in shorter-term shareholding have been in place since the 1980s – back when some stock exchanges were still trading on a floor with brokers making hand signals at each other.
But regardless of the reason for the short-term trading bias, there is a bad managerial incentive being created.
So let me bring Jack Welch AKA Mr General Electric into the picture. Mr Welch built up his investment and directional philosophy around the concept of Shareholder Value Maximisation, which basically says that the main goal of managers and directors should be to maximize the share price for the holders of the company’s shares. And his message spread far and wide.
So at first, it seems like a fairly good idea. The owners of the company will surely have the greatest interest in seeing the company grow and do well. And the business world then turned its attention to “aligning the interests of management with those of the shareholder” by granting management share options and performance-linked bonus incentive schemes and so on.
The problem is: what happens when the owner of the business is only interested in having his value maximized over the next 7 months, or the next few weeks, or some other incredibly short period of time? Because that’s what the above graphs are implying: that the average shareholder expects to extract their maximized value within a year of buying their shares.
Next question: are such owners interested in long-term projects? Or in sustainable growth that might require some upfront capital investment, but will pay out great returns in three to four years time? And are these owners even interested in replacing capital equipment?
If we’re honest, I think that we’d answer all those questions with a collective negative. Because those shareholders are interested in quarterly earnings, and how those can be maximized by cutting costs and generating the greatest profit from the assets immediately disposable to that end.
Far from value maximisation, that sounds like value destruction for future shareholders.
To the point where Jack Welch turned around and called his idea the worst in history.
Awkward.
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.
