John Kay Shows How to Clean Up the Stock Market

LONDON -- It is often said that financial markets pay too much attention to the short term and too little to the long term. Last year the U.K. government decided to see if this was true, appointing professor John Kay, a well-respected economist, to look into this and to also see if the stock market was serving the needs of investors and companies.

The conclusion from Kay's interim report, published in March, was that the stock market nowadays primarily serves the interests of intermediaries, rather than those of investors and companies, because a culture of short-termism has been allowed to develop.

Kay's full report was released this week. It re-emphasizes all of the points made in his earlier report, paying particular attention to how quarterly reporting requirements and cash bonuses have caused companies and investment managers to overemphasize their short-term performance at the expense of the long term.

Managers are stewards
In the Middle Ages, when a knight went to fight in the Crusades, he would leave his lands in the hands of a steward -- a person he trusted to act in his best interests. This type of relationship is a cornerstone of English trust law because a steward is deemed to be a fiduciary and is therefore held to a much higher standard of behavior than if he or she were simply acting under contract as an employee.

Kay points out that all financial intermediaries, such as banks, fund managers and brokers, are stewards of investors' wealth. So they have a legal duty to act prudently and in their investors' best interests instead of favoring their own interests. Therefore, their use of "get-out clauses" to eliminate their fiduciary responsibilities, in particular those which allow them to have conflicts of interest, should be banned.

Misaligned incentives
Kay goes on to point out that quarterly reporting, short-term performance measurement, paying bonuses that are tied to these figures and the idea that risk is defined as volatility over the short term, are damaging the long-term performance of the economy (and investors' returns) because this pressurizes companies to invest in projects which have short payback periods.

So the incentives for company directors and investment managers need to be restructured, with bonuses being tied to long-term performance and not being paid in cash. Furthermore, if the shareholders suffer then the company's managers should also suffer, which means that asymmetrical situations where the directors win but the shareholders lose, such as getting a big bonus for ruining a company, must not be allowed to occur.

Stop quarterly reporting
Scrapping quarterly reporting requirements would reduce the pressure that's placed upon company managers to hit their short-term targets. One company that did this three years ago is Unilever (LSE: ULVR.L  ) , a stalwart of the FTSE 100 index that nowadays only releases sales information for its first and third quarters.

When it comes to long-term investing one of the greatest practitioners of the art is Warren Buffett and I've put quite a bit of money where my mouth is by owning shares in his company Berkshire Hathaway (NYSE: BRK-B  ) for the best part of two decades. What's more, Buffett has recently been buying shares in a British company. Discover what he bought -- and the price he paid -- within our latest free report!

Costs, costs
Kay also goes on to remark about how the increasingly large number of intermediaries in the financial services industry has driven up investors' costs, though these costs are often concealed in the small print. He recommends that investment managers be forced to disclose investors' costs in an easy-to-understand format.

Another issue which Kay raises is the difficulty that many investors have in voting their shares thanks to the use of nominee accounts. He recommends that the government address this by looking into a cost-effective way in which shares can be held in investors' own names on an electronic register.

Some businesses have to think long term
Sometimes the nature of a company's products forces the management to take a long-term view. A good example is Diageo (LSE: DGE.L  ) , which last month announced that it was going to invest more than 1 billion pounds in new whisky distilleries. Given that Diageo's flagship product, Johnnie Walker, takes at least eight years to mature, this shows that the company is planning for the long term.

If you want a copy of Kay's report you can find it on the Department for Business, Innovation and Skills' website. His key recommendations are on page 13.

Whether any of Kay's report will be implemented is another matter, especially since the financial services industry is almost certainly going to strongly lobby against it because it will reduce its income if implemented.

Further investment opportunities

Tony owns shares in Berkshire Hathaway, Diageo and Unilever. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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