A short-term stranglehold
Over the years, the horizon on which investors base their decisions has become ever shorter. According to McKinsey, in the past forty years the average period a share is included in a portfolio fell from 4.8 to 1.6 years. The management of listed companies complain that the enormous attention that analysts and investors pay to the figures for the next quarter leads them to invest less than would be good for maximum value creation in the long term. McKinsey found that medium-sized and unlisted companies annually invest 9.8% of their assets whilst comparable listed companies only invest 2.2%.
Although pension funds would be pre-eminently suited to be long-term investors, they participate in this short-term dance: in particular on the public markets, attention is often focused on the performance in the short term compared to a benchmark and the management thereof: If an internal or external manager shows one or two years of ‘under performance’ you must be someone very special not to sack them.
Two years is not really a period in which there is sufficient time to focus on the strategic value creation which takes place in the underlying companies.
The invisible hand
For pension funds, passive or near passive investment has in the past ten years proved to be a good, simple and reliable recipe for realising market returns. Nevertheless, passive investment in the market index also contributes to short-term investment: by trusting that the invisible hand of the market is going to ensure that the price is right and so for an optimum use of the invested capital in the long term.
As many investors trust this invisible hand, who then makes sure there is an efficient deployment of scarce capital in the long term? In a sense we are the collective ‘free riders’: we trust that returns on the stock markets are realised ‘automatically’. We use the stock market highway as we see fit but never consider who is doing the maintenance. We are subsequently surprised if the road contains big potholes in the form of financial crises or badly managed companies. The body of thought behind the efficient market, as expressed by Eugene Fama for example, provides the theoretical backup for this behaviour.
Something is therefore going wrong between the demand and supply of capital. And there is more: many companies produce relatively high-levels of CO2 as a side effect of their activities, for example. In the short term that may lead to profit maximization but in the long term it will result in the companies – and us – being confronted with both a social and an economic problem.
It could even be argued that one of the reasons for the Big Financial Crisis was that there was a collective belief that the market corrects and heals itself: ‘Sit back, relax and enjoy the flight’.
The discomfort described above is increasingly being experienced on a wider scale worldwide
Pension funds, asset managers and companies are convinced that they can perform better than they are currently doing and that this will provide added value both for their members and for society.
There is a fast-growing group of investors engaged in long-term investment. Internationally this is FCLT, ‘Focussing Capital on the Long-Term’ for example. This is a joint venture between pension funds, companies, asset managers and consultants. PGGM is a member, just as a number of other pension investors worldwide. FCLT develops tools and approaches which support institutional investors and the management of companies in value creation in the long term.
In the Netherlands, the subject matter is explicitly on the agenda of the CIO consultation, where CIOs of 15 pension funds and administrators come together. At a recent meeting of Kempen Capital Management, FCLT was the focus of attention. A room full of people from the Dutch pension sector was enthusiastic – and occasionally sceptical – about long-term investment.
In practice, long-term investment means different things to different people.
But what exactly is it? Many people have written about it (there is a list at the bottom of the article). Below, I list the ingredients which, in my view, form the core of what long-term investment entails:
- Value: the price (what I am currently paying in the market) and the value of an investment are not always the same. ‘Expensive’ and ‘cheap’ do therefore exist. Expensive and cheap do not exist in the efficient-market hypothesis.
- Fundamental thinking: in the long term, the value created by a company or an investment also determines the market price. You must therefore understand how this value creation comes about.
- Focus: on the basis of this knowledge, you are keen to invest in some companies but not in many others. Logic dictates that you invest in much fewer companies than in the whole market and you add focus to the portfolio. This again is a major deviation from the efficient-market idea.
- Patience: you invest long-term in a company because you expect that your capital will be used efficiently and that it will lead to good returns in the long term. You are patient.
- Stewardship: logically you will act as an owner. You are involved and make sure that the company is well managed, realises a better return and manages its risks properly.
- Benchmark: such an approach demands a framework in which a benchmark is given a totally different meaning and plays a different role than is currently typically the case.
- Broad return concept: the return concept includes more than the financial return. An important question is also: does this company deliver prosperity gains in the long term (a contribution to sustainable growth) or are their major negative side-effects (CO2-emission)?
Special role for pension funds
With the growing awareness that pension capital is most eminently suitable to fulfil a long-term function, we are facing the question how we can shake off the grip the efficient-market theory still has on our behaviour and our way of thinking. I view the efficient-market hypothesis as an important part of a greater whole. The greater whole is concerned with the question how to allocate scarce capital successfully in the long term in a world which, at most, only in a limited way meets the assumptions of the current theory. The current theory would then become an beautiful room in a larger home.
This puts a special responsibility on and provides an opportunity to the asset owner, such as the pension fund for example. The asset owner potentially has the horizon, the knowledge and the scale to have a material impact on the allocation of capital and the results of this in the form of returns and prosperity.
To lend substance to this, it is important to formulate the broader return concept and devise ways to make this operational. How do I acquire the competences and how do I create the context to operate successfully in the long term? Do I also want to realise social gains with my investment? Do I want to deploy the steering power of money to stimulate the sustainability of the Netherlands and the world? And for which part of the fund that I manage?
The advantage of a wider perspective is the insight we acquire on the value creation which we can realise together as institutional investors. More long-term stimulus from investors is going to encourage companies to demonstrate more long-term behaviour in the use of capital: there will be more value creation and a sum which is greater than the (invested) parts.
In the coming years FCLT and Dutch and other parties will work out the body of thought behind long-term investment further – probably on a limited scale first – and give it concrete substance.
It is also important that a theory emerges which shows that long-term investment is a properly substantiated step for long-term asset owners such as pension funds. It would not surprise me if this were to lead to a Nobel prize one day! The most important ingredient for getting from thinking to doing is the will and the conviction that gains can be realised, both for the funds and for society.
Andrew Ang & Knut Kjaer: ‘Investing for the Long Run’, 2011
Rafaelle Della Croce, Fiona Stewart & Juan Yermo: ‘Promoting longer-term investment by institutional investors: selected issues and policies’, on OECD.ORG, 2011
FCLT: ’Investing for the future: a long-term portfolio guide’ on FCLT.ORG, 2015
John Kay. ’Other People’s Money’, Profile Books, 2015
John Maynard Keynes, ‘The General Theory of Employment, Interest and Money’, chapter 12, 1936.