Rewarding long-term investors
The received wisdom about investment in equities is to identify growth stocks and keep invested for the long term. Though there are some spectacular successes among short-term investors and speculators too, investment literature is replete with examples of visionary investors who have garnered fortunes by holding on to equities representing successful businesses.
This is so because in the real world, long-term wealth creation frequently involves investment in projects that involve short- to-medium term pain but offer significant value over the long term. However, the darlings of the equity market are the stocks that generate predictable quarter over quarter growth in earnings.
It is only rarely that entrepreneurs with a clear long-term vision to capture the big opportunity — transcending several economic cycles and wars — have the luxury of not pandering to the fickle equity market investor. A widely traded company does not have any control over the investment horizons of its shareholders, though it would like to keep speculators and indeed short-term investors at bay, if possible.
Short sellers generally do not enjoy a good reputation with companies and regulators because they attempt to profit by selling stocks that they do not own. Short sellers borrow stock from long-term investors like pension and retirement funds that participate in stock lending schemes.
Their purpose in lending stocks is to earn a fee that enhances yields on their long-term investments. For a well functioning market, however, there should be enough participants with differing views about valuations. By selling borrowed stocks, short sellers do play an important role in the market by imparting it liquidity that would otherwise have been unavailable.
Short sellers serve another useful purpose by beating down overvalued stocks thus preventing potential price bubbles. Regulators generally keep a close watch on short sellers for market manipulation and abuse, because in the interest of the integrity of the market such acts have to be severely dealt with — whether it occurs on account of naked short selling or on account of unbridled ramping up of prices.
The relationship between company managements and hedge funds — generally regarded as short-term traders — has of late, come to a head with companies like Fairax Financial, the Canadian insurer, and Biovail, the Canadian pharma company, suing a group of hedge funds alleging spread of rumour and untrue negative research to profit from shorting the stocks and hoping to buy these stocks at much lower prices.
Of late, there is also an effort to proactively deal with this situation by incentivising investors to hold on to stocks for the long term. A recent example is that of DSM, the Dutch life sciences and specialty chemicals company, which has proposed to pay loyalty dividends to long-term investors.
The DSM proposal envisages rewards for those registered shareholders of the company who have held the shares for more than three years at a stretch with a 30% loyalty dividend bonus over the average dividend in the preceding three-year period and increasing by 10% per year thereafter.
The intention is to not only reward the long-term investors in the company’s stock but also, as the company states “to intensify communication with these shareholders”. The DSM proposal, by adequately incentivising such shareholders to hold on to their shares, discourages long-term holders from lending their stocks to hedge funds who in turn short the stock or acquire voting rights for other purposes.
Encouraging long-term investment behaviour has taken other forms too. One such method that is particularly popular with French companies, is to allot double voting rights to long-term shareholders. In another recent development in the UK, the terms of the Standard Life floatation provided that owners who retain their shares for one year will receive an additional 5% of shares.
Why are company managements overly concerned about the investment horizons of their shareholders? Much of the “noise” in stock prices — short-term price movements that cannot be explained by any fundamental change in business outlook — is created by investors trading shares with a short-term perspective.
No entrepreneur would like someone to be able to anonymously short his stock or acquire voting rights without the attendant economic value being parted with, especially when such rights are used to seek short-term remedies from boards that may not be in the interests of creating long-term value.
Stock lending facilitates this transfer of power from long-term investors to the short-termists. The ownership agenda is to successfully execute the long-term plans of the company for which it would be helpful to have shareholders, committed to them for the long term.
For an efficient market — with abundant liquidity and where all available information is quickly fed into stock prices — it is essential to have investors with different investment horizons and with differing views on valuation.
In a market without stock lending activity and where all investors hold stocks for the long term, there is likely to be little liquidity and the price discovery process is likely to be sub-optimal. Any proposal that rewards inve-stors based on the longevity of their shareholding strikes at the root of the concept of equal treatment to all shareholders holding a particular class of shares.
There is also the potential for misuse of such proposals, especially in family-owned businesses where the family can award itself substantially higher dividends and acquire disproportionately high voting powers at the cost of minority shareholders.
Reducing the dynamics of the marketplace to a simple proposition that long- term investing is good and short-term is bad is a rather dangerous proposition. Even long-term investors would require liquid secondary markets to acquire or divest stakes in companies. The free market mechanism is the best known system to find the equilibrium between investors with different investment horizons and valuation views.
Quite often, long-term investment is the net result of a series of short-term buy/hold investment decisions. Creating a system that discriminates between shareholders of the same share class has the potential to fragment the market and is against the tenets of good governance and efficient markets.
This is so because in the real world, long-term wealth creation frequently involves investment in projects that involve short- to-medium term pain but offer significant value over the long term. However, the darlings of the equity market are the stocks that generate predictable quarter over quarter growth in earnings.
It is only rarely that entrepreneurs with a clear long-term vision to capture the big opportunity — transcending several economic cycles and wars — have the luxury of not pandering to the fickle equity market investor. A widely traded company does not have any control over the investment horizons of its shareholders, though it would like to keep speculators and indeed short-term investors at bay, if possible.
Short sellers generally do not enjoy a good reputation with companies and regulators because they attempt to profit by selling stocks that they do not own. Short sellers borrow stock from long-term investors like pension and retirement funds that participate in stock lending schemes.
Their purpose in lending stocks is to earn a fee that enhances yields on their long-term investments. For a well functioning market, however, there should be enough participants with differing views about valuations. By selling borrowed stocks, short sellers do play an important role in the market by imparting it liquidity that would otherwise have been unavailable.
Short sellers serve another useful purpose by beating down overvalued stocks thus preventing potential price bubbles. Regulators generally keep a close watch on short sellers for market manipulation and abuse, because in the interest of the integrity of the market such acts have to be severely dealt with — whether it occurs on account of naked short selling or on account of unbridled ramping up of prices.
The relationship between company managements and hedge funds — generally regarded as short-term traders — has of late, come to a head with companies like Fairax Financial, the Canadian insurer, and Biovail, the Canadian pharma company, suing a group of hedge funds alleging spread of rumour and untrue negative research to profit from shorting the stocks and hoping to buy these stocks at much lower prices.
Of late, there is also an effort to proactively deal with this situation by incentivising investors to hold on to stocks for the long term. A recent example is that of DSM, the Dutch life sciences and specialty chemicals company, which has proposed to pay loyalty dividends to long-term investors.
The DSM proposal envisages rewards for those registered shareholders of the company who have held the shares for more than three years at a stretch with a 30% loyalty dividend bonus over the average dividend in the preceding three-year period and increasing by 10% per year thereafter.
The intention is to not only reward the long-term investors in the company’s stock but also, as the company states “to intensify communication with these shareholders”. The DSM proposal, by adequately incentivising such shareholders to hold on to their shares, discourages long-term holders from lending their stocks to hedge funds who in turn short the stock or acquire voting rights for other purposes.
Encouraging long-term investment behaviour has taken other forms too. One such method that is particularly popular with French companies, is to allot double voting rights to long-term shareholders. In another recent development in the UK, the terms of the Standard Life floatation provided that owners who retain their shares for one year will receive an additional 5% of shares.
Why are company managements overly concerned about the investment horizons of their shareholders? Much of the “noise” in stock prices — short-term price movements that cannot be explained by any fundamental change in business outlook — is created by investors trading shares with a short-term perspective.
No entrepreneur would like someone to be able to anonymously short his stock or acquire voting rights without the attendant economic value being parted with, especially when such rights are used to seek short-term remedies from boards that may not be in the interests of creating long-term value.
Stock lending facilitates this transfer of power from long-term investors to the short-termists. The ownership agenda is to successfully execute the long-term plans of the company for which it would be helpful to have shareholders, committed to them for the long term.
For an efficient market — with abundant liquidity and where all available information is quickly fed into stock prices — it is essential to have investors with different investment horizons and with differing views on valuation.
In a market without stock lending activity and where all investors hold stocks for the long term, there is likely to be little liquidity and the price discovery process is likely to be sub-optimal. Any proposal that rewards inve-stors based on the longevity of their shareholding strikes at the root of the concept of equal treatment to all shareholders holding a particular class of shares.
There is also the potential for misuse of such proposals, especially in family-owned businesses where the family can award itself substantially higher dividends and acquire disproportionately high voting powers at the cost of minority shareholders.
Reducing the dynamics of the marketplace to a simple proposition that long- term investing is good and short-term is bad is a rather dangerous proposition. Even long-term investors would require liquid secondary markets to acquire or divest stakes in companies. The free market mechanism is the best known system to find the equilibrium between investors with different investment horizons and valuation views.
Quite often, long-term investment is the net result of a series of short-term buy/hold investment decisions. Creating a system that discriminates between shareholders of the same share class has the potential to fragment the market and is against the tenets of good governance and efficient markets.
posted by SY at 12:50 PM
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