Investor expectations are pushing companies to the edge of their competencies. Surely there's a better way to connect businesses and those who run their money? The answer is in James Featherby's Of Markets and Men.
In part II of the City Grump's series of extracts from the excellent Of Markets and Men, its author, James Featherby, draws out the disconnect between money managers and those who give them the money: you and me.
Asset managers are losing themselves in a sea of speculation and hypothetical returns. In turn, many large companies are taking ever greater operational risks in pursuit of high performance. Featherby suggests an intriguing new way we can re-engage with those who run our money and with the companies they invest in; read on!
“Speculative trading is problematic partly because there is no sense of responsibility for any underlying business or the economy as a whole, and if you are not responsible you are unlikely to care. Similarly, claims based trading, hedging arrangements that in return for a price allow us to make financial claims on others that do not vary depending on their future profitability, has produced a financial climate in which too many are uninterested in the welfare of society or the business that produces those profits. Together, speculative and claims-based trading have begun to be destructive to the process of efficient capital allocation. The market was not designed to be used for these purposes on this scale.
The decision making process of many asset managers, including pension funds and insurance companies, is heavily influenced by statisticians and actuaries with little expertise in the business of business. (…) They have the prime seats at the table, and they steer the conversation towards sectoral asset allocation and hypothetical returns, not individual investments and specific implications. We should not quickly forget that the economic theories of rational expectations and efficient markets failed to predict or prevent the financial crisis or the massive loss of share values that followed. And it is now clear that there are no risk free assets. Models that pretend otherwise are just as likely to misallocate capital as good old fashioned business judgement.
Companies are also increasingly operating at the edge of their competencies as a result of competitive pressures and investor expectations. This seems to have been the case with BP’s Deepwater Horizon, but it is also the case amongst banks, insurance companies and financial investors trading in securities they may not fully understand.
The investment in research and development of new technology for products and services including financial ones is increasingly out of balance with the investment devoted to risk identification, prevention and remediation. There was, for example, significant underinvestment by the banks in in the infrastructure necessary to understand and manage the sub-prime products they held on their balance sheets. And when a large player in a market makes a competency mistake the risk to society is increased because the consequences of that mistake tend to reverberate louder and further.
In the name of efficiency, there has also been a significant change in recent years in the trade-off between business stability and financial efficiency. Many businesses now carry minimal stock, outsource vital functions to third parties they cannot control, rely on suppliers without giving them support, and leverage their operations with significant debt. In other words, businesses are taking greater risks with less inbuilt operational resilience; and others are frequently feeling the consequences when the business stumbles or falls. The consequences are amplified when the business is big.
Scale also reduces the resilience of society in another respect. Companies tend to have command and control mentalities. This means that, even after a period of reflection, they tend to take one-way bets with their strategic decisions. Their inclination is to develop a single house view, and then follow it closely. And given the human tendency to believe and follow conventional wisdom this makes them, and therefore the rest of the economy, less resilient to life’s uncertainties.
Diversification by mega-businesses, including full service banks, does not avoid systemic risk if all those businesses are diversifying in the same way. Diversity of business model, a different concept entirely, is more beneficial to society. Complex and diverse is more resilient than complex and similar.
Modern investment has mostly become a mathematical exercise where the investor seeks to maximise its financial return commensurate with risk. It is largely uninterested in where or how the money is invested…We do not want farms that produce at the edge of the envelope: no matter what the season or the weather producing food to their maximum capacity and without regard to what that means in terms of soil fatigue, animal welfare, bio diversity, disease resilience, and frankly sheer enjoyment of the countryside.
In the end a farm run at the edge of the envelope will die of exhaustion. We do not want that in farming. We should not want that in investing… Bi-productive investment, by contrast, intentionally seeks to be productive twice - for the investor at one end of the investment chain, and for the company and its other stakeholders at the other end.
The heroes (of investment management) might no longer be mathematicians and nuclear physicists who can construct ever more intricate trading strategies. They might become social and environmental experts who can best advice how to channel private sector finance for the benefit of both society and investors. (...)
Significantly, moving towards bi-productive investment would re-connect investors with their investments, and perhaps this would be the most profound change of all. Our current investment arrangements mean that we are disconnected from where the money is invested. Few of us could name the top 10 companies in which our savings and pensions are invested. With that level of knowledge it is no wonder that we do not care what the companies do with our money, how they treat their staff, or how they handle environmental challenges. With bi-productive investment care and interest stand at the beginning of the investment process and are not left as possible by-products that are in practice usually forgotten.
Man was born free but everywhere his investment advisor has tethered him to anxiety. (...) As many have remarked, our attitude to investing has historically been dominated by fear and greed, to one degree or another. Our isolationist, reductionist, utilitarian and controlling values make us poor investors. We do not want to look a fool either by doing worse than everyone else or by missing out on opportunities that might have made us richer.
What if we decided instead that life was better when it was more of an adventure? Would we be more philosophical about any temporary setbacks in financial return, and more delighted by any unexpected financial successes? Would our savings and investments turn from being a hoard to be protected into a source of pleasure and surprise?
Connecting investors with the purposes to which their capital is put would radically reform notions of stewardship. We would see an investment environment develop that was far less short-term as investors came to appreciate that time is needed to produce and sustain financial, social and environmental benefits.
In turn, this would transform the objectives and incentives of company directors and business managers, who would no longer find themselves under pressure to manage for short-term financial outcomes rather than invest in research, development and productivity.
Businesses would develop a clearer sense of purpose, and a greater understanding of their social usefulness and this would lead to improved staff moral and engagement (…) (businesses) would be clearer at board level about corporate objectives and about communicating those objectives internally and externally.
We may need a new metaphor for business and its connection with the society of which it forms a part, including other businesses. The invisible hand is past its sell-by date, not least because the picture it paints is too individualistic. Business as jazz may be a more useful metaphor: an orchestra of different players, both within and alongside each business, each weaving their harmonies into the rhythm of the whole: every participant aware of and responding to the contribution of others; each instrument making its own unique contribution. One song. Many voices.”