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Week commencing 7 August 2006 |
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Proxy Voting: Another Example of How Herding Can Hurt |
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From being reluctant participants, institutional fund managers are embracing proxy voting. What might be good for one is not necessarily beneficial for the whole market when everyone decides to join the herd. Over the last 25 years, the proportion of stock held by institutional investors in advanced industrial economies has risen dramatically. According to one estimate, U.S. institutional investors now hold approximately half of all listed corporate stock and about 60% of the outstanding shares of the one thousand largest corporations. In Australia, it would not be unusual among the larger listed companies for three quarters of outstanding shares to be held institutionally. With this dominance has come a practical problem. Because of their size, stocks have become progressively harder to sell from large institutional portfolios. Not only might the position be difficult to sell but something else would have to be found in which to invest. It might be just as easy to change the company by forcing a new strategy upon management or, ultimately, precipitating the introduction of an entirely new management team.
An Alliance of Mutual
Interest Such relationships are being fostered further by the strong likelihood that the same fund managers will be invested in other companies on whose boards these directors also sit. At the same time, public opinion, never wholly favourable toward big business has taken on a more aggressive tone toward company management. The greater public scrutiny which has also been supported by more extensive government regulation gives institutional managers additional scope to justify more activist roles. It must be said that ego also plays a role. Some fund managers enjoy being called on by the nation’s most prominent chief executives to solicit their approval. Increasingly, too, executives find a common interest with fund managers. The value of their executive option packages will depend on them persuading fund managers in enough numbers of the merits of their business plans. Conversely, fund managers will believe that their own performance bonuses will depend on company executives taking up their suggestions about how to structure their businesses in a different way to help boost short term investment returns. An unlikely bond is formed between the two groups which might not always be in the best interests of the shareholders of the company if, for no other reason, they have different investment time horizons. Fund managers are having their investment performance analysed quarterly with business being affected after one to two years if performance is deemed to be inadequate. The tenure of chief executives is down to three or four years in many instances so that some results where changes are required need to be evident in about half that time. Meanwhile, investors planning for retirement want to see stable investment returns over a decade or more. The last group can afford to be the most patient of them all.
Proxy Advice: Form a
Herd Here That saves the institutional fund manager from having to commit resources directly to consider individual proposals or to develop criteria to judge companies consistently across a portfolio. There might be good sense in an individual manager taking this course although, culturally, the industry does have a tendency to use consultants as a risk mitigation tool. However, duplicated across the market, the tendency to outsource these judgments means a single specialist proxy advisory firm or a few like minded firms with many clients can dominate market decision making. A more complex systemic risk arises when a proxy advisory firm gains enough market clout to be able to approach companies to advise them, based on its share of investment market advice, on what is likely to get past shareholders and how the companies should go about framing their resolutions. Companies, based on this advice, put forward what they think will be accepted by the institutions who dominate the voting. The institutions, also based on advice, are encouraged to vote for resolutions which have the imprimatur of the advisers.
Conspiracy Theory or
Simply What Usually Happens? After all, no one really objected when the first equity analyst at a broking firm said that he had come up with a bright idea for how one of his companies could restructure its business to boost returns for its shareholders. What could have been more innocuous than that? Certainly, his initiative was welcomed by his corporate advisory colleagues who used the idea as the basis for a business pitch to the chief executive of the same company. The chief executive was happy to have the idea. Later, everyone considered it reasonable for the analyst to be rewarded in some way for contributing to the broader interests of the firm. Justice prevailed. The same analyst was then encouraged to come up with more similarly commercial ideas. Meanwhile, analysts at other firms were being told how their firms were losing business because they had lacked the commercial acumen of their colleague down the street. People also thought it was reasonable enough when the chief executive decided to allocate the next investment banking mandate to an adviser, when all other factors had been considered, based on which firm was most likely to have a favourable recommendation on his stock. How else was he going to decide objectively? If these had been isolated instances gone uncopied within the investment market, probably no one would have minded. They might even have been considered beneficial and in the interests of market efficiency. With the benefit of hindsight, however, we know that what had appeared originally as innocuous behaviour eventually and seamlessly merged into overtly criminal actions leading to extensive legislative changes in most western financial markets to alter the relationship between equity analysts and corporate advisers within the same operating group. The lesson here is that markets left on their own seem incapable of striking the right balance. The herding instincts are just too strong. History says we assume otherwise at our peril. And, because systemic dangers often arise from such seemingly innocuous behaviour, early intervention nearly always appears unreasonable. Consequently, it falls to individual investors and their governments to pick over the mess, sometimes with outdated and irrelevant legislation by the time they get round to it, only after the risks have been realized. |
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Weekly Chart Spot |
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Expenditure in Australia on mineral exploration is pushing toward record levels. For the year to December 2005, the Australian Bureau of Statistics has estimated that mineral exploration spending came to $1,136.1 billion. Its survey of industry spending intentions suggests that spending in the six months ending June 2006 would have been 26% higher than in the corresponding period of 2005. If the higher expectations have been realised, total spending for 2005/06 would be close to $1.4 billion. As well as showing the exploration spending tally including the survey results, the chart shows the movements in the non rural commodity price index published by the Reserve Bank of Australia. The expected turn in exploration spending has come with the improved industry pricing conditions. |
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International Accounting Standards: Do They Matter? |
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Since June 2005, all reporting entities under Australia’s Corporations Act have had to prepare financial statements according to International Accounting Board (IASB) standards. the impact on the reported earnings and balance sheets of companies are not uniform and depend, in part, on the nature of their businesses and their historical asset valuation methodologies. In any event, it is unclear how much investment markets have already been taking account of differences in accounting practices to value companies. A growing number of studies has attempted to measure the benefits from adopting international accounting standards or bringing regulation of local companies, including disclosure policies, into line with more common international standards. Covrig, DeFond and Hung[1] tested whether adoption of international accounting standards enhanced the ability of companies to attract foreign capital. They found that average foreign mutual fund ownership was 45% higher among firms using international accounting standards and that average foreign mutual fund ownership increased by 35% in the year following a switch from local accounting standards to international accounting standards. This study covered 29 countries including Australia and over 25,000 mutual funds. Armstrong, Barth, Jagolinzer and Reidl[2] studied the European reaction to international accounting standards adoption and concluded that equity markets responded positively to evidence that increased the likelihood of international accounting standards being adopted. These gains were more evident among companies not already cross listed in the USA. Using the Fama-French three factor valuation model, Gomez-Biscarri and Espinosa[3] concluded that valuation models are likely to work best with standardized accounting data. The model worked well for companies within a single accounting jurisdiction whether that was an individual country or globally, when all the companies had switched to IASB standards. The model worked least well when trying to compare values across borders among companies using different standards. This led the researchers to conclude that a unifying framework of accounting reporting would improve the efficiency of the global financial market. Hope, Jin and Kang[4] investigated the factors which influence countries’ decisions to adopt international accounting standards. They concluded that adopting international financial reporting standards can improve investor protection and make capital markets more accessible for foreign investors. Barth, Landsman and Lang[5] investigated whether reporting under international accounting standards is associated with predictable differences in accounting quality and cost of capital. They found an improvement in accounting quality and, less conclusively, that there is some reduction in cost of capital after adopting international accounting standards. Although not a study dealing primarily with international accounting standards, Hail and Leuz[6] found that more rigorous market regulation leads to a reduction in company cost of capital but that the benefit is largely confined to the markets to which capital restrictions apply. When markets are fully integrated so that investors are free to choose the destination of their funds, the benefits of regulation become negligible. The balance of evidence seems to suggest that common accounting standards should be beneficial although the research also seems to say that it does not necessarily matter what the common standard is. For example, there is nothing in these studies which says that US GAAP is going to be less beneficial as a standard than those overseen by the IASB. The research also seems to say that benefits are more likely to flow from accounting standard changes when governments are preventing the free flow of capital. More rigorous disclosure practices appear to ease some of the costs associated with barriers to the flow of capital. Put another way, the more fully integrated a country’s capital market is with the international capital markets, the less beneficial is accounting standard harmonisation going to be. That said, the effects of regulatory and accounting standard changes are still evolving so that research conclusions are necessarily tentative and subject to review in light of new information. [1] Covrig, Vicentiu, DeFond, Mark L. and Hung, Mingyi, "Home Bias, Foreign Mutual Fund Holdings, and the Voluntary Adoption of International Accounting Standards" (December 2005). EFA 2006 Zurich Meetings [2] Armstrong, Chris S., Barth, Mary E., Jagolinzer, Alan D. and Riedl, Edward J., "Market Reaction to Events Surrounding the Adoption of IFRS in Europe" (April 2006), Research Paper 1937, Stanford Graduate School of Business. [3] Gómez-Biscarri, Javier and López Espinosa, Germán, "The Influence of Accounting Standards on Valuation Models: An Application to the Fama-French Model" (April 25, 2006). [4] Hope, Ole-Kristian, Jin, Yiqiang Justin and Kang, Tony, "Empirical Evidence on Jurisdictions that Adopt IFRS" (May 24, 2006). [5] Barth, Mary E., Landsman, Wayne R. and Lang, Mark H., "International Accounting Standards and Accounting Quality" (March 2005). [6] Hail, Luzi & Leuz, Christian (2006). International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?. Journal of Accounting Research 44 (3), 485-531. |
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Publisher |
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As
Chief Economist and a director of a leading
Australian investment bank as well as a
top-rated institutional equity analyst, he has
marketed investment advice in all the major
international financial centres.
As a
professional economist, he was also a senior
member of John Howard's personal staff when the current Prime Minister was Commonwealth Treasurer. |
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