Focusing Capital On The Long Term: From Talking To Walking
The title of this Letter was also the title of a workshop for Dutch pension fund managers organized by Kempen Capital Management in Amsterdam this past March.
As the title suggests, the goal of the event was to move participants from talking about the merits of ‘long-termism’ to actually living it. The program started with two ‘context’ presentations, one by McKinsey’s Dominic Barton about the ongoing ‘short-termism cycle’ that must be broken, and one by this author about what academia has to say about the ‘short-termism’ problem, and if shifting to ‘long-termism’ really increases investment return prospects.
This Letter summarizes the Barton message, and sets out mine in some detail.
The FCLT Initiative
The Focusing Capital on the Long Term initiative was kick-started by Dominic Barton and CPPIB’s Mark Wiseman three years ago. Its stated goal is to break the ‘short-termism’ cycle that rotates from a perceived need by investors for short-term performance to a perceived need for continuously positive quarterly earnings guidance by corporate boards and senior management. The result is a systemic underinvestment in the kind of longer-term value-creation that retirement savers need to generate adequate, affordable post-work income streams.
In the Amsterdam workshop, Barton listed three steps needed to break this ongoing value-destroying ‘short-termism’ cycle:
- Shift the focus of corporate boards to supporting long-term value-creating initiatives.
- Shift the focus of institutional investors to investment strategies that recognize the importance of corporate long-term value-creating initiatives.
- Create an environment of constructive dialogue and active engagement between the corporate and investment communities.
Barton pointed to a number of concrete steps the FCLT initiative has taken over the course of the last three years towards achieving these three outcomes.i The most recent initiative was the launch of the 250 stock S&P Long-Term Value-Creation Index earlier this year. Only companies with high sustainability and governance scores will be included in the LTVC Index.
What insights does academia have to offer on the ‘investing for the long-term’ question? More specifically, does it really produce higher investment returns? It was my job to answer these questions. I started with the confession of never having completed the PhD (Economics) program I entered in 1968. I escaped in 1969 to join the investment department of an insurance company. So I am only a ‘semi’ academic, but with the comparative advantage of understanding both the theory and the ‘real world’ practice of institutional investing.
One of the plusses of this duality was meeting John Maynard Keynes early in my career (only figuratively speaking, as he died in 1946). I was awed by the man’s towering intellect, his wide range of interests, his willingness to go against academic orthodoxy, his focus on solving practical problems, and his interesting social life in English high society of the day. You will see that JMK and his ideas and actions are featured prominently as this Letter unfolds. But first, a few words about my 1969 entry into the institutional investment world.
My Institutional Investor Days
My institutional assignment was to answer the question: “Is portfolio theory useful in a ‘real world’ institutional investment department?” I don’t pursue the answer to that question here, except to say that it can be, under the right set of circumstances.ii Here, I want to describe my entry into the strange world of institutional investing and what I learned.
I discovered that this world has an inside hierarchy made up of portfolio managers, research analysts, and traders, as well as an outside hierarchy made up of institutional brokerage sales people, research analysts, and traders. This unique ‘inside/outside’ world had its own currency called ’soft dollars’. The basic idea was that stock trading generated gross commissions which the broker divided into net commissions and a ‘soft dollar’ component which went into the investor’s ‘soft dollar’ account. Most of these ‘soft dollars’ were spent on research. However, there were also trips, lunches, dinners, and other benefits.
In short, here is how ‘institutional investing’ seemed to work in a pensions context: employers offered pension plans to their employees, and hired investing institutions to manage pension assets for a fee. Brokers fed an ongoing stream of trading ideas to these institutions, which in turn placed buy (or sell) orders with the brokers that generated the trading idea. And what were the motivations in this game? To ‘beat’ the competition! Brokers competed with each other to sell the ‘best’ trading ideas. Institutional investors competed with each other to produce the ‘best’ investment returns. This was ‘short-termism’ in action!
Keynes: an Early Institutional Investor!
Sometime during my 1970s period of personal discovery I became aware Keynes had described this institutional investor behavior 40 years earlier in his opus “The General Theory of Employment, Interest, and Money”. I dusted off my copy, and found that Chapter 12 reflected my own 1970s observations pretty accurately. Keynes dismissively called it “beauty contest investing”, in contrast with the real purpose of investing: turning savings into value-producing capital. It is surely ironical that Keynes had already called for a FCLT initiative in 1936!
My rediscovery of Chapter 12 raised another question: how did Keynes know so much about the strange world of institutional investing? Much later, I would discover the answer: because as a sideline, he managed the King’s College/Cambridge University Endowment Fund from 1921 to his death in 1946. Keynes was an early institutional investor himself!
How did that go for Keynes? Cambridge professors David Chambers and Elroy Dimson decided to find out by computerizing the Fund’s 1921-1946 trading and valuation records. They found that he flailed about at first (i.e., behaving like a beauty contest investor). However, he learned from his early mistakes and by the 1930s he had become a low-turnover, high-conviction ‘value’ investor. In a 1938 speech, he said the best strategy ”….is to carefully select a few investments having regard to their intrinsic value for a period of years ahead….”. And how did the Endowment Fund do over the 25-year period it was managed by Keynes? Chamber and Dimson estimate the Fund generated a net excess return of 8%/year over a passively-managed fund with the same risk characteristics.
Is there any corroborating evidence that this strategy of carefully selecting and holding investments with strong long-term value-creating prospects produces superior multi-decade returns? There is. About the same time as Keynes penned his famous Chapter 12, apparently unbeknown to him, two Columbia University professors named Benjamin Graham and David Dodd formalized Keynes’ approach in their classic 1934 text “Security Analysis”. Their most famous disciple was Warren Buffett. His estimated 1976-2011 (35-year) net excess return was 13%/year.iii
There is more. In the year 2000, Yale University’s David Swenson wrote “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investing”. In this book, he integrates the Keynes and Buffett stories, and summarizes the five common success drivers as: 1. Long-term focus, 2. Equity-bias, 3. Contrarian ‘value’/’bottom up’ approach, 4. High-conviction, 5. Simple decision-making structure. Adding credibility to his 2000 Keynes-Buffett story, Swenson had already been applying these rules to managing the Yale Endowment for 14 years, as he continues to do to this day. The measured performance of the Yale Endowment Fund? A net excess return of 5%/year for the last 20 years.
New for this talk, I uncovered two more stories that fit the ‘five common success drivers’ theme, though with a more explicit focus on long-term sustainability and strong ESG scores. David Blood and Al Gore founded Generation Investment Management based on these principles in 2004. Alex van der Velden and his team began managing money this way for PGGM in 2007 and independently as Ownership Capital since 2013. Both organizations are generating net excess returns of 5%/year with equal or lower return volatility than their index comparator.
I noted earlier that FCLT and S&P have just launched that 250 stock S&P LTVC Index based on state-of-the-art Sustainability/ESG selection criteria. To that point, my February 2015 Letter reported the results of a study conducted by Eccles, Ioannou, and Serafeim titled “The Impact of Corporate Sustainability on Organizational Processes and Performance”. The study matched up the investment performances of two 80-stock portfolios over the 1993-2010 period. One portfolio had high sustainability scores, the other low sustainability scores. The high-scoring portfolio outperformed the low-scoring one by 5%/year over the 17-year period, while exhibiting 20% lower return volatility. That same Letter turned the spotlight on the #1 sustainability company Unilever. It has outperformed its index comparator by 4%/year over the last 15 years with a beta of 0.7.
Finally, I wrote a 2014 article in support of the FCLT initiative titled “The Case for Long-Termism”.iv There I document the cases of Mass Financial Services (MFS) and Ontario Teachers’ Pension Plan (OTPP). Both organizations have generated a net excess return of 2%/year for 25 years using the principles of long-term investing set out above.
A Counter-Example from the IMF
A recent IMF study authored by Brad Jones titled “Institutionalizing Countercyclical Investing: A Framework for Long-Term Asset Owners” offers an interesting counter-example to this listing of long-term, high-performance track records. His findings are based on examining the investment behavior of a large, diverse group of institutional investors ($24 trillion) over a 25-year period.
Rather than finding the market-stabilizing, counter-cyclical behavior he had hoped for, he found the opposite to be true. Specifically, he found that, on average, institutional investors contribute to financial market instability in two equally-important ways: 1. Investors fail to rebalance after major market movements, and 2. Investors chase performance by doubling up so as to ride major market trends (i.e., they chase historical performance in the hope it will continue).
In short, the IMF study shows ‘short-termism’ is alive and well in the global institutional Investment community, and continues to adversely affect the behavior of financial markets. Jones concludes that changing this will require four things:
- More effective institutional governance
- Recognizing and addressing underlying principal/agent problems
- Measuring the right things, including the longer-term risk of failure
- Updating regulatory processes to promote counter-cyclical rather than pro-cyclical behaviour
Will this be enough to take us from talking to walking the ‘long-termism’ road?
George Bernard Shaw and John Maynard Keynes would both say ‘no’ to that question:
Shaw: “The reasonable man adapts himself to the world……..the unreasonable one persists in trying to adapt the world to himself…..thus all progress depends on the unreasonable man……”
Keynes: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally…”
I agree with them, and that leaves us with two possible paths to walking the ‘long-termism’ road:
- Persuade more unreasonable, unconventional people like Keynes, Buffett, Swenson, Lamoureux, Bertram, Gore, Blood, van der Velden, Wiseman, and Barton to join the cause…..
- Somehow turn long-term investing into a reasonable, conventional practice.
Fortunately, these two paths are not mutually exclusive. The more unreasonable, unconventional people start walking down the ‘long-termism’ road, the more it will seem like a reasonable and conventional thing to do.
- For example, my April 2015 Letter summarized the key recommendations in the FCLT’s 54-page “Long-Term Portfolio Guide” related to investment beliefs, risk appetite, benchmarking, and incentive compensation. It is Chapter 22 in my just-released book “The Future of Pension Management”.
- For a more complete answer, I refer curious readers to the 1979 FAJ article (with Jim Farrell) “Can Active Management Add Value?”
- Frazzini, Kabiller, Pederson (2013), “Buffett’s Alpha”, NBER Working Paper. Ambachtsheer (2014), “The Case for Long-Termism”, Rotman International Journal of Pension Management, Fall 2014.
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