The stock market's obsession with the short term gives private investors an advantage.

Why The Stock Market Is Failing Britain

Published in Investing on 5 March 2012

A new report highlights fundamental failings.

Last year John Kay, a very accomplished economist who is a director of several companies, was asked by the government to see if the stock market is serving the needs of Britain's investors and companies. His interim findings were published last week and they make interesting reading.

Kay argues that today's stock market primarily serves the interests of the fund management industry, rather than those of companies and investors. He goes on to say that a culture of chasing short-term performance targets has developed, which is damaging the British economy and also harms investors' returns.

Secondary markets are good

The London Stock Exchange (LSE: LSE) consists of two markets. Companies come to the primary market to raise capital by selling shares and bonds through initial public offerings, but afterwards these are traded on the secondary market, which is where most of the action occurs.

Many investors would be reluctant to invest in the first place if they didn't have an easy way out via the secondary market. Since they do, this encourages them to buy shares and bonds, and it allows companies to charge a higher price for their shares and bonds in the primary market.

You can always sell your shares in BP (LSE: BP), HSBC (LSE: HSBA), or indeed most other quoted companies when the market is open, but if you couldn't access the secondary market, you'd have to find a willing buyer, which could take quite some time and would greatly increase your transaction costs.

Another well-known secondary market, one which has revolutionised the trade in second-hand goods, is the auction website eBay (NASDAQ: EBAY.US). Before eBay you had to rely on word-of-mouth, classified newspaper adverts and/or specialist dealers -- today eBay gives you access to a global marketplace.

Obsessed with the short-term

Kay and his team say that the stock market tail now wags the economic dog to such an extent that it damages Britain's interests. Many contributors to the report consider that the combination of quarterly reporting and institutional fund management has caused the investing community to obsess about the next set of figures at the expense of everything else.

As a result, many companies focus on meeting the institutions' short-term expectations, often by "managing" their quarterly earnings, to such an extent that they take their eye off the long term.

Another problem is that chasing short-term targets and concentrating on beating the forecasts can encourage excessive risk-taking. This can reduce your long-term returns, as well as having some serious consequences for the economy.

We saw this happen in a big way several years ago when Royal Bank of Scotland (LSE: RBS) collapsed during the credit crunch, due to a reckless expansion programme, and it had to be bailed out by the long-suffering taxpayer.

Take advantage of the short termers

I believe that the stock market's obsession with the short term gives private investors an advantage. Unlike the typical fund manager, you won't be sacked if you have a bad quarter, so you should be able to take a long-term view.

This can pay off handsomely when the stock market is having one of its hissy fits, because when this happens, there are bargains to be had. Benjamin Graham summed this up nicely when he said; "In the short run, the market is a voting machine, but in the long run it is a weighing machine."

Separation of owner and manager

Another of Kay's concerns is that because most people nowadays invest through funds, rather than by directly owning shares, the economic interest of share ownership has been separated from the decision-making process. The choice of whether to buy, sell and exercise the voting rights attaching to shares is now overwhelmingly concentrated in the hands of the institutions.

This is nothing new; separating the control over property from its ownership has been a cornerstone of English trust law ever since the 11th century, when the King's Knights left their lands under stewardship before they went off to fight in the Crusades.

But it has mushroomed with the growth of the fund management industry during the last few decades, and the result is that most shareholders are absentee landlords with little interest in how their companies are run. The industry encourages this by offering nominee accounts, and making it very hard (and often expensive) for shareholders to exercise their votes.

The paradox of voting your shares

The difficulty that private investors have in voting shares held in nominee accounts is a bone of contention for some people. Personally I couldn't care less about exercising my voting rights unless my stake is large enough that that it might actually have an effect. If I don't like what I see, I "vote" by selling my shares.

When it comes to voting I'm a big fan of Downs Paradox, named after the public policy expert Anthony Downs who described it in his 1957 book An Economic Theory of Democracy. Downs says that if a rational self-interested person has just one vote in a very large electorate, then they should not bother to vote because this will not influence the outcome.

So, if you own 1% of the company, your vote is substantial and is thus worth exercising. The same goes if you are a constituent in a parliamentary election, which was won last time by just a few hundred votes. In both of these instances, your vote is very valuable.

But if you own 0.0005% of a company's shares, Downs Paradox says that a much better use of your time is to do something else, such as reading its report and accounts! Even though I attended Diageo's (LSE: DGE) annual general meeting last October, I didn't bother to vote -- my stake, whilst fairly substantial, is but one vote amongst more than a million others.

Kay's full report will be published this summer along with his recommendations. If you want to read his interim report you can find it at this webpage.

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