Showing some faith in long-range forecasts: PosTel Investment Management's Alastair Ross Goobey argues investors are often to blame for fund managers' short-termism

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The Independent Online
ANYONE who wonders where the revenues from North Sea oil go should take a look at the enormous overseas assets now owned by the pension funds.

Pension fund managers, for all their faults, understood that the balance of payments surplus created by North Sea oil, and the concurrent strength of sterling, were likely to be transitory.

At the end of last year UK pension funds had an estimated pounds 120bn invested in overseas equities, bonds and property. If the yield from that investment is only 3 per cent, that adds up to net income of more than pounds 3bn a year. And that ignores potential capital gains on the investments and the hedge they provide against the chronic weakness of sterling.

But pension funds will not win themselves any praise for their contribution to the financial well-being of the nation while they stand accused of starving industry of capital and creating short-termists out of management.

So how much truth is there in these allegations?

To take short-termism first, where there is room for concern is whether the current structure is conducive to one institution taking a distinct approach from the next.

Pension fund managers are constantly threatened by the performance tables, so that if they do what every other pension fund manager does, there is little personal risk. If they do something different and get it right, they may gain some business; if they do something different and get it wrong, they could lose all their business.

The responsibility, how8ever, lies with the trustees and consultants who hire and fire the managers. It is they who must think whether they are acting in the best interests of their schemes, or simply churning out managers.

To quote Roy Harrod in his Life of Keynes: 'Having chosen his stocks carefully, he was entirely unwilling to be frightened out of them by short-term reverses. Nor did he take quick gains. Having convinced himself that the stock had a good long-term future, he waited patiently, through ups and downs, for the long-term potential to develop.'

That is how I think investors should behave - and we do. We explicitly tell companies that we will support them against hostile bids, unless and until the management has lost our confidence.

We invite companies to test our reaction to capital-raising or new investment plans, and are not fearful of making ourselves insiders as a result. We are large enough not to have to deal in all our holdings at all times. And, because we also deliberately index a portion of our UK equity portfolio, we own 1.5 per cent of all quoted 7companies. So we will own shares in the bidder as well as the intended target, and there is some evidence to suggest that bidders do not realise all the benefits they expect from their activities.

It is true that not all funds behave like this. Many are very active traders in the companies they own. In 1987, the WM company estimated that the average UK fund sold 40 per cent of its UK equity portfolio, indicating an average holding period for a share of only two and a half years.

This figure has now fallen back to 30 per cent, meaning that the average share is held for three years and four months. But averages conceal big differences.

We often adjust portions of our UK equity portfolio, or even individual companies, several times during the year, without more than marginally affecting our underlying holding.

Arbitrage be8tween Royal Dutch and Shell or an ordinary share and its convertible would fall into this category, and some sales or purchases are a consequence of adjusting our exposure to the various asset classes - bonds, UK and foreign equities, etc.

But it doesn't really matter if the institutions or their sponsors are short-termist or not. What matters is if a company management's perception is affected to such a degree that they believe they cannot invest in long-term projects.

I think there is this belief, although it is largely misplaced. Management does not seem to understand the role of shareholders. In a speech in March praising the Japanese keiretsu - interlinking networks of firms - Ian Brunton, until recently UK business strategy manager of ICL, asked: 'Do British shareholders add value or are they just parasites?'

This shows so little understanding of managerial capitalism that it is difficult to know where to start.

Too often it is management that is the parasite, awarding itself long contracts at high 7salaries at the expense of those who are risking their capital.

And so to the notion that we are starving companies of much- needed capital, an idea based on the way that dividend payout ratios appear relatively high in Britain, particularly when compared with Germany.

I would argue that there would have been no well funded occupational pension provision in this country if British companies had followed the German example.

In the early Eighties, Siemens increased its dividend for the first time in 13 years, only to cut it again the next year.

British funds would not have switched into equities in the way they did from the early 1950s had British companies taken that approach - to the enormous cost of British industry.

Yet dividends should not be maintained at all costs. Cyclical companies will 8see their profits rise and fall, sometimes alarmingly. The answer is to split their dividends in two parts - a long-term dividend, maintained except in extremis, and growing at a reasonable rate over time, and a short-term dividend that varies as to the state of the cycle.

The long-term dividend will give a valuation base for investors, but not lock companies into unsustainable dividend levels.

The dividend should be a signal that management expects to be able to maintain this level of payout. Should they fail it tells the investor that the management is incapable of planning their cash flows or predicting profits with any degree of certainty. A cut dividend in these circumstances is a management failure.

Should the relative attraction of equities be substantially reduced through an effective cut in dividends, companies would pay more for their equity capital, and pension funds would be likely to allocate more to bonds, decreasing the long-term real returns of their schemes at a substantial cost to the employer. But assume for a moment that higher levels of retention were to be engineered, possibly through a return to the pre-corporation tax days, or reintroducing capital allowances.

At the same time, as suggested in the recent policy document from Robin Cook, Labour's trade spokesman, some penalty would be introduced for 'churning' equity holdings and a substantial new onus of proof for hostile bids would be placed on the bidder.

What sanctions would then remain for the company owners to rid themselves of incompetent or greedy management? Would managements change their ways if, even though protected against hostile takeovers, they were still vulnerable to an institutional coup at an annual meeting?

What process of allocation of scarce investment resources would take place?

It would be dangerous to tinker with the capital markets in the ways suggested.

Rather, if pension funds are to take a long-term view, their sponsors should encourage them. If investment managers want to add value, they should embrace relationship investing. And if corporate management wants supportive long-term shareholders they should keep them fully informed and not treat them as adversaries or parasites.

They should also not treat the companies that they manage as their personal fiefdoms.

8 It is debatable whether the existing capital markets, to which the pension funds are so central, have failed to finance business expansion.

Figures published by the London Stock Exchange for capital- raising in 1993 show a total of pounds 47.4bn was raised in equity and bond finance.

Final salary schemes have proven the cheapest way yet invented of financing income in retirement. It would be a pity to throw that out because there is a perceived, but not established, failure in the allocation of capital - something that has more to do with attitudes than with the structure of institutional investment.

It would be particularly ironic if we were to do so just as the rest of Europe and Japan are adopting the Anglo-Saxon approach to funding pension schemes.

(Photograph and graphs omitted)

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