A Piecemeal Approach to Fixing Capitalism is Bound to Fail?

A lot has been made since the Financial Crisis of 2007/8 of the need for better business reporting, with initiatives from the likes of the International Integrated Reporting Council (est. 2011) and the Global Reporting Initiative (est.1997). Think Tanks have also spoken of the need of better reporting. Examples from Tomorrows’ Company are the reports, “Tomorrow’s Corporate Reporting: A critical system at risk” (2011), and “Tomorrow’s Business Success: Using integrated reporting to help create value and effectively tell the full story” (2014).

As the executive Summary of “Tomorrow’s Corporate Reporting: A critical system at risk” notes, external crises – from investment bubbles and crashes to fraud and market upheaval – have always been a force for major changes to the regulatory system and corporate reporting”. Usually, they focus on “whether companies should present additional detail on their activities, comply with new rules and conform to new conventions”.

The result has been increasingly complex and heavily regulated reporting yet, “the fundamental concepts underpinning corporate reports have actually changed very little over time”, it remains, “rooted in the past”. And the report notes that the many initiatives and consultations underway at the time it was written, “all focus on specific issues around the content of reports, rather than the dynamics of the system as a whole and its structural weaknesses”. Their own report, therefore, “focuses on the overall architecture, culture and behaviours of those engaged in the corporate reporting system”.

Despite all these efforts, and the six years after the system-wide look at the reporting problem, there are few signs of significant improvement. Large scale radical improvements still seem a long way off. And, in The End of Accounting published recently, Baruch Lev and Feng Gu argue things are worse, not better. Their shocking claim is, “Today’s financial reports provide a trifling 5-6 percent of the information relevant to, and used by, investors”. This and their other claims are backed by a great deal of evidence.

What does this tell us? Does it tell us that we really must improve corporate reporting? Or, does it tell us investors really do not care about it? If they cared, wouldn’t we expect them to be making very strong and loud calls for improvements? Does the fact they aren’t making such call confirm they do not care? And, what might the fact they don't really care tell us? These are the questions I have been asking myself.

Recently I was offered the chance to try and get some answers from a former hedge fund investor, then regular institutional investor, now director of one of the big accounting firms. I asked him, “How many investors have the ability to understand the fundamental drivers of the future value of the businesses they are investing in, or care about them?” His answer was, “somewhere between zero and one percent”.

I’ve since had the chance to put the same question to several other current and former institutional investors. The answer has been similar each time. But, let me make this clear. The number with the capability may be higher, “up to 30-40%” one interviewee suggested. So, the real issue is that they just don’t care. “The only information they are really interested in is that which will influence the mood of the market, and move the stock price”, as another interviewee explained. And this means they pay far more attention to other factors, such as macro economic trends, and the soundbites from or about, firms. It should be no surprise then, managing expectations using briefings filled with soundbites is a common practices among the listed companies.

This is the clearest possible confirmation I have heard that we live in an “expectations economy” as Prof. Roger Martin called it in his book Fixing the Game. Where, money makes money by taking bets on expected stock price movements, either up or down, and where great volatility generates the greatest potential winners and losers. In the “casino”, as it has been called, nobody is really interested in the fundamentals of a business. They are only interested in the signals that generate the ripples and waves, or the occasional tsunamis, in the expectations game. 

If investors and the market are not interested in the fundamentals, why are we spending so much time and effort trying to fix the reporting of them? Is it not the bigger system that needs fixing first? Or, as Tomorrows’ Company might put it in a new report, “Tomorrow’s Capitalism: A critical system at risk”. In other words, should the focus not be on the overall architecture, culture and behaviours of those engaged in the system of capitalism, rather than on the specific issues around the corporate reporting system.

In the scheme of things, if the system is this broken, reporting is just a sideshow. The concern that poor reporting is leading to the misallocation of capital is trivial. Between 99-100% of Capital is not being invested, it is being used to buy chips in the casino if only 0-1% of investors have any real interest in fundamental drivers of the future value of businesses.

Recently I attended the Drucker Forum in Vienna. This year the theme was “The Entrepreneurial Society”, and my conclusion at the end of day one was that if we want to create a better entrepreneurial society we need to see it as a complex ecosystem with many agents. We must map the system to get a better understanding of who the key players are, what the key processes are, where the obstacles and blind spots may be, and what changes are required.

Then I suggested, “To map and understand this may help us think about and design the kind of Entrepreneurial Society we want, and where to focus our attention. And I argue that the current lack of understanding has led to an entrepreneurial society that is full of insecurity, anxiety, fear and desperation. A situation that gives rise to great dissatisfaction, providing fuel to power the growing wave of populist backlashes seen in the UK (Brexit Vote), the US (election of Trump), and in other European Countries (the rise of the Far-Right parties). Many so-called entrepreneurs are not entrepreneurs by choice, but by necessity. They are low paid, have little security and fewer rights.  

In sharing these comments about The Entrepreneurial Society, I want to suggest the comments I made are relevant to the whole issue of addressing casino capitalism. It seems clear, almost a decade after the banking crisis, and all that followed, the casino is still at the heart of the current form of capitalism, and we are still exposed to all the associated dangers.

One of those dangers is real and present. Cheating is taking place in the casino. This is the result of providing CEOs with compensation based on large chunks of stock, intended to align their interests to those of shareholders as the owners.

The stupidity of this should have been obvious to those who proposed the idea of stock-based compensation. Information is valuable to players in the markets. It is a source of advantage. Clearly, the CEO has more information about the future performance and value of a business than any shareholder could possibly have. In addition, he has both influence and timing advantages. He can influence corporate events and the timing of them. He can also have a good idea what their impact will be. And, he can combine these advantages, to manage when information about events is made available. To me, this seems akin to insider trading, but read the following case study and draw your own conclusions.

Roger Martin, writing in Harvard Business Review (October 2014) recorded that John Chambers, the CEO of Cisco Systems since 1995 became a billionaire by running a publicly traded company. But during his tenure Cisco shareholders lost value, and suffered two bubbles and busts. It was “a pretty wild ride” for the shareholders since 2007 says Martin. Those who hung on through to the end of June 2014 experienced an overall decline of 27% in the value of their stock, and two 60% drops along the way. But it wasn’t so bad for Chambers. “Those two big dips were handy for picking up attractively priced stock-based compensation”. If instead of exposing shareholders to massive volatility Chambers had overseen a steady decline, his stock-based compensation would have lost about 20% of its value, rather than gaining 18%. 

The conclusion is not that every CEO is gaming the system. It is that under the current system design, capitalism offers neither investors nor CEOs reason to be interested in creating real value that produces wealth and prosperity from the provision of goods and services. Instead, they have every reason to focus on managing and manipulating market expectations and are under pressure to do so to meet the short-term expectations of the markets. And that is exactly what the leaders of most listed companies do, with the assistance of the CFO.

If investors are not interested in the fundamental drivers of future value in a business, and the incentives encourage CEOs to focus on managing expectations rather than the production of real value from the provision of products and services, then a research report by McKinsey and Company may be less shocking than it first seems.

The report shows many company boards simply don’t know how the companies they serve create real value. Of the board members surveyed, only 22% felt the boards they served on had a clear understanding of the way the company created value, and only 16% thought they had a good enough understanding of the dynamics of the industry the firm is in. When I interviewed the CEO of a large investment management company and asked him if he thought the figures were accurate and, if they are, did he agree it means boards are failing in their fiduciary duty, he said he thought the figures were about right, and yes it did mean they were failing in their fiduciary duties. The evidence would also suggest that other executives are happy to have the company focus on managing and manipulating market expectations, not on creating real value.

In a survey of over 400 financial executives by Lia Dichev, John R Graham and Campbell Harvey, published in January 2014, eighty percent admitted they would decrease discretionary spending on R&D, advertising, and maintenance to meet short-term earnings targets. More than fifty per cent say they would delay new projects, even if it were to mean sacrifices in value creation. Such actions, often supported by boards, have a negative impact on future performance. They are therefore doing exactly the opposite of maximizing shareholder returns, they are destroying them. To me, this is evidence enough that CFOs cannot be trusted to perform a value-added function. But there are also other reasons.

In the same report, The Misrepresentation of Earnings, it was sound “CFOs believe that in any given period a remarkable 20% of firms intentionally distort earnings, even when they are adhering to generally accepted accounting principles”. And “the economic magnitude of the misrepresentation is large, averaging about 10% of reported earnings”. “Whilst most misrepresentation involves earnings overstatements, interestingly, a third of firms that are misrepresenting performance are low-balling their earnings or reversing a prior intentional overstatement”. These findings seem to support the notion that the reporting of earnings is used to stimulate managed volatility of the kind seen at Cisco Systems.

By way of another example, the retail supermarket giant Tesco overstated its anticipated profits by ￡250 million. As Evening Standard columnist Anthony Hilton rightly commented in his article, How City missed Tesco’s fall from grace, “If analysts had focused more on corporate culture and less on predicted numbers, they might have had a better understanding of the dynamics of the business”. The same journalist goes on to note that “there have long been things in Tesco’s behaviour and business model that did not seem sustainable, and were possibly even toxic”, adding that “Companies are about people, not numbers, and the clues to these now-obvious problems could be found in the company’s reputation.” “This was stellar in the City because analysts will tell you the foundation of a great corporate reputation is the ability to grow market share and profits year after year. But the customers, suppliers and communities where the company operates had a different perspective. Tesco’s reputation with these stakeholders was sometimes rather a contrast”.

His comments on Tesco raise another issue regarding the analysts, another group of actors in the system, whose advice led to the decisions by banks resulting in the banking crisis. Many Investors rely on the reports of analysts as the basis of their decisions to buy or sell, but how well do analysts really understand the fundamental drivers of the future value of businesses?

Kim Warren, CEO of Strategy Dynamic and Former professor at London Business School says, “It is interesting to note that the Chartered Financial Analyst Institute now boasts nearly 100,000 qualified members worldwide, and that its Charter Program is regarded by the Economist as “the gold standard among investment analysis designations” But, “Interestingly, nowhere in this three-year program of study is there any requirement for its graduates to understand anything about strategic analysis of a business and its market environment. Nor is there any mention of how strategic management affects financial performance”. And he asks,” How then are they likely to come up with realistic forecasts?”

The interesting thing here is that investors are aware of this issue. I know because I have discussed it with several of them? On a personal level, each investor I have spoken to on this matter has made it clear they do not trust the advice of the analysts. But the point is that analyst opinions, whether well founded or not, drive market expectations which investors cannot ignore, and the responses are therefore the group responses of the ‘herd’. This is the result of them having their performance compared to the benchmark performance of the industry, so all boats rise or fall on the rising or falling tide. Rather than Group-Think it seems to be Group Non-Think, and further evidence of the systemic problems within the current form of capitalism.

These days it seems fair to say, few would argue capitalism is working the way it is supposed to. No wonder then, there are calls for reform and more regulation. But will reform and more regulation work? The evidence to date does not give much room for optimism. Well intentioned reforms have had negative impacts and the players always seem to find a way to game the system.

The solution is to understand the whole system, the relationships that drive it, the interdependencies and the way all this created the powerful vortex that has destroying the legitimacy of capitalism, decimated wealth creation, dragging down GDP, killed the economic prosperity of nations, and destroyed long-term shareholder value, and the value of pensions.

Just as with the challenges of increasing entrepreneurialism, when the issues and problems are systemic and inter-dependent, you can’t really fix them when they are broken unless you adopt a systemic approach and act on several fronts in a coordinated way. Achieving this will be difficult. It requires some consensus among a majority of players - that the system is not sustainable, and what needs to change to fix it. It then requires their cooperation in bringing about a coordinated approach to the execution of solutions.

If there is some good news, it is evidence of a growing realisation that all players loose from the status quo, except the casino speculators. So, many parties have a growing vested interest in fixing the system. But, we must wonder how short does the average lifespan of a corporation need to be, how small does the number of new stock market listings need to be, and how low must productivity need to get before serious coordinated action is taken?