Only a reassessment of our values will avert another crisis

Most financial service professionals believe tighter regulation of financial markets will not stop another financial crisis, according to a recent survey.

Perhaps a reminder of what happens when greed overtakes reason might help. Today the ratings agency Standard and Poor’s said it estimates that the biggest US banks may still have to pay out more than $US100 billion to settle legal issues surrounding the rush for sub-prime mortgage products that started the global financial crisis in the first place. Not a great long-term return for the banks’ investors.

Or maybe a reality check about what their rampaging greed has meant for the rest of the citizens of the world. The Organisation for Economic Co-operation and Development (OECD) is warning that the fallout of the financial crisis, is starting to affect the elderly with lower and delayed pension payments and the gap between the highest and lowest income households in developed countries widened in the three years since the crisis.

Sadly, the only way to affect real change in behaviour is to change the values of those in power, because it is those in power that set the agenda. Kinetic Partners, the same group that conducted the survey mentioned above also did research that found that most believed it was the culture set by the CEO that influenced whether good decisions were made and another financial crisis could be averted. This is backed by a whole swathe of academic research pointing to the powerful elite prioritising the values of our society.

So what are the most prominent values? Academics Bruno Dyck and David Schroeder suggest materialism and individualism are the twin hallmarks of the moral point of view that underpins management thought. The Protestant focus on work and individual struggle for salvation and emphasis on material success has become normalised in western management and is the ‘incontestable, objective, morally neutral reality’ adopted as the natural facts of life, rather than the moral facts of life. This translates into modern management’s focus on efficiency, productivity, profitability relative to other comparable companies and the expectations of the market.

The central criterion for managerial rhetoric is concerned with economic growth, organisational survival, profit and productivity. In academic texts on corporate finance this belief is reinforced.  According to the Principles of Corporate Finance, ‘the goal of maximising shareholder value is widely accepted in both theory and practice’ because, the authors argue that shareholders want three things, the first of which is ‘to be as rich as possible’. Another perspective on this is offered by Jill McMillan who argues that companies are held captive by ‘the tyranny of the bottom line’ and profits are for the benefit of the ‘privileged class of organisational shareholders who possess the dominant right to maximise return on their investment and the commitment of management to pursue that goal.’

But if much of the money is invested with ‘organisational shareholders’ (meaning institutional investors) comes from citizens investing for their retirement, then it should be us that guides which values dominate investment, and given a chance to have a say, I believe many people would have not ‘profit at all cost’ as their number one value.

Below is a simplified version of my suggested model for a two-way communication system with their members.Model for engagement

Democratic capitalism achieves communism’s goal

Phillip Adams’ was bemoaning the failures of capitalism this week in The Weekend Australian, adding it to the pile of other failed ‘isms’ and he points out that we need new answers to stem the widening gulf between those that have and those that don’t. He proposes a hybrid economic model.

We don’t need to invent a hybrid. We have already done it, we just don’t recognise it. Democratic capitalism has succeeded in achieving communism’s ultimate goal. It has shifted the ownership of the means of production to the citizens away from unelected elites. In most Western nations, the citizens provide the money for substantial chunks of the equity markets and the bond markets. It is just when we put our money into our retirement funds, managed by institutional investors, the ownership of those funds is suddenly assigned to those institutional investors. Our money become ‘their investments’. When really, these investors are merely managing our money and it is our money that buys the shares (which are units of ownership in companies), so we own the companies. The key is to make the institutional investors listen to a wider array of voices as to what constitutes a long-term ‘value’ building in a company.

The problem is we are still living in an age that assigns a higher moral value to people with money (or control of other people’s money) rather than people with knowledge. We lionise business leaders for their ability to make money, not their ability to change the world for the better. We agonise that we will not have enough money in retirement to maintain our lifestyle, so we turn a blind eye to bad company behaviour in favour of returns. We value our ability to buy things, more than our ability to understand things.

Perversely though, more and more of us comfortable in our middle class lives are getting uncomfortable about how big business is shaping our society, our planet and the futures of those who may not have the opportunity to worry about whether to go to Bali or holiday at home this year.

If we want this to change, we have to challenge this power structure and its associated values. We need to engage with institutional investors and get them to step up to the plate in engaging with company management and boards on issues that matter to us. We need investors not to punish companies on the stock market when they choose to do something that is better for all of us in the long term, but shaves off some profit in the short term.

Institutional investors need to democratise investing and create opportunities for people to engage with them and share their views. A starting point may be a simple online tool, like Vote Compass. It was used in the latest Australian election to help voters understand what mattered to them and which party best represented their views. A similar tool could help institutional investors understand how we feel about particular issues. Institutional investors could then represent these views to senior managements of companies and hold them to account on behalf of us all.

Greed unfettered by conscience reigns again

Five years ago, the US government and regulators allowed investment bank Lehman Brothers to collapse.  The bank was to be the example to the industry of what happens when greed and the pursuit of profit at all costs prevails.

Sadly, it appears they didn’t learn a thing. Greed unfettered by conscience remains the order of the day.

Investment banks exist to grease the wheels of the economic machine, bringing investors and businesses together. These servants of company development and economic growth, however, appear to have transformed themselves into the masters of the corporate universe.

Investment banks’ role is to arrange companies’ borrowing, issues of shares and conduct a lot of the share trading and broker merger and takeover activity. They put people with money together with people who want that money to invest in their business. This means they have a vested interest in promoting lots of activity, which is what generates their revenue. So it doesn’t matter whether a deal creates long-term social and economic problems or not, their only interest is deals being created. How else will they hit the targets that pay their gigantic bonuses?

Now the UK Chancellor of the Exchequer is going into bat for the financial services sector to protect their ‘right’ to receive uncapped bonuses. There is grave concern that the bonus cap may led to an increase in base pay and that top ‘talent’ may go to non-European competitors who don’t have to comply with the cap. To be clear, the bonus cap will only apply to those who earn more than €500,000 (~$AUD720,000) a year….so they are hardly on struggle street. But a pay packet of this size is not about being paid what someone is worth, it is a way of gaining status through a comparison with peers.

Perhaps a walk along struggle street might help the investment bankers reassess their views about the reward they need to carry on their work. It may also give them some perspective about the devastating impact of their sector’s behaviour and how long it takes to recover. Right now, More than 46 million Americans are living in poverty and the median household slipped, all thanks the hangover created by the global financial crisis. While job growth may by recovering in the richest country in the world, the jobs are in low paying sectors of retail and restaurants. Meanwhile, the stock markets are recovering and the bankers are getting their bonuses again.

Earlier this year, the investment banking industry was asked to explain why they charge institutional investors for access to the chief executives of their client companies, often without the companies even knowing. The investment banks don’t provide the money for anything, institutional investors on our behalf do. Institutional investors need to exercise their financial muscles to wrestle the investment bankers back into their role as servants.

Fat profits from empty calories

Is a rapid rise in obesity levels in poor countries an acceptable side effect of multi-national companies and their investors pushing hard into these markets to create new profits?

In June this year, the World Health Organisation (WHO) said the increasing number of people in low and middle income countries being overweight and obese was creating major long-term public health problems. WHO identified that more than 75% of the world’s overweight children lived in those countries that also suffered issues associated with under-nutrition.

One of the key problems was the rising availability of cheap, highly calorific, or energy dense, foods and drinks that had little nutritional value. Driving this increase of consumption was intensive marketing, by multinational food and drink companies, particularly to children, according to another WHO study. Marketing about unprocessed foods in these countries did not exist.

There is so much money to be made in these low and middle income countries from selling soft drinks and the junk food that companies are targeting these markets as their future. Indeed, Coca Cola was very excited about the profit-making potential of the poor. In a presentation to a Barclays Capital conference in September this year, Coca Cola’s  senior executive Ahmet Bozer talked about ‘seizing the moment’ in sub-Saharan Africa with their ‘sparkling drinks’ (read the calorific Coke and the like) leading their charge into the market.

Bozer identified that there was a target consumer base of 6.1 billion people in Coca Cola’s International business and 37% of these were under 21. A core strategy was to drive sales growth through the flagship ‘sparkling’ market. Coca Cola was in the market for young drinkers to become loyal buyers of their product throughout their life, not as an occasional treat drink but as an everyday choice.

Some of the biggest American institutional investors in the world have major stake in Coca Cola. As at 30 June 2013, Berkshire Hathaway held 9% of the company, followed by Vanguard at 4.8%, State Street at 3.8%, Fidelity at 3.4% and BlackRock at 2.6%. Vanguard, State Street and BlackRock also have large stakes in PepsiCo.

Imagine if these institutional giants, who manage the money of the citizens of the US and others, actually told Coca Cola to revise their strategy.

What would happen if these investors told Coca Cola they would not sell their stock if Coca Cola took responsibility for the impact of their products on the health of their consumers (many of them without the benefit of the same level of health education as those of us in high income countries)? What would happen if Coca Cola focused on pushing their bottled water and healthier choice drinks into these markets instead? What impact would that have on this impending major health issue?

It doesn’t mean Coca Cola can’t make money, but rather make money out of products that don’t leave a trail of long-term health issues for its customers, the very people that will keep the company in business.

It doesn’t mean that investors can’t make returns on their investment in Coca Cola, but if nothing changes, what it does mean is that we, as the people that ultimately provide the money for institutional investors, value wealth over our health and the health of others less fortunate than us.

Who owns what is as clear as mud

One of the great transparency furphies in the corporate world is that you can find out who are the top shareholders by looking in their annual reports. The problem is a flick through the annual reports of most of Australia’s largest companies you may think you are reading the same list over and over again.

Most of the names on the list are nominee companies. The biggest ones in Australia are HSBC Custody Nominees (Australia) Ltd, JP Morgan Nominees Australia Ltd and National Nominees Ltd.

Nominee companies are custodian services that allow investments from a number of investors to be aggregated into one entity. According to the Australian Securities and Investments Commission (ASIC) they typically hold securities, arrange the banking of dividends and some form of consolidated reporting. They don’t engage with senior management or boards about how companies are run on behalf of their clients.

In fact, large listed companies raised the use of nominee companies as a key barrier to engaging  institutional investors in submissions to the 2008 Parliamentary Joint Committee on Corporations and Financial Services inquiry into barriers to the effective engagement of shareholders on corporate governance. The companies said the use of nominee entities also made finding the ultimate owners of shares difficult. This makes it very hard to align the long-term investment goals of superannuation funds and the short-term remuneration and performance goals of senior management and professional investors.

The parliamentary committee also found that institutional investors, such as superannuation funds, made decisions about whether to engage with companies’ management and boards based primarily on the economic cost to them. Some found engagement to be a distraction from their stated primary role of generating investment returns. The use of nominee companies would provide a useful way of distancing themselves from the companies and, therefore, actual engagement.

So it appears institutional investors not only don’t canvas the opinions of the people that provide them the money to invest, they are not that interested in engaging with the companies they invest in either. If they do, they certainly don’t share it with their clients.

Who pays for Woolworths’ bigger piece of pie?

Woolworths reported another increase in its net profit after tax today and shareholders will receive an increased dividend. This is great news for short-term investors, but with Woolworths casting a bigger and bigger shadow over our retail sector, it is also important to look at how the pursuit of these numbers impacts our society.

For instance, despite consumer price deflation, Woolworths has managed to increase its profit margin on its continuing operations to 26.94%, its fifth straight rise and an increase of more than one per cent on five years ago. So the question is, if prices are dropping but profit margins are rising, who is being squeezed?

The Federal Government’s FOODMap report, released in July 2012, analysed the Australian food supply chain. According to the report, Woolworths and Coles account for 68% of all food and liquor sales in Australia in 2010/2011. The report found that increased pressure from these food retailers for cost savings and larger scale has led to further rationalisation in food production. That means more people going out of business and fewer people producing more at lower margins. Further pressure is placed on these producers from cheaper imports being substituted for local product.

Both Woolworths and the Wesfarmers-owned Coles are pushing hard into the ‘own label’ space in their supermarkets and this has given them enormous, and uneven levels of power in the supply chain. Smaller, local producers have no bargaining power and those that want to stay in business must agree to the retail giant’s terms. This doesn’t just affect food producers, but all of the suppliers to the business.

So while the stock markets may revel in the results of this retail giant today, surely as ultimate investors in the company, we have to ask what other costs are we prepared to pay for Woolworths to generate these profits.

We, as members of superannuation funds and other investment vehicles, provide the capital to the likes of Woolworths, and we can use our collective power to get them to be more transparent about their activities. We just have to get the institutional investors who manage our money on our behalf to be more active.

Will savers have a say in Kay’s Investor Forum?

In July last year, John Kay released his Review of the UK Equity Markets and Long-Term Decision Making which examined the impact of recent behaviour in the UK equity market on investment performance and corporate governance.

One of the key recommendations was the creation of an Investor Forum, a place where a collective group of institutional investors could discuss issues affecting the companies in which they invest, collectively act on issues and advocate on behalf of savers (the people like you and me who entrust their money to institutional investors).

This recommendation was silent, however, on how these institutional investors may collect and reflect the views and values of these savers so they can advocate on their behalf effectively. It was also silent on how this advocacy and collective action be communicated back to the savers so they can see what the investors are doing and participate in an ongoing conversation about that activity.

Then in June, nearly a year after the release of the Kay Review, a number of these institutional investors, including Schroders, Legal & General, Baillie Gifford and The Wellcome Trust announced that it was setting up a working group to look at the concept of an Investor Forum. The three big industry bodies*, who represent the asset management and institutional investment groups, all back the initiative.

But will this working group consider collating the views and values of those savers or will it be a closed shop for investment professionals? How will they rank the issues on which they act collectively and on which they advocate? What safeguards will be in place to ensure they do what they promise to do and act upon the long-term interest of savers, not just as savers but as citizens, employees, consumers and community members?

A report is due out in November.

*The Investment Management Association (IMA), the National Association of Pension Funds (NAPF) and the Association of British Insurers (ABI).