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Debunking convention

20 May 2019

Much of what passes as conventional wisdom in the business and financial world turns out to be wrong – or at least does not convey the certain truth its advocates like to believe.

Much of what passes as conventional wisdom in the business and financial world turns out to be wrong – or at least does not convey the certain truth its advocates like to believe. Still, new circumstances generate new ideas and perhaps the financial crash and its aftermath created an abundance of challenge. This month, I discuss some of the most thought provoking.

The first is some pioneering work by researchers at the Universities of Utah, Purdue and Cambridge, which suggests that big bonuses lead to worse performance. This stands on its head the cosy assumption that management incentives drive better results.The study looked at data on
CEO earnings and corporate performance for all NYSE, Amex and Nasdaq companies for 17 years from 1994 to 2011. The results are stark: the top 10% of CEOs – as measured by the generosity of their pay relative to their peers in similar firms – earned negative returns of 5% over one year and 9% over three years.

This is not the only problem caused by executive bonuses. London-based economist Andrew Smithers states that the short-term nature of these bonuses inhibits management from making investments their businesses need to prosper in the medium term because they do not want to upset the stock market or risk knocking their share price with a short-term fall in profits while they
finance the new project. He concludes that bonuses are making management risk averse and condemns businesses to long-term decline.

The second challenge is directed at the role of finance in the economy. It is generally believed that the more sophisticated the financial sector, the more efficiently the economy will run – but it is not that simple. The New York-based fund manager Jeremy Grantham noticed that the bigger the US financial sector became, the slower the rate of GDP growth. Grantham found that until 1965 the
US economy expanded at about 3.5% a year. The financial sector has doubled in size since then, from 3.5% to 7% of GDP, but the rate of growth of the economy as a whole has got slower. By the year 2000 the average growth rate had slipped to 3%. Today, the US struggles to even get to that level. So it appears you can have too much of a good thing. An economy’s financial sector, like everything else in business, is subject to diminishing returns.

There is also a third tranche of criticism focused on banking behaviour. Lord Adair Turner has shown how the UK banking system is the root cause of severe instability. He says that over three-quarters of bank loans are linked to property, which create a self-fuelling boom and bust cycle. The availability of credit pushes up property prices and as prices rise it encourages a further round of
speculative borrowing and buying, pushing prices up even more and beyond what is supportable in the long term. When the bust comes the spiral goes into reverse and thedeleveraging causes huge pain throughout the economy.

Into this mix comes Daniel Pinto, the owner-founder of Stanhope Capital, an independent fund management group. Pinto takes aim at the pernicious deadening effect of corporate governance, which has resulted in too many of our leading companies being headed by people who are more like administrators than entrepreneurs. Not only are they risk averse but they are surrounded by independent directors who lack sufficiently detailed knowledge of the business to do anything other than present a further brake on progress. The combination is toxic: too much executive energy is devoted to roadshows and analysts presentations to keep the stock market happy, and far too little focus is on what needs to be done to make the company prosperous in 10 years.

These views may be rejected by most but if they remind people that business is fiendishly complex, and that it pays never to take anything in governance for granted, they will have made a contribution.

Anthony Hilton
is financial editor of the London Evening Standard

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