Mindsets matter. For more than two years, we and others have been talking about the need to shift the prevailing view among managers, boards of directors and investors from “quarterly capitalism” to what we call “capitalism for the long term”. Together with Harvard Business Review and the Management Innovation eXchange, we have issued a challenge calling for the most instructive case studies and provocative ideas that will help us re-imagine capitalism for the long term.
Despite promising signs of change, such as a growing turn away from the standard practice of issuing quarterly earnings guidance, old attitudes die hard. More and more, we realize, the crucial first step is to tackle our deeply embedded intellectual frameworks. Beliefs drive actions and altering our belief systems will ultimately do more than anything else to amplify and reinforce the kinds of behavioral changes that, in the end, are the only measure that counts. In this blog post we’d like to focus on two belief shifts that are critical.
1) Believe in your power to make markets efficient — but abandon the efficient market dogma
The global financial markets are an extraordinary information processing engine. Nothing beats the tracking mechanism of stock prices when it comes to quantifying the constant push-and-pull of thousands and thousands of investors and managers, pursuing and acting upon different strategies. And yet . . . it’s an extraordinary leap of faith to go from acknowledging this fact to believing, as orthodox efficient market theory holds, that markets are so efficient that all relevant information is always and immediately embedded in prices. Such a belief implies that any and all decisions that improve a company’s short term share price must logically also be improving its long term health and vice versa. There can be no contradiction, or so the theory goes.
In fact, much evidence suggests that the market often gets it very wrong in the short term — with the most telling example being the 2008 financial crash itself. Beyond such large and violent macro-swings, our own research at McKinsey suggests businesses that reallocate their capital more aggressively can generate higher long term returns than their more passive peers – even if, in the first few years, such actions initially reduce previously expected earnings (and thus may prompt a set of investors to sell down the stock, regardless of the long term value creation). Assuming the market is perfectly efficient, it appears, merely damns it to inefficiency.
Our suggestion: instead of passively accepting that the market is always right, investors, managers and boards of directors need to think in terms of how they can actively make it more efficient. In short, they need to develop and contribute viewpoints to the market – not assume the market already contains them – and then be ready to stick to their guns. This is the way both to achieve higher returns and make the market more efficient.
2) Believe in the real game — long-term value creation — and stop acting as if you are meeting your highest calling if you simply play by the rules
We direct this urgent call less at operating managers, who are out there getting muddy and trying to score goals every day, than at other critical corporate players, such as the trustees of pension funds and sovereign wealth funds or a company’s independent directors. Does anyone honestly think this crowd today are doing all they could to provide good governance and proper stewardship? Sadly no. Too often they focus more on checking the boxes and ensuring that they have met their (not inconsiderable) compliance obligations. But with a crucial mental reset, they could and should play a much more vital role in pursuing the real prize, which is long-term value creation.
For big pension fund and SWF managers, that role change starts with spending the real time required to understand and have a forward-looking viewpoint on their investments. There are many ways to achieve this end, once belief systems shift. One path could be to concentrate one’s portfolio. For example, Dutch pension fund PGGM, with over 100 billion euros under management, decided a few years ago to focus one of its 3 billion euros of its equity portfolio on 15-20 stocks, engage with those investments as an active long-term owner — and stop tracking the indexes. Another course might be to take more activity ‘in house’, especially if contracting investment management out makes it difficult to achieve alignment with one’s chosen asset managers. Or it may involve keeping a wide portfolio but concentrating governance efforts on shaping management and strategy at a few stocks at a time – and doing so either alone or in collaboration with others.
Independent directors confront the same challenge: currently they too often serve as the box-checking last step in signing-off on a CEO-run strategic process. If they want to move beyond obeying the letter of the laws governing their fiduciary duties and delve deeply into the content of strategy, then they need to increase one critical investment: their time. This won’t be easy, but there are signs the core belief system may be changing. In a recent survey of some 1600 members of boards of directors, we found that their number one goal is to spend more time on strategy and the best way to achieve this, they believe, is to carve out 10 more days a year for their board duties (a third more time than they are currently spending).
The key step is to foster deeper board engagement. Beyond that, we have learned, it also helps if an active independent director’s relevant skills match up with the strategy of the company he aims to steward. Our recent research on 110 large European companies managed by private equity firms found a strong correlation between successful value creation and the skill set of the partner serving as lead director. PE partners with extensive M&A experience delivered better results when the companies they were overseeing were also embarked on an aggressive M&A strategy. Similarly companies pursuing organic growth created more value when the lead directors from their PE owners had backgrounds with deep management expertise.
Obviously much more needs to be done to foster a capitalism that is truly patient, principled and socially accountable. The list stretches from adopting an investor relations policy that concentrates on fostering a long term investor base and developing better metrics to tackling, with guidance from active owners, some of the flaws and inequities in executive compensation. We intend to continue exploring those issues–and the solutions required to better address them–in our ongoing research. But the critical first step, we’re convinced, is for more and more institutional investors and independent board members to abandon old orthodoxies and embrace a new belief: the belief that through greater engagement and more active ownership/stewardship they can enhance the market’s efficiency while delivering greater value creation for stakeholders and shareholder alike.
See on blogs.hbr.org