April 2, 2013

A Carrot for Long-Term Investors

When stocks are bought or sold in a fraction of a second, what's to keep investors hanging on? Patrick Bolton has a novel way to encourage buy-and-hold.

Betsy Wiesendanger
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Investment windows are getting shorter and shorter — so much so, that the term “short-termism” is now standard lingo in financial circles. In 1960, the average holding period for a stock on the New York Stock Exchange was more than eight years. But today, when all it takes is the flick of a keyboard button to execute a seven-figure trade, more than 80 percent of stocks change hands within a year, according to NYSE figures.

There’s nothing inherently wrong with flipping a stock to reap a quick profit, to be sure. But the cumulative effect of all that frenetic trading has been destructive, according to a substantial body of research. Among the consequences:

  • Missed investment opportunities. Managers whose overriding motivation is to boost quarterly returns can not only engage in dubious accounting manipulation but also forego opportunities to invest in operations that can increase the long-run fundamental value of the firm.
  • Greater risk. Companies that feel pressure to meet the market’s unrealistically high earnings growth expectations can take on far too much leverage.
  • Greater market turbulence. “The reason we should be worried about short-termism is that financial markets go through these episodes of speculation — huge bubbles and crashes,” says Patrick Bolton, a Chazen Senior Scholar. “That’s incredibly destabilizing for the whole economy.” It also forces individual households to carry unnecessary risk by, for example, jeopardizing their retirement portfolios.

But Bolton has a solution — or, at least, a possible antidote. At a December 2012 conference on long-term investing, cosponsored by the Committee on Global Thought at Columbia University and the Sovereign Wealth Fund Research Initiative, Bolton proposed a financial instrument he calls “L-shares”: a special class of equities that provide an additional reward if shares are held for a contractually specified period.

The Lowdown on L-shares

In brief, L-shares offer a warrant that gives the holder the right to buy the underlying share at a specific price by a specified date. Under Bolton’s proposal, these L-warrants would be attached to shares of stock and would be exercisable only if the share is held for a “loyalty period” of, say, three years. If the stock is sold before the loyalty period ends, the right to the warrant is lost.

Bolton sees numerous benefits to this scheme. Shareholders would be induced to take a more long-term view rather than simply seeking to maximize quarterly returns.

And he hopes such an incentive would encourage shareholders to become more vocal. In his classic essay on the governance of organizations, Albert O. Hirschman describes two ways shareholders typically respond to a governance crisis in a company. One is to “exit,” or dump the shares before the crisis becomes fully apparent to others. The other is “voice,” or keeping the shares and becoming involved in the attempt to resolve the crisis. Getting involved can range from simply voting against management at shareholder meetings to mounting a full-fledged proxy fight. The “voice” strategy, Hirschman argues, is likely to be more beneficial to the firm’s long-range health because activists can enact mandates that will halt the decline of the firm.

Weighing the Pros and Cons

L-shares have other pluses. In tough times, cash-strapped firms may want to temporarily suspend a costly dividend payment or postpone a planned stock repurchase by instead offering L-shares. Michelin did something very similar in 1991, when it offered shareholders a warrant exercisable in two years in exchange for a dividend cut. “The move was a way to save precious cash reserves, as well as rewarding shareholders who remained loyal to the firm during a difficult transition period,” says Bolton.

L-shares might also be a powerful bargaining chip in negotiating a partnership or joint venture, says Bolton. Granting L-shares to a strategic investor would strengthen ties between the partners while maintaining the partner’s ability to trade shares if liquidity problems occurred.

Of course, the idea is not without its drawbacks. If a firm issues L-shares rather than dividends, financial markets might interpret that as a signal that the company is in trouble. And many of the finer points of implementing L-shares have yet to be done right, says Bolton, including accounting treatment of the shares and how loyalty would be tracked (for more, see Bolton’s working paper).

What’s next for L-shares? “We just want to make this idea more widely known,” says Bolton. “It may work for some firms but not for others. But let them try it out.”

“These are propitious times for this simple innovation,” he added. “The need for more long-term management reorientation and the demand for long-term investment products has never been greater.”

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