|It'sNo Gamble- The Economic and Social Benefits of Stock Markets|
WE CONCLUDE THAT STOCK MARKETS are an essential part of a market economy, and provide important "social benefits." The scope of our analysis has been far from exhaustive, yet we are confident that our assessment stands up to scrutiny. We have examined many of the principal activities of stock markets in some detail, and hopefully managed to debunk some myths and correct some popular misperceptions.
To set the scene, we first outlined the history and structure of stock markets, reviewed developments in new financial innovations, and discussed some of the pertinent current and evolving issues. We showed that stock markets perform a central role in the process of economic growth by bringing together groups of investors and matching them with companies needing capital in such a way that investors are able to satisfy their preferred mix of risk and reward while the best investment projects of competing companies are financed.
We then examined several aspects of the stock market's role in corporate governance as one of its social benefits. Ownership of a company's stock confers, in theory, control over the company's activities, thus providing a role for shareholders to exercise discipline over managerial self-interest.
Chapter 2 focused on the separation of ownership and control in shareholder-owned corporations and on differential voting shares. Both of these institutional features of corporate structure are frequently seen as weakening the ability of investors to fully exercise their ownership rights. In the parlance of economic theory, managers find it possible to engage in "non-value maximizing behaviour," i.e., pursue their own goals, sometimes to the detriment of shareholders. The various corrective mechanisms shareholders have at their disposal include takeover threats, discussed in chapter 3.
The other side of the coin is the danger that investors may be too impatient and put unreasonable pressure on managers to deliver high profits, quarter after quarter, possibly at the expense of the long-term prosperity of the corporation and the economy at large. The alleged myopia of institutional shareholders, in particular, has been widely suggested as a prime reason for the decline of North American industry.
We argued that the importance of this phenomenon may be overstated, and that at any rate, institutional shareholders have recently been moving toward a "relationship investing" role with corporate managers, in which they take a more active part in guiding and pressuring managers to take actions consistent with the needs of shareholders. We also presented evidence that the market recognizes that shares with more votes should have more value, so that the disadvantages of differential voting shares are offset by the market's setting of differential prices.
We then turned in chapter 3 to one of the most contentious aspects of the stock market's role in corporate governance - the market for corporate control. Much of the economic and finance literature views the stock market as a fundamental corrective mechanism ("a huge voting booth") through which owners assert their control over managers. Our discussion of mergers and takeovers confirms the validity of this characterization. Indeed, in our view, this function of stock markets, together with their prominence as a barometer of investor confidence, helps explain their pervasive influence over so many world economies. In most developed industrialized countries the share of stock markets in corporate financing is perhaps surprisingly low, as is evident from the statistics we presented in chapter 5. The influence wielded by stock price trends is much greater than the financing ratios would suggest - both for the management of a corporation whose share price takes a tumble, and for an economy whose leading stock markt index changes direction.
The market for corporate control, and its chief instrument, the "hostile takeover," has evolved quite dramatically over the last two or three decades. The media, especially in the U.S., but also in Canada and elsewhere, have paid close attention to some of these developments. They raised the public awareness and profile of such financial innovations as "junk bonds," and of the tactics of "corporate raiders," their spectacular profits, and sometimes unethical or illegal practices. Unfortunately, the substantive economic impact of mergers and takeovers, and the social benefits accruing from the services of the stock market, have been much less well publicized and explained.
The point may have been lost that when deciding whether to make a bid, the acquiring managers presumably consider how they - and the merger - will add to the value of the target firm. Access to new markets or to capital, or improved position in the existing markets, technological synergy between the two firms, economies of scale and scope, possible tax advantages from combining a profit position of one firm with a loss position of the other, and, perhaps most importantly, replacement of a weak management team, are among the potential benefits for shareholders.
Managers of the bidding firms do, of course, pursue their own interests as well, and mergers and takeovers afford opportunities for promotion, control over larger staff, and increased managerial compensation, among others. The successful bidder often increases the corporate debt, reduces employment, and sells off parts of the target firm. In a hostile takeover, the bidder deals directly with shareholders of the target firm; their cooperation can only be assured by offering a premium (between 30 and 50 percent in recent experience) for their shares. Managers of the target firm are usually offered separation payments ("golden parachutes") to reduce their resistance to the takeover. The services of investment bankers, lawyers, and other experts assisting in the transaction are costly as well. On balance, however, takeovers do appear to add value to the economy.
Measurement of the efficiency gains resulting from takeovers is difficult, and an unknown portion of the benefits may be absorbed by the pursuit of managerial objectives and by the various types of transactions costs. An immense academic research effort has addressed the problem of identifying the sources and magnitude of benefits from mergers and takeovers, and their distribution among the various "stakeholders." While many of the findings are subject to debate, there are some reasonably robust conclusions based on U.S. and Canadian evidence: takeovers benefit the shareholders of the target companies; the gains to the shareholders of acquiring companies are much smaller, and from the 1980s on turned into losses; gains from economic efficiency resulting from takeovers (as distinct from tax savings, and other redistribution effects) increase the combined value of the acquired and acquiring companies; golden parachutes are not usually harmful to shareholders since they facilitate the transaction; and gains fromtakeovers do not generally result from increased monopoly power of the larger company resulting from the merger. As well, the fears that the threat of takeover encourages managers to focus attention on short-term financial results (behave myopically) to the detriment of R&D spending and other investments with longer payoff have not been substantiated by the evidence.
Careful academic analysis of leveraged buyouts, including those initiated by the incumbent management and financed by junk bonds, also yields a different picture than that painted by the mass media. When management owns a higher proportion of equity, the connection between ownership and control is restored. Managerial incentives are strengthened not only because of the ownership link, but also under pressure of the "discipline of debt," albeit in the form of junk bonds. Small companies sometimes issue junk bonds because they are cut off from bank financing, and the purchasers prefer the high-yielding bonds to equity claims in small and relatively unknown companies. Junk bonds thus satisfy needs of both lenders and borrowers which would otherwise be unsatisfied.
A direct measure of the stock market's social benefits is its ability to perform its "middleman" function. In chapter 4 we showed that the process of economic growth requires investor confidence, and that such confidence results from investor satisfaction with how well the market channels the investors' funds through to profitable investment opportunities. The market's performance in this respect is known as "efficiency."
Markets need to be efficient in both the external (prices reflect value) and the internal (they do so at low cost) sense. If the stock price does not represent the firm's value then investors are putting their money in the wrong place. If the cost of getting the stock price to reflect true value is too high, the economy suffers more mistaken investments. Canadian stock markets are global competitors and must be measured against global standards. In both senses, Canadian markets are similar to those of the U.S.: prices of common stocks are "fair" in most cases, and transaction costs are reasonable. Measured against Japan and Germany, Canada fares less well as the cost of capital in North America is typically higher than in those countries, which can impair global industrial competitiveness.
In applying an ethics perspective to stock market activities, we focused separately on two broad areas: mergers and takeovers, and cases of "moral failure" represented by malfeasance of traders.
We took the position that the overriding criterion of ethical behaviour in mergers, takeovers, and defences against hostile takeovers is the interest of shareholders, subject to the limits defined by the "loyal agent" concept. We examined, and found wanting, the objections against hostile buyouts based on their negative effects on some groups of stakeholders, the alleged resulting neglect of long-term investments, and the alleged disregard of moral duties associated with ownership.
The recent growth of stock markets in the developing and newly industrialized countries as well as in the former centrally-planned economies has far outstripped the trend in developed industrialized countries. This performance illustrates, once again, the unique advantages capital markets have over banks as a source of medium- and long-term risk financing in earlier stages of economic development and in periods of economic uncertainty - these advantages largely accruing from the spreading of risk among many shareholders as opposed to a bank assuming all risk. The disciplining function stock markets exert over management is of additional importance in these countries, where management talent even more scarce than in developed industrialized economies.
One of the themes frequently brought up throughout the book are the relative merits of the two main versions of shareholding. The first is characterized by the "Anglo-American" propensity of investors to treat share ownership as a means of gaining access to short-term returns. They allow managers considerable autonomy, and quickly sell shares when there are signs that the firm is not doing well. A typical shareholder, even a big institution, typically holds only a small percentage of shares in any one company and trades them frequently. The exercise of shareholder control over management through shareholder vote and board of directors is weakened, and a remedial response has been the proliferation of takeovers and leveraged buyouts.
The second version of shareholding is sometimes described as "relationship investing," or as "Continental European-Japanese" corporate ownership. Here, investors take a long-term view and stay loyal to the firm, partly because several investors typically have a large stake. For example, many German firms have at least one shareholder - usually a bank, or a customer, or a supplier - with a stake exceeding 25 percent. ["How to be a capitalist," The Economist , July 3, 1993, pp. 18-19.] Not surprisingly, such shareholders take a much greater interest in corporate governance and are less likely to be accused of neglecting long-term investments in R&D, training of labour force and other "intangibles."
In several previous chapters we alluded to the controversy surrounding the connection between ownership structure and the comparative competitive performance of economies representing the two systems. Those who profess the superiority of "relationship investing" are tempted to recommend a fundamental redesign of the "Anglo-American" version of corporate ownership. A recent Canadian proposal, for example, speaks of "unleashing the latent power of the Canadian banking system," and encouraging the creation of a bank holding company with ability to engage in nonfinancial activities (Courchene, 1992).
The way in which such transformations are accomplished is of fundamental importance. Careful observers note that both of the major versions of corporate ownership are changing. Institutional investors in the "Anglo-American" system are less reluctant to take on larger stakes in a single firm, and a wide cross-section of investors have financed the growth of R&D-intensive firms in the drug industry, telecommunications, start-up software companies, etc. Changes are taking place in the other system as well. For example, German investors are increasingly questioning the close links between banks and industrial companies, there are growing pressures for enactment of a first German law banning insider trading, and shareholders are insisting on higher financial returns. In sum, "all dream of establishing in Germany the Anglo-Saxon equity culture in which shareholders rule." ["Learning to love equity," The Economist , July 3, 1993, p. 71.]
And whither regulation amidst all of this change? The most consistent critics of government interference remind us that regulators of capital markets tend to entrench the type of structure they are best familiar with. From this perspective, efforts to enact legislation against takeovers, or unnecessarily restrictive prohibitions on insider trading have the (intended or unintended) effect of protecting the incumbent management against shareholders. Restrictions on bank ownership in industrial enterprises fall into this category as well. The alternative is to allow the system to evolve, within limits, on the grounds that "capitalism has a knack of finding its own way." ["How to be a capitalist," The Economist , July 3, 1993, p. 19.] We endorse this philosophical position. Our limits - given by the need to preserve investor confidence in the integrity of capital markets - are spelled out throughout the book.