Could loyalty shares really compel investors to hold shares for longer periods of time?
The debate over how to combat the tendency toward short-term thinking by companies and investors holds no promise of being resolved any time soon. Two weeks ago, at the Millstein Governance Forum at Columbia University, panelists in various sessions considered the issue from numerous perspectives.
The widely held belief that activist investors are motivated by the prospect of a short-term pop in a stock price is increasingly being met with public testimony from activist hedge fund firms about the value they add upon securing a seat on the board by pushing management to take a deeper look at underperforming areas of the business and taking what are often long-term steps to improve them.
During one panel at the forum, the founding partner of one such firm spoke about his firm's push to deconstruct the consolidated financial results of a fast food chain whose shares it owns into their constituent parts to see how its core branded stores were contributing to profits, apart from the contribution of a coffee shop chain it also owned, which, as a franchise-based business, had a completely different model.
When it finally succeeded, the board saw 8 percent margins on a stand-alone basis versus an average margin of 16 percent-17 percent for the fast food industry as a whole. That prompted a deep dive into the fast-food chain’s business practices that revealed a lot of waste and room for improving the product and the customer service. In addition to scrapping little-used fax lines into every store, the hedge fund firm was instrumental in changing the basis of store managers’ pay to each store's cash flow from the previous reliance on revenue. An analysis of differences in product and customer service between the fast-food restaurant chain and a key competitor resulted in a much more attractive product offering. It also led to the decision to spin off the coffee shop business; nine years later, the hedge fund firm still owns shares of the fast-food chain.
There are other decisions regarding board composition that can ‘serve or feed the long-term business strategy of a company,’ said Bill McNabb, Vanguard’s CEO and chairman, during another session. He cited the example of a personal care products company that recently added a director from the tech sector whose experience is expected to be helpful as the company pivots more toward e-commerce in the future.
It didn’t take long to figure out he was referring to DIRECTV CEO, president and chairman Michael White, who joined Kimberly-Clark’s board in September. In a statement when White’s election was announced in June, chairman and CEO Joseph Falk said that, in addition to his financial and operational background, White’s ‘digital industry experience at DIRECTV will greatly benefit Kimberly-Clark.’
Where White’s election to Kimberly-Clark’s board seems to have been proactive, Neiman Marcus’ appointment in spring 2014 of three new directors to its board – including Starbucks’ chief digital officer and the former head of social media at Google – came only after the company had confirmed security breaches of its credit card payment system.
At the Millstein forum, Columbia Business School Professor Patrick Bolton summarized a proposal in a recent paper he co-authored, recommending that companies grant loyalty share warrants to shareholders who have held a stock for at least three years as a way to ‘incentivize more of a commitment.’ Those shareholders would then have three more years to exercise these warrants. Bolton emphasized that his proposal differs from the Ferrari model, where loyalty is rewarded with double-voting rights, and Toyota’s version, where the recently issued Model AA class shares are designed specifically to fund the automaker’s five-year research and development efforts into new technologies in a way that reduces the volatility of the share price.
The French government seems to have embraced the ‘nudge’ approach advocated by behavioral economists Richard Thaler and Cass Sunstein by making loyalty shares the default for more committed investors. Under France’s Florange Law, passed last year, investors are granted double votes for shares held for more than two years unless that is opposed by a vote of two thirds of the company’s shareholders. Italy’s legislature has made single-vote shares the default, permitting double-voting rights for loyalty shares only if two thirds of a company’s shareholders opt in, as reported in Law360.com last month.
There has been quite a bit of pushback from minority investors in Europe against the idea of tying loyalty shares to increased voting rights. Bolton believes financial rewards are a better incentive to investor loyalty than additional voting power, which he thinks results in more entrenchment of controlling shareholders, reduces liquidity in the shares and doesn’t motivate more engagement by shareholders, as reported in Law360.com.
But any loyalty share scheme seems to underscore a central problem in investing worldwide these days: a lack of confidence in senior management’s ability to deliver long-term profits.