The Professor's New Clothes

There was some special pleading in City AM yesterday in an article titled Why financial markets matter for the real economy. His full paper his here.

He lays out the issue concisely enough:

Of course, real production requires funding. And so it’s clear that primary financial markets create value, by providing new capital to businesses. But the vast majority of activity occurs in secondary financial markets, where no new funds are being raised. Hedge funds, mutual funds, and other investors typically trade second-hand stocks and bonds, and do so among each other. Real companies are not involved, so surely they can’t benefit?

Although the answer is clearly 'no', he argues that the answer is 'yes'. It's worth reading the article in full just to see how threadbare his arguments are, but his logic boils down to this:

Many of the key drivers of a firm’s long-run value, such as its strategic positioning, are difficult to measure objectively. Like an efficient polling system, the stock price aggregates the information of millions of investors, each with their different viewpoints, and summarises them into a single number which can be used by anyone for free.

For example, a bank deciding whether to lend, a worker choosing which company to join, and a customer or supplier deciding whether to enter into a long-term relationship can use the stock price (in addition to other measures) to guide them.

It's clearly all nonsense (especially the bit about banks basing lending decisions on the share price!) and you will see why if you are prepared to consider the obvious alternative to having companies with quoted shares.

(Clearly, it's best if businesses are privately owned and that the profits accrue to the people prepared to invest in the business, we are agreed on that.)

That obvious alternative to plc's with quoted shares is a corporate ownership/financing model somewhere between a 'Limited Liability Partnership' and a 'building society'. Let's call it a 'deposit funded company' (DFC) for sake of argument.

A quoted plc raises money by issuing new shares for cash on the primary market. Investors get one vote for each share. Directors decide how much of the profits to allocate to general reserves and the rest is paid out as dividends. If the business makes losses, the shares go down in value.

If shareholders want to realise their investments, they can only sell their shares 'second hand' to subsequent investors on the 'secondary market'. This means that the directors of a quoted plc are largely insulated from their own bad decisions. They've got the shareholders' money with no obligation to return it. I know that theoretically a majority of shareholders could vote to sack them and replace them with new management, or vote for the company to be liquidated, but that hardly ever happens.

A DFC raises money in much the same way as a plc. Investors would deposit money into 'capital accounts' with them. Investors would get one vote for each £ average balance held in the period in question. Directors would allocate part of the profits to general reserves, and the balance would simply be credited to investor's accounts as interest or profit share, just like a building society or an LLP. If the business makes losses, this will be netted off with the general reserve and if the losses are huge, the difference will be deducted from 'capital accounts' like negative interest.

So far so good. The big differences are:

1. Investors in a DFC would realise their investment by withdrawing money from their accounts again - just like when you withdraw money from a building society account or when a partner leaves a partnership and is repaid his capital. That might be because they don't like the directors' decisions, because they want to spend the money or they want to invest elsewhere.

2. The amount an investor pays in to the business is broadly speaking equal to his share of the company's actual assets. If an investor buys shares second hand, what he is paying for is the value of future profits or dividends, which is usually (but not always) a much larger figure than actual assets but this figure is pure speculative guesswork, so fluctuates wildly and more or less at random.

3. Investor's total profit allocation in a year would be pretty much the same as the dividends they would have received, but expressed as a percentage of cash invested, it would be much higher than the dividend yield on shares.

4. The yield on a DFC account would be a very accurate reflection of how well or badly the actual business is doing. There is no smoke and mirrors, investors cash position would mirror the fortunes of the business very closely. Investors would look closely at the performance of the business and not be distracted by share price fluctuations. A DFC investor knows what return he is getting in near-cash, and he can compare that with previous years or with the return which other DFCs are paying. That is all be needs to know.

If you own plc shares, half of your total return is dividends, fair enough but these bear no relation to your pro rata share of the assets; it is more the case that the share price is a function of the dividends. And your share price gains or losses in a period bear little or no relation to your share of the assets, the business' actual performance or anything else 'real'.

5. If DFC investors are unhappy with directors' decisions, they will simply withdraw their deposits, so directors will get instant feedback on what 'the markets' want them to do. Or the whole thing will become much more democratic. Some directors might think it a good idea to branch out into new market or product XYZ but instead of just steaming ahead, they are more likely to ask investors to vote on whether they think it is a good idea.

If the business is in a real mess and too many investors want to withdraw at the same time, the directors will just have to put a stop on withdrawals for the time being. This is no different to trading in the shares in a company being suspended, or a quoted company becoming a private company again (private company shares are very illiquid).

6. With plc's, there is a primary market for companies to raise new capital, a secondary market for people to trade them later on and sporadic share buy backs.

With DFC's there is not even a need for a primary market, let alone a secondary one. The middlemen are completely cut out. Investors pay directly into and withdraw from 'the business'.

There would be no need for directors to stage gimmicky share buy backs when they run out of new things to invest in, because this would happen organically - if the DFC's business has run out of new things to invest in and is just accumulating surplus cash, then investors yields (expressed as a percentage of their account balances) will fall and they will withdraw funds to invest somewhere better, thus pushing up the percentage yield on the new lower account balances.

7. This will allocate real capital most efficiently. Ignoring risk premiums, investors will tend to withdraw and invest in such a way that each DFC is paying a very similar 'interest rate'.

8. It would also be a boost to employee share ownership. The value of plc shares depends on the company having the right workforce. So if an employee wants to buy shares in the plc he works for, he is paying for the value of his own future efforts - the harder he works, the higher the share price, which is a subtle form of debt slavery.

With a DFC, employees would rank the same as everybody else, if they invest in their employer, all they are paying for is a share of the actual assets used in the business, the same as a self-employed person having to pay for the assets he needs in his business, which is perfectly fair and reasonable.

9. There would be hardly any 'insider trading' or high frequency trading as there would be nothing to speculate on. This is entirely unproductive activity and their loss is proper investors' gain, improving returns to investors by a small margin. There would be little 'asset stripping', because it would be impossible to buy shares in a business at below net asset value. Investors would always be paying close to market value for the underlying assets.

What's not to like?