08 Sep 2003  Research & Ideas

A Bold Proposal for Investment Reform

Do the markets need an investor's union? Should company audits be overseen by stock exchanges? If you want to restore investor confidence, think radical reforms, say professors Paul Healy and Krishna Palepu.

 

For companies to redeem credibility with investors, argue Harvard Business School professors Paul Healy and Krishna Palepu, "fundamental and even radical reforms must be made to the way America's markets process the flows of information between consumers and providers of capital." Their recent Harvard Business Review article, "How the Quest for Efficiency Corroded the Market," proposes a number of radical remedies including tax breaks for long-term investors, the establishment of an investor's union, and making stock exchanges responsible for auditing of public companies.

Stock exchanges as auditors? The stock exchanges should be responsible for hiring and firing auditors, negotiating their fees, and overseeing the outcomes of the audits themselves, say Healy and Palepu. As they see it, the exchanges have a strong incentive to take on this role. After all, the availability of high quality information on corporate performance is critical to the effective functioning of the exchanges and maintaining their reputations for listing reliable securities. In this e-mail Q&A, Healy and Palepu expand on this and other reform ideas.

Cullen: You indicate that to get out of the rut we're currently in, both the suppliers and those demanding information have to be willing to consider radical ideas in terms of reform. What radical measures should the investor community or those demanding information consider?

Healy and Palepu: We believe that there are costs as well as benefits from liquidity in the capital market. The benefits have been widely discussed—the costs have not. One suggestion we propose is to provide even stronger incentives for long-term investing—namely to create a much more accelerated decline in tax rates for long-term investors than we currently have. For example, investors that hold for periods of longer than five years would pay a 0 percent tax, whereas those holding for very short periods would pay a hefty tax.

A second radical idea is to create an investors' union, similar to the consumer union that produces Consumer Reports. This should be a nonprofit organization, with responsibility for rating the performance of financial analysts from the viewpoint of retail investors.

We believe that there are costs as well as benefits from liquidity in the capital market. The benefits have been widely discussed—the costs have not.

Finally, we recommend that the external auditor problems can only be solved through a major change in the relation between auditors and the companies they audit. This may be achieved by making the audit committee responsible for hiring and firing the auditor. But we doubt it. Instead, we propose that a third party, the stock exchange, take responsibility for these functions. Stock exchanges' interests are the creation of a well-functioning capital market, where good and bad news are equally likely to be disclosed in a timely fashion. They are therefore likely to empower the auditors to take a more critical look at companies' financial statements. Stock exchanges could fund the cost of audits through a modest transactions charge.

Q: In your article you argue that the availability of high quality information is crucial to an efficient and functioning market. The market information environment can be seen from two angles—those supplying information and those demanding it. Who exactly are the players on the demand versus the supply side?

A: The supply side includes management and those associated with reviewing and attesting to management information, the audit committee, the board of directors, and the external auditors. The demand side comprises the users of company information, such as sell-side analysts, buy-side analysts, fund managers, the financial press, and retail investors.

Q: Past market reforms have not focused much on the quality of information, particularly from the point of view of the demand side. Why is this so?

A: Much of the blame for the recent problems has fallen on those responsible for preparing information. The auditors and audit committee, in particular, are perceived to have failed to carry out their duties, leading to reforms within the audit industry and new requirements for independent, qualified audit committees. The assumption underlying these reforms is that if good information is available, the demand side will use it to make informed investment decisions. Yet, recent evidence questions this assumption. Seasoned investment professionals acquired dot-com stocks that showed poor reported financial performance, and which they recognized were wildly overvalued. Fund managers owned 60 percent of Enron at its peak (and beyond) despite the company's lofty multiples that were difficult to justify given the company's reported performance at the time. (Of course, we later learned that this performance was over-stated due to accounting problems at Enron.) Unless we can ensure that analysts and professional investors use information to evaluate a company's long-term fundamentals, simply fixing the quality of information supply is unlikely to fully solve the recent problems.

Q: Are there inherent flaws in the set up of an asset management business? Given that it is a business, can it properly look after the needs of its investors while also looking after the bottom line?

A: Ironically, the primary challenge to the production and use of high quality information in the asset management business comes from increases over time in liquidity for investors. Liquidity is typically thought of as a positive, since it allows investors to quickly switch their savings out of poor performing stocks or mutual funds, putting pressure on asset managers to act in owners' interests. However, as recent research in behavioral finance indicates, it also encourages investors to switch assets to the most recent hot funds each quarter. This creates problems for fund managers that want to take a long-term perspective. One poor quarter can lead to significant fund outflows, and several poor quarters can potentially cost the manager his/her job. As a result, fund managers face pressure to follow the crowd—to hold the same hot stocks as competitors.

For example, even the most skeptical professionals felt compelled to get into the dot-coms. To steer clear of these stocks would expose a fund manager to criticism and the fund to outflows during the boom. And when the crash came, the manager could argue that investors in the fund were in the same boat as everyone else, and so the fund manager really shouldn't be blamed for the poor performance.

Q: Your article suggests setting up a nonprofit investors union. Could you go into more detail on how such an organization would be set up and operated?

A: The Consumer Union attracts highly talented professionals to help provide scientific information to consumers about a wide range of products. The Union is funded through consumer subscriptions to Consumer Reports, and through private grants. This model has several advantages. By directly linking its output to consumer use of its service, it provides a powerful incentive to meet consumers' needs. And by remaining fiercely independent, it is able to attract high quality professionals who subscribe to its public-service mission. Our idea is that a similar organization—which we call Investors Union—could be set up to help provide equity investors information on the quality and long-term performance of analysts and investment managers. Our vision is that it will be an independent, nonprofit organization deriving its funding either from foundation or government grants, or from the sale of its information.

Q: The typical U.S. investor is more informed about financial markets today than twenty years ago. Do you think it's likely the public would be more receptive to the reforms you suggest and have a better understanding of the benefits associated with them?

A: Investors continue to see the benefits from equity investing. However, they are feeling burned from recent corporate scandals and seemingly widespread earnings management. They are also focused on short-term performance of the stock market, both in good and bad times, and therefore, perhaps over-reacting to the current events. We need to rebuild trust in management and the institutions that help to make the market. This is the perfect time to debate the merits of the current proposals as well as to consider other options. We believe that the current responses are inadequate, since they do not attack the root causes of the recent problems. Our intention is to encourage further discussion and debate in the hope that a more creative and enduring solution can be found.

Improve company analysis

by Paul Healey and Krishna Palepu

The model for our proposals for the investment analysis industry is the Consumers Union, an independent nonprofit organization established in 1936 that provides information on product quality and reliability. Over the years, through the publication of Consumer Reports magazine, the CU has established itself as the consumer's best friend. Today, it spends more than $20 million a year on product testing. More than 100 experts work in the organization's fifty labs, conducting research in a variety of product categories including appliances, automobiles, chemicals, electronics, food, home environment, and home improvement. There are more than 4 million subscribers to Consumer Reports and millions more to its other publications and online reference service.

The most effective way to rescue the fund management profession would be to reduce investors' incentive to trade so actively.

To preserve its independence, the CU finances itself entirely from the sale of its information products and services and from donations and grants from noncommercial sources. It chooses which products to test, purchases the test items rather than taking free samples from manufacturers, and accepts no advertising. It also prohibits manufacturers from using its ratings in their advertisements. The CU is governed by a board of directors, which is directly elected by the CU's members, who are largely Consumer Reports subscribers.

The CU improves the functioning of product markets in several ways. It gives consumers confidence in products that are not well-known brands. For example, when Toyota first introduced its small passenger cars in the U.S. market in the 1960s, it was a relatively unknown brand. Thanks in part to high ratings for its cars from Consumer Reports, within ten years Toyota was the number one imported auto brand in the United States. The CU is also the consumers' protector: Consumer Reports magazine was one of the first publications to alert consumers to the harmful effects of nicotine in cigarettes.

We propose the creation of a similar independent, nonprofit organization for the financial markets—an Investors Union, perhaps. We do not believe that the IU should conduct primary analysis of listed companies, however. Instead, we propose that the new organization rate the performance of the analysts at the various banks and brokerage houses by tracking the historical quality of their earnings forecasts, qualitative analyses, stock recommendations, and price forecasts, as well as their degree of independence. This approach would be more effective, at least in the near term, because it would build on the existing research infrastructure and requires only modest incremental investment. It would also preserve the benefits of competition among analysts.

Funding for the new IU could come from several sources. One could be through the direct sale of ratings to investors. A second could be through foundation grants and donations. The IU could also raise funds by publishing—like the CU—a periodic Investor Reports.

At first glance, these new ratings might seem redundant; the performance of investment analysts is already tracked by investors through, for example, Institutional Investor (II) ratings. But such ratings have proven to be unreliable: Now discredited analysts such as Jack Grubman, Mary Meeker, and Henry Blodgett were rated as All Star analysts by II not long ago. In fact, academic research shows that there is little sustained difference in forecast performance between II All Star analysts and the rest. Clearly, II ratings seem to reflect factors other than analysts' ability to perform high quality analysis.

Excerpted with permission from "How the Quest for Efficiency Corroded the Market," Harvard Business Review, Vol. 81, No. 7, July 2003.

About the author

Ann Cullen is a business information librarian at Baker Library, Harvard Business School, with a specialty in finance.