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dominic-barton's picture

The Power of Beliefs to Move Markets and Mindsets

Co-authored by Conor Kehoe.

Dominic Barton is the Global Managing Director of McKinsey & Company. Conor Kehoe is a Director in McKinsey's London office.

Mindsets matter. For more than two years, we and others have been talking about the need to shift the prevailing view among managers, boards of directors and investors from "quarterly capitalism" to what we call "capitalism for the long term". Together with Harvard Business Review and the Management Innovation eXchange, we have issued a challenge calling for the most instructive case studies and provocative ideas that will help us re-imagine capitalism for the long term.

Despite promising signs of change, such as a growing turn away from the standard practice of issuing quarterly earnings guidance, old attitudes die hard. More and more, we realize, the crucial first step is to tackle our deeply embedded intellectual frameworks. Beliefs drive actions and altering our belief systems will ultimately do more than anything else to amplify and reinforce the kinds of behavioral changes that, in the end, are the only measure that counts. In this blog post we'd like to focus on two belief shifts that are critical.

1) Believe in your power to make markets efficient — but abandon the efficient market dogma

The global financial markets are an extraordinary information processing engine. Nothing beats the tracking mechanism of stock prices when it comes to quantifying the constant push-and-pull of thousands and thousands of investors and managers, pursuing and acting upon different strategies. And yet . . . it's an extraordinary leap of faith to go from acknowledging this fact to believing, as orthodox efficient market theory holds, that markets are so efficient that all relevant information is always and immediately embedded in prices. Such a belief implies that any and all decisions that improve a company's short term share price must logically also be improving its long term health and vice versa. There can be no contradiction, or so the theory goes.

In fact, much evidence suggests that the market often gets it very wrong in the short term — with the most telling example being the 2008 financial crash itself. Beyond such large and violent macro-swings, our own research at McKinsey suggests businesses that reallocate their capital more aggressively can generate higher long term returns than their more passive peers - even if, in the first few years, such actions initially reduce previously expected earnings (and thus may prompt a set of investors to sell down the stock, regardless of the long term value creation). Assuming the market is perfectly efficient, it appears, merely damns it to inefficiency.

Our suggestion: instead of passively accepting that the market is always right, investors, managers and boards of directors need to think in terms of how they can actively make it more efficient. In short, they need to develop and contribute viewpoints to the market - not assume the market already contains them - and then be ready to stick to their guns. This is the way both to achieve higher returns and make the market more efficient.

2) Believe in the real game — long-term value creation — and stop acting as if you are meeting your highest calling if you simply play by the rules

We direct this urgent call less at operating managers, who are out there getting muddy and trying to score goals every day, than at other critical corporate players, such as the trustees of pension funds and sovereign wealth funds or a company's independent directors. Does anyone honestly think this crowd today are doing all they could to provide good governance and proper stewardship? Sadly no. Too often they focus more on checking the boxes and ensuring that they have met their (not inconsiderable) compliance obligations. But with a crucial mental reset, they could and should play a much more vital role in pursuing the real prize, which is long-term value creation.

For big pension fund and SWF managers, that role change starts with spending the real time required to understand and have a forward-looking viewpoint on their investments. There are many ways to achieve this end, once belief systems shift. One path could be to concentrate one's portfolio. For example, Dutch pension fund PGGM, with over 100 billion euros under management, decided a few years ago to focus one of its 3 billion euros of its equity portfolio on 15-20 stocks, engage with those investments as an active long-term owner — and stop tracking the indexes. Another course might be to take more activity 'in house', especially if contracting investment management out makes it difficult to achieve alignment with one's chosen asset managers. Or it may involve keeping a wide portfolio but concentrating governance efforts on shaping management and strategy at a few stocks at a time - and doing so either alone or in collaboration with others.

Independent directors confront the same challenge: currently they too often serve as the box-checking last step in signing-off on a CEO-run strategic process. If they want to move beyond obeying the letter of the laws governing their fiduciary duties and delve deeply into the content of strategy, then they need to increase one critical investment: their time. This won't be easy, but there are signs the core belief system may be changing. In a recent survey of some 1600 members of boards of directors, we found that their number one goal is to spend more time on strategy and the best way to achieve this, they believe, is to carve out 10 more days a year for their board duties (a third more time than they are currently spending).

The key step is to foster deeper board engagement. Beyond that, we have learned, it also helps if an active independent director's relevant skills match up with the strategy of the company he aims to steward. Our recent research on 110 large European companies managed by private equity firms found a strong correlation between successful value creation and the skill set of the partner serving as lead director. PE partners with extensive M&A experience delivered better results when the companies they were overseeing were also embarked on an aggressive M&A strategy. Similarly companies pursuing organic growth created more value when the lead directors from their PE owners had backgrounds with deep management expertise.

Obviously much more needs to be done to foster a capitalism that is truly patient, principled and socially accountable. The list stretches from adopting an investor relations policy that concentrates on fostering a long term investor base and developing better metrics to tackling, with guidance from active owners, some of the flaws and inequities in executive compensation. We intend to continue exploring those issues--and the solutions required to better address them--in our ongoing research. But the critical first step, we're convinced, is for more and more institutional investors and independent board members to abandon old orthodoxies and embrace a new belief: the belief that through greater engagement and more active ownership/stewardship they can enhance the market's efficiency while delivering greater value creation for stakeholders and shareholder alike.

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tim-macdonald's picture

I strongly second your conclusion that "the critical first step...is for more and more institutional investors ... to abandon old orthodoxies and embrace a new belief: the belief that through greater engagement and more active ownership/stewardship they can enhance the market's efficiency while delivering greater value creation..."

Institutions - Insurance, Endowments, Pensions and Annuities - have emerged as the new stewards of our private wealth. Vast sums of money are entrusted to their care, and part of their charter of trust is to invest that money to make more money.

They want to invest for the long term, because their core business is to provide financial security to their constituencies over the long term (unlike banks, who are charged with providing liquidity to their customers in the moment, moment-by-moment).

How can they do that within the short-term architecture of the Exchange-based Capital Markets?

It is beyond my ability to contribute meaningfully to the important issues of shareholder activism and board participation in the context of large, established public companies, but I have this "hack" to propose.

What if, instead of driving young Enterprises to follow in the footsteps of their Public Company predecessors, and enter the Capital Markets to begin the process of managing their business with the end goal of managing their share price, we instead enable a direct connection between Enterprise and Investment built on a strategy of realizing investment returns by sharing in Enterprise profits?

If we can take share price out of the return realization equation, won't that give both Enterprise and Investment greater freedom to align their interests along a range of shared values, including how they both agree that want to define acceptable returns (both as to timing and method of realization)?

This is not as revolutionary as it may seem. Institutions routinely invest this way in Real Estate, in Project Finance, even in the Fund Managers who manage their trading activities for them. For some reason, they just don't invest in more general commercial Enterprise that way. Why not?

Circling back to one of your earlier points, money flows on information and communication. Today we have computers, the Internet, email, the World Wide Web - this MIX project - and many other ways to create and exchange information and ideas, in real time, from remote locations, that simply were not available when the Exchange-based architecture for connecting Enterprise to Investment was first adapted to fuel the engines of American Industrial Expansion into our Western Frontier, back in the 1850's. These technologies that are not available to us today make direct communication -- and direct engagement -- between Enterprise and Investment possible in new ways that still very much need to be explored.

As with all truly transformative innovations, this will have to start small. It won't have a big impact on big companies that already operate in the public markets and on a global scale. At least not right away. But we have to get started.

robin-stafford's picture

Unfortunately, those boards, independent (sic) board members and institutional investors are all bound up in convoluted reward systems that are designed to drive just the opposite of the behaviour that might foster the kind of capitalism described. Those 'old orthodoxies' are massively lucrative to those practicing them whilst being deeply destructive for everyone else. But why would they abandon them when they have every incentive to continue as they are? As has been perfectly demonstrated by the financial services sector over the last 3 years, despite overwhelming evidence of the destructive results of their current 'orthodoxies'.

So regardless of whether you believe that rewards on the scale seen over the last 10-15 years are even remotely justified, changing the basis of the incentive schemes to drive very different behaviour has to be the start point.