The News

Does the stock exchange still properly serve our economy?

27/08/2007

Several facts cast serious doubt on the utility of the stock exchange to our economy at the present time. 

First, companies listed on Euronext Paris raised a total of 37.5 billion euro in 2006. However, the CAC 40 companies alone (a subset of Euronext) paid out a total of 39 billion euro to their shareholders thus resulting in a deficit of at least 1.5 billion euro. The overall picture in 2004 and in 2005 was similar.  One needs to go back to 2003 to find a situation where the total amount of capital raised (31.6 billion euro) exceeded dividends and share redemptions (22 billion euro).  Listed companies are no longer being financed; instead they are getting poorer. 

Second, a recent Ernst & Young study on the evolution of the NASDAQ shows that investors are disaffected with technology stocks. In particular, from 2001 to 2006, the average valuation of a technology company at the time of its listing represented only 39% of the average valuation of companies first listed back in the 1992-1996 time period (which was well before the 1999-2000 boom). The NASDAQ, the specialised US stock exchange which financed all the American technology giants, from Intel to Microsoft, from Cisco to Oracle, is in a deadlock: public listings no longer compensate for the risk taken by the investors. And yet the economy is booming and capital is readily available.
 
Third, in 2005, the average holding period of shares by American mutual funds fell to its historical record of only 10 months.

What is the common root of those three facts? Quite simply it is the stark reality that long-term investment is no longer profitable. Even though they only have a small percentage of capital, hedge funds manipulate market prices and set the agenda: mergers, acquisitions, rapid distributions of assets through bonus dividends and share redemptions. The same policy is applied by a large number of LBO funds through company takeovers by delisting or in the private sector, through massive debt financing, rapid restructuring, distributions of assets, cost cutting in order to quickly improve profitability and sales to other LBO funds. What is the level of risk attached to such operations? Almost none because the targeted companies are established enterprises with records of sustained profitability. The only risk is a self-induced risk through debt leverage at the burden of the target. When significant profits, quick cash distributions and limited risk are available, why would anyone invest long-term?

We are clearly facing an anomaly in the system: it is simply not possible to quickly earn money with no risk over an extended period of time. As in the past, the system will correct itself. But one may ask when and at what cost to our economy.

The price we are paying for this is already high. We will only manage to achieve the universally sought after society of “innovation and technology” if long-term investments are revitalised. We will only create technological champions providing increased levels of future employment if there is a stock exchange with the capacity to build on the investments made by those who assumed the start-up risk. Our high performance SMEs which are so dearly valued by our governments will only conquer exportation markets if they can find support from the stock exchange.  Similarly, the best family-run companies will remain as targets for LBO funds for so long as capital transmissions cannot be done effectively through the stock exchange. The key point to keep in mind is that the exchange is the only medium which provides the means for genuine economic growth based on long-term interests, i.e. capital contributions, cash flow for initial shareholders, the possibility of hiring the best managers, and, most importantly, independence.  

What should be done then to make sure that the exchange fulfils its original role of being an engine for the economy? For starters, we should alert our institutional investors (insurance companies, pension funds and mutual funds) of the need for them to make sure that a large part of their investments is reserved for long-term investments. At the moment, those institutional investors are actually financing LBOs and hedge funds. By not participating in shareholders meetings, the institutional investors give hedge funds the openings they need to pursue their aggressive strategy. Furthermore, those institutional investors are shifting any resources they have from long-term to short-term investment.

What else can be done? Certainly tax laws should be modified to address the current problem. It would be useful to seriously consider promoting long-term investments, in particular as part of initial public offerings, by granting advantageous tax treatment to such investments, both for individuals and collective investment vehicles. However, at this stage, the most important measure is establishing proper taxation for hedge and LBO funds. How can we today justify exempting capital gains of those funds and allowing interest on debt financing be tax deductible, thereby leading to an additional return on profits which itself distorts competition?
By applying proper taxation to these funds, we would act equitably and at the same time we would reinstall a basis for a genuine and fair choice to be made between short-term or long-term investments. 

Let’s face the truth: we are currently weakening our best companies at the very moment when they need support to combat fierce competition from Japan, Korea, China, and India.  All of those countries have developed highly ambitious and efficient strategies with an emphasis on long term interests while we allow short term interests to eat away at our economy.

Jean-Bernard Schmidt