WHY THE FTSE IS THE WORST INVESTMENT MARKET IN THE WORLD FOR HIGH-TECHNOLOGY AND KNOWLEDGE-BASED COMPANIES - Research Evidence

Some Background.

We wrote 'Having Their Cake' because our experience at the top of big industrial enterprises was that the financial markets disadvantaged those companies that wished to consistently invest in their businesses for the long term. Furthermore, we had much direct personal experience of the value destruction, wastefulness and human chaos caused by ill-conceived mergers and acquisitions, which are a short cut way of growing a business much favoured by investment banks.

Because the companies for which we worked were very international, we had the experience of working with senior managers of many nationalities. That gave us a privileged insight into their views of the UK financial markets and their impact.

We have vivid recall of a letter written by a Dutch managing director to his British group CEO after the conclusion of the annual budget round had revealed that the cash available to pay a very high dividend to investors would be tight - and therefore capital expenditure would have to be cut back. His letter asked pointedly how on earth he was expected to improve the performance of his factories (which surely was in shareholders' medium-term interests) when the capital to modernise antiquated, under-invested plants kept being removed. Furthermore, said he, you can't run a business on a stop-go basis according to the whims of a set of transient speculators (which is how he saw the City).
Even American managers expressed amazement at the short-termism and ignorance of many UK investors.

When we retired from corporate life, we wanted to make our experiences available to a wider audience and we started to research a book. The more data we uncovered, and the more people we interviewed, the more it became plain that the interface between large company managers and the financial markets was resulting in patterns of behaviour that were hugely destructive of larger companies in advanced knowledge and technology industries, the bedrock of developed economies.
In 'Having Their Cake' we catalogued what had happened to FTSE 100 companies and those in the tier beneath. The demise of British-owned companies in advanced service and high technology industries has been spectacular over the last 20 years or so. Some companies have been destroyed, some have retired (hurt) to the relative quiet of the lower reaches of the FTSE 350, some have moved out of the equity markets to private ownership and many, many have been acquired by foreign competitors.

Whatever your views may be of the location of company ownership, foreign acquisition of knowledge-based companies means a loss of intellectual capital, a reduction in UK-based research and development, the removal of strategic decision-taking to another country and a loss of innovation. All of these consequences will have corrosive long-term effects on national prosperity and the skills base. This is before one considers the knock-on effects on highly paid employment and on university science and research. To characterise this loss as being the 'Wimbledon Effect' is superficial and misleading.

The book 'Having Their Cake' was generally well reviewed. Well-known economist John Kay finished a generally positive review by writing, Many more case studies, and more comprehensive statistical analyses are required to confirm the suggestive and disturbing arguments that Young and Scott put forward. But I believe they would.

Well, here is some more research - in fact a major study conducted by Professor Andrew Tylecote of Sheffield University Business School, UK, and Dr Paulina Ramirez of the University of Ireland. This study looks at different investment styles and strategies in the UK, US, France, Germany and Japan, and comments on their effects on innovation, R&D and investment in advanced manufacturing industries. The researchers draw on their own investigations and a vast amount of data from across the world.

In summary, they conclude that the UK investment system, which is dominated by institutional investors, focused on the economics and dynamics of industries rather than on companies and which tends to shun close long-term engagement with individual businesses, is unique in the world, and markedly different even to that of the US, with which it shares some basic features.
Their paper is long and quite complex, so here is the gist of their argument, the 'story', so to speak.

1. In the world, there are two sorts of relationships between investors and enterprises, Insider-dominated and Outsider-dominated.

Insider-dominated systems are characterised by close and long-term relationships between companies and investors, often banks, but also stock market investors. These systems also may include many dedicated family or small private and employee shareholders. These kinds of shareholders tend to have a depth of understanding of individual companies that comes from long involvement.
In such systems, it is also not unusual to see cross- holdings of shares between companies that collaborate to share know-how, technology and expertise in order to serve customers and compete effectively. Such systems tend also to be characterised by the inclusion of stakeholders other than investors in decision-taking.
Japan, France and Germany, together with Scandinavia, the Netherlands and many Far Eastern economies tend towards such systems.

Outsider-dominated systems, which are found in their strongest form in the UK and US, are characterised by the dominance of large, highly liquid stock markets, with investment substantially channelled through professional institutions. These institutions tend to be distant from the companies in which they invest, may have high levels of industry knowledge, but generally lack intimate knowledge of individual companies.
"Hurrah", you may shout, "Red-blooded capitalism - just look at the performance of the US economy and their levels of technological entrepreneurialism - let's have more of it and a good measure of creative destruction to boot".

Before indulging in such celebrations, take a second look. The researchers identified some markedly different factors between the US and the UK:

• There is a vastly greater amount of employee share ownership in the US than in the UK - generally by people who understand their companies and are dedicated to them. Companies in turn tend to act towards such employees in a very including manner.
• There are many more individual shareholders in the US, in fact, individual shareholdings amount to 48% of the total in listed companies (19% in UK and falling). Individuals tend to be longer term investors than many institutions.
• Research conducted in 1997 found that in the UK, 62% of listed stocks were owned by financial institutions, as opposed to a dramatically lower 37% in the US.
• The availability of venture capital is far higher in the US, as is the incidence of 'Business Angels'; wealthy, knowledgeable individuals who take a close and long-term interest in the companies in which they invest.
• Some US states have laws that make hostile takeovers difficult, (Delaware is one, which is one of the reasons why so many US companies are incorporated there), definitely not the situation in the UK, where the law tends to encourage M&A activity. Delaware law allows employee shareholders to vote in the case of a takeover bid, and positively encourages family ownership.
• There is a far higher incidence of long-term focus and value investors in the US. These investors tend to develop close and understanding relationships with the companies in which they invest, and seek to be helpful and somewhat nurturing towards those companies, in the belief that performance will be enhanced.
• Just to cap it all, the US government has proven itself to be decidedly protective of the interests of US companies, in terms of corporate bail-outs, preference for contracts, rampant protectionism and subsidies.

The net effect of all of this is that the US has some of the characteristics of insider-controlled systems, certainly much more than UK.

So, to sum up the gist of this section of the research: the UK has an investment system that is dominated to a greater degree than any other country by impersonal institutions that are obsessed with short-term returns and do not care for or have much interest in, individual companies in which they invest. (Our words).

Their first instinct in the case of any trouble is to sell the shares, their second is to try to cause a takeover, and only as a last resort will they engage the management. When they do, the fact that they understand little of how companies really work, because engagement is not their natural style, and their people are not trained or experienced to do so, makes the outcomes rather uncertain.

US investment institutions have much more company-specific expertise and a significant proportion of investors tend to seek long-term and engaged relationships with the companies in which they invest.

The implications?

1. Investment institutions that have little involvement with individual companies, that compete to beat industry indices and bet at arms length on share prices, tend to have low tolerance for risk and a preference for short-term results.
2. Investors who engage closely with and have good knowledge of companies and their technologies will tend to have a longer term perspective and support higher levels of R&D.
3. Most (but not all) innovation is not based on 'breakthrough' inventions - it is incremental and builds on growing funds of knowledge and experience. Such innovation is long-term, complex, depends on the interaction of many activities and requires firm-specific understanding.
   Companies that rely on high levels of innovation to succeed therefore tend to benefit from long-term relationships with investors who understand their businesses.
4. Some forms of research are more generic and can be understood at a greater level of scientific generality - pharmaceutical research tends to be like this.
5. Business academics are predicting that future success in global markets will come from new forms of collaboration between companies. Insider-dominated systems, which are characterised by the inclusion of many stakeholders and cross-holdings between collaborating partners, may well have material advantages in the future world of collaboration/competition.
   Maybe the US has the best of both worlds- a tough performance orientation and high investor and employee involvement.
   This aside, there is strong evidence that collaborative and trusting long-term relationships between industrial suppliers and customers confer huge economic benefits.

So what does this mean?

1. Britain has an investment system that is very short-term in its outlook, and generally not very interested in understanding the complexities and dynamics of individual companies. Generally speaking, investors would rather sell the shares or support a takeover bid of a company than engage in a close long-term relationship, especially if there are problems.
2. The researchers describe the pressures that UK institutions exert on companies as 'asymmetrical', that is they tend to encourage high dividends and short term performance and punish high levels of long-term investment.
3. These features are uniquely marked in Britain - more so than the US and much more so than in other developed countries.
4. Companies in advanced knowledge and science-based industries need high and consistent levels of investment - and are helped if investors understand their businesses. Britain is deficient in such investors.
5. Future success in high-tech and advanced knowledge businesses is also likely to be based to a great degree on inter-firm, cross-border collaboration. British investors tend to be suspicious of such arrangements, especially if they lead to circumstances that may make individual companies difficult to acquire.

Evidence.

1. The UK is strong in just two sectors of advanced technology - Aerospace and Pharmaceuticals. Pharmaceuticals is described by the researchers as a special case, where the need for R&D is understood on an industry-wide scale and risks are reduced by patent protection and having governmental and quasi-governmental bodies as customers.

   The two UK players in aerospace, BAe Systems and Rolls Royce, are protected by a UK government 'golden share' that makes them difficult to acquire, although BAe Systems is known to have unsuccessfully hawked itself around US companies looking for a 'merger' partner.
   Thus UK investors will support higher levels of R&D in Pharmaceuticals, because the industries can be understood without having a close relationship with individual companies and in BAe and Rolls Royce, because they find it difficult to stop them.
   However, Sir Ralph Robins, ex-chair of Rolls, is on record complaining bitterly at the short-termist tendencies of UK investors.

   In all other high-knowledge, high technology sectors, the UK is markedly under-represented by substantial companies. These include:
   • IT hardware
   • Electronic and electrical equipment
   • Semi-conductors
   • Office, accounting and computing equipment
   • Radio, TV and telecommunications equipment
   • Chemicals - a rapidly declining sector in the UK
   • Automotive
   • Computer software, except for standard software.
   • And for good measure, Investment Banking and international Consulting - and probably to come, Stock Exchanges!
   This list might be described as the sinews of a modern economy.
2. Levels of R&D are markedly lower in UK companies, apart from Pharmaceuticals and Aerospace. Once upon a time, in the 1960's, British companies invested more in R&D than foreign competitors, but there has been a steady decline since then, that has coincided almost exactly with the emerging dominance in the UK of large investment institutions.
   
   The British tragedy is that we have moved from a system of high R&D spend, accompanied by rotten management, to one of low R&D spend, accompanied by a different form of poor management!
3. In some industries, the levels of R&D spend by foreign companies in the UK is higher than that of indigenous companies - and this does not count the R&D that foreign companies carry out elsewhere.
   In nearly all industries the levels of capital expenditure by foreign companies in Britain greatly exceeds that of indigenous companies.
4. The cost of funds to companies is higher in UK than all developed countries, mainly because of high dividends. (which might be regarded as investment foregone).
5. Britain is now in a situation where the adverse balance of trade is probably endemic and permanent - and anyhow, some 50% of gross UK exports are now made by foreign-owned companies.
6. The nature of industrial and commercial supplier-customer relationships is markedly different in the UK from that of many other countries.
   To quote one researcher: With some notable exceptions, British firms display the same kind of low-trust, short-term ethos with suppliers in manufacturing as the City does to manufacturing in general.
   Other research into the relationships between suppliers and customers in the food industry blames poor, short-term, aggressive and contractual relationships for some £3 billions of the adverse gap in the balance of payments account.
7. The productivity and value-added of British-owned companies is markedly lower than that of foreign companies, even their subsidiaries in Britain.

Endpiece.

We have probably produced enough words and facts to fill readers' heads right up! Those, like John Kay, who want more evidence can easily refer to the copious statistics at the back of Tylecote and Ramirez's research paper, as well as a mass of evidence from such bodies as the UK Department of Trade and Industry, Institute of Fiscal Studies, OECD, etc, etc.

What makes their research particularly disturbing is that it stacks up with so much other supporting data, as well as with the experiences of many people in management, the pensions industry and even within the financial markets - and it also accords closely with our own experience and research for 'Having Their Cake'.
Of course, the British condition is not all bad news, far from it. The country can thank smaller companies, entrepreneurs, venture capitalists, inward investors and the leaders of some large companies for their enterprise and innovative skills. There is also a band of brave souls within the City that would like change, but it is our experience that the bulk of the market behaves towards them with indifference at best and sometimes very aggressively.

Society, ie, such people as small investors, employees, pension fund members, researchers, scientific academics and all those who depend on larger high-knowledge businesses, now and in the future, are being sadly let down by the financial markets.

'UK Corporate Governance and Innovation.'

Professor Andrew Tylecote, University of Sheffield Business School and Dr Paulina Ramirez, Centre on Innovation and Structural Change, University of Ireland, Galway.

1. British companies expenditure on Research and Development and capital expenditure, the twin roots of high performanmnce in technologically sophisticated industries, is less than half that spent on Mergers and Acquisitions. In US, despite hi levels, much lower than R&D investment It is well known that up to 70% of mergers and acquisitions fail to create value.