The Free Market Doesn't Have to Be Short Term

LONDON -- It is often said that we live in a culture of instant gratification -- and this is especially true of financial markets. The debt crisis was a spectacular example. Upfront profits blinded over-confident investors to long-term risk -- with disastrous consequences. Since the crash, lack of confidence has given rise to a different type of short-termism.
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LONDON -- It is often said that we live in a culture of instant gratification -- and this is especially true of financial markets. The debt crisis was a spectacular example. Upfront profits blinded over-confident investors to long-term risk -- with disastrous consequences. Since the crash, lack of confidence has given rise to a different type of short-termism. Increased risk-aversion often causes investors to head for the exit at the first sign of trouble -- even if it means sacrificing their long-term faith in a company. The current global market volatility is yet another example.

As a result, the average holding period for a stock market investment -- which was once measured in years -- has fallen dramatically. Although the figures are skewed by the advent of high-frequency trading, the culture of short-termism is more widespread. More investment funds now trade against a company's short-term profit announcements rather than its long-term fundamentals. Although this can be seen as a natural response to tough market conditions, the impact of such "impatient" capital can also be profoundly negative.

Imagine that an investor recycles their capital across a hundred companies in the same year. They are naturally less inclined to take an interest in environmental or social costs -- such as reliance on landfill, unsustainable resource use, or uneconomically cheap labor -- providing such costs do not impact a company during the period of their investment. It remains in their interest for these costs to remain "externalized" -- that is, passed onto the wider world while profits are retained in the company. A long-term investor, however, is naturally more averse to such externalized costs, expecting them to be addressed if only to mitigate the investor's own risks.

Impatient capital has made the free market synonymous with short-termism and volatility. It doesn't have to be that way.

The issue of externalized costs elicits a schizophrenic reaction among self-professed market purists. In Britain, there were howls of protest when the government bailed out several banks -- because business costs were being externalized onto the taxpayer. Yet many of the same voices are more relaxed when it comes to costs that the nuclear industry externalizes onto the taxpayer for cleanup costs -- or the significant sums provided to the fossil fuel industry in various subsidies. In place of these double standards, there should be one rule for all -- that the entire cost of a business' activity should be included in its share price. In the energy sector, that alone would transform the competitiveness of renewables.

Such an approach has come to be called "true cost" economics -- yet there is nothing new about such thinking. It is in fact much closer to Adam Smith's original conception of a free market -- namely one where each agent pursues the benefit and pays the costs of his or her activity. The further we have strayed from this vision of the market, the more of a role has been left for governments to step in. Yet government responses have been inconsistent, alleviating the cost of some externalities while penalizing others. Such inconsistencies only encourage investors to arbitrate between different incentives and penalties -- taking a short-term approach rather than investing on a long term, true cost basis.

Short-termism -- including skewing the market with different state interventions -- doesn't only affect how companies operate. It also affects which companies get off the ground in the first place. Although our inboxes are full of long-term trends, capitalizing on these demands a patient approach and an assurance that underlying fundamentals will assert themselves. In place of such an approach, many investors have confined themselves to "business as usual" -- including investing against today's regulatory regimes -- on the basis that this appears lower risk. But what looks like low risk measured on a few year's time horizon appears different in the longer term. This is especially true in the energy sector, which will continue to be subject to geopolitics, resource constraints, the fiscal strength of governments and a tidal wave of technology innovation.

There is, fortunately, a growing awareness of the limits of short-term capital. In its place, many are now taking what is called a "patient capital" approach. This means picking companies which have good long-term fundamentals and which are also minimizing their long-term risks, including by internalizing their costs. Energy efficiency, the circular economy and clean industrial processes are all long-term growth sectors -- yet the winners will be those companies that don't only deliver sustainability, but also themselves operate sustainably.

In spite of prevailing short-termism among investors, businesses themselves are providing a growing universe of opportunity in this area. Caught between inexorably rising resource prices and increasingly aware consumers, many large companies -- including Unilever and Walmart -- have now put in place radical efficiency programs and broad sustainability measures.

Such programs are starting to pay serious dividends. UK-based retail group Marks & Spencer is now returning over £100 million per year to shareholders as a result of its "Plan A" efficiency drive. Changes among large corporates are in turn stimulating the smaller environmental technology companies which help deliver these goals. According to government figures, the UK's "green business" sector grew 25 percent between 2010 and 2013 as businesses and public sector went on an efficiency drive. Whereas many said the environmental businesses would not stand austerity, the sector is instead helping to deliver it! A good global indicator of increased efficiency is that the rebound in economic activity since the financial crisis has not been accompanied by a corresponding rise in energy use. At the same time, winds stocks are booming, while investors who are over exposed to fossil fuels are losing out.

These type of changes are expanding both the universe of investible companies and the potential investor base for sustainable investors. Over the last decade, the volume of funds in the hands of fund managers broadly classed as "sustainable" has grown to over $21 trillion. Although people who place money with such funds are unified by a desire for stable, long-term growth, different types of investors are also motivated by specific calls to action. It could be generational concerns for a family office; compliance with the UN's Principles for Responsible Investment for a large institution; or alignment with broader corporate goals for a charity or religious institution. Particularly encouraging is the growing number of everyday investors choosing sustainable investments for their pensions or savings. For consumers themselves to start thinking as proactively about their investments as they do about their purchases is perhaps the greatest step towards becoming a more long-term economy.

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