“Myopia [short-termism] is a first-order problem faced by the modern firm. In the last century, firms were predominantly capital-intensive, but nowadays competitive success increasingly depends on intangible assets such as human capital and R&D capabilities (Zingales (2000)). Building such competencies requires significant and sustained investment. Indeed, Thurow (1993) argues that investment is an issue of national importance that will critically determine the U.S.’s success in global competition.”
So I wrote in my 2007 “job market paper”, later published in the 2009 Journal of Finance. The “job market paper” is the signature paper from your PhD thesis, that you take on the academic job market and often ends up seeding your future research agenda as a faculty member. Indeed, most of my work over the last 10 years has focused on the causes of and potential solutions to short-termism. These include short-term executive contracts, excessive disclosure requirements, the stock market ignoring intangibles, and investors owning too small stakes. So, I have a vested interest in claiming that short-termism is a massive problem. With The Purposeful Company, I have been applying these insights from research to propose policy reforms that will encourage companies, investors, and stakeholders to think more long-term.
- The Boy Who Cried Wolf
Short-termism is not a new allegation, particularly in the US. My job market paper opened with a 1992 quote from renowned Harvard professor Michael Porter:
The nature of competition has changed, placing a premium on investment in increasingly complex and intangible forms—the kinds of investment most penalized by the U.S. [capital allocation] system.
Porter argued that the US stock market was excessively liquid, leading to shareholders buying and selling companies based on short-term profits rather than long-term value. He advocated a move towards the Japanese system of long-term, stable stakes. However, the evidence of the past 25 years has suggested that the Japanese model has not been the panacea previously thought. While this may be for reasons other than its illiquidity, more direct evidence shows that liquidity has many beneficial effects on firm value.
Steve also includes a 1979 quote from renowned corporate lawyer Marty Lipton, and a 1980 quote by Harvard professors Robert Hayes and William Abernathy, alleging the problem of short-termism. If companies were underinvesting since the 1980s, surely they’ll feel the effects today, after nearly 40 years? But, Steve uses data from 1951 to show that US corporate profits are now near all-time highs, and that the long-term growth in profits has easily outstripped supposedly more “long-term” countries such as Japan. Moreover, the growth in profits was faster after than before 1980s – indeed in the period in which the financial sector, and the focus on shareholder value maximization – both alleged drivers of short-termism – started taking off. Thus, critics alleging short-termism may seem like the boy who cried wolf.
One may argue that corporate profits are not the best measure of value creation, since they are narrowly focused on shareholders. However, evidence suggests that, in the long-term, shareholders and stakeholders are aligned: serving stakeholders ultimately benefits shareholders – and 40 years is a long time period. More direct evidence suggests that society has benefited. Steve cites numbers from the World Bank suggesting that, in 1980, 2 billion people lived in extreme poverty (44% of the world’s population), which by 2012 fell to 900 million (13%). The World Bank projected last year that, for the first time, this number was expected to have fallen below 10%. Steve writes that “while causality is hard to prove and many factors have contributed to this result, US companies – through international outsourcing and globalization – have played an important role in these outcomes.”
- No Open Goal
And that’s what venture capital (VC) tries to do. Its end investors commit their capital for 5-10 years, allowing a VC fund to make long-term investments that address the financing gap. So, if (a) short-termism has increased over time, the scope for venture capital has increased over time, and (b) if short-termism is a problem, then venture capital should be unusually profitable.
Steve shows that neither hypothesis is true. Starting with (a), the capital committed to VC funds as a fraction of the stock market has fluctuated in a relatively narrow band of 0.10-0.20% over the last 35 years. This does not suggest there are huge untapped opportunities to invest in innovation. Turning to (b), numerous studies suggest that, while VC funds outperform the market, this outperformance is relatively modest. For every 1% increase in the stock market, VC earns around 1.1-1.2%, and this modest outperformance may not fully control for the greater risk of VC nor be scalable.
Similar results also hold for private equity, which – like VC – also has committed capital and thus the ability to make long-term investments. Also – like VC – it invests in private firms, which are shielded from the alleged short-termism of the stock market, such as the need to report quarterly earnings.
- Unicorn Valuations
Relatedly, U.S. companies are increasingly less likely to be profitable when they go public. This holds not only for tech IPOs and biotech IPOs. Investors are increasingly likely to back biotech and fracking firms, even though they have significant periods of negative cash flows.
So Why Is Short-Termism Seen As A Problem?
Given the evidence above, why is short-termism seen as such a problem? Steve points to a number of potential causes:
- Executives may have a vested interest in claiming that short-termism is a problem, to make them less accountable. Claiming that they shouldn’t be evaluated until 3 years down the line guarantees them employment for at least 3 years.
- Companies are seen as focusing excessively on share buybacks and dividend payouts rather than investment. In Steve’s words, “This argument is something of a non sequitur. It suggests that in a buyback or dividend, the money simply disappears rather than going to investors who spend it or use it to make other investments. It also suggests that companies that don’t need money should invest it anyway, rather than give it back to shareholders.”
- Indeed, I believe that the current criticism of dividends and, in particular, buybacks, stems from substantial misunderstandings. I discuss these misunderstandings (in non-technical language) in p7-8 of my supplementary evidence to the UK House of Commons.
- Confirmation bias. In the current political climate, many people see companies as evil, and are very willing to accept evidence that supports this view and reject evidence that contradicts it. As Steve writes, “the short-termers ignore a lot of evidence that goes against their position”.
Where Do We Stand?
Has Steve’s paper wiped out a large chunk of my research agenda and policy initiatives? No – it reinforces the need to take an evidence-based, circumspect approach to reform. It points to short-termism being a much more nuanced problem than the media or politicians claim. It is very tempting to make sweeping, unqualified statements (e.g. “all firms are short-termist”), as these are more likely be turned into headlines or Tweeted in 140 characters. But, doing so is very dangerous. Few issues are black-and-white; indeed, despite being a staunch Remainer, I posted on the case for Brexit. Conveying the view that all executives are crooks who sacrifice long-term value for short-term profit contributes to an anti-business sentiment which in turn is a potential contributor to the rise of populism, Trump’s election, and the Brexit vote. Being fast and loose with the evidence has serious consequences. Moreover, the view that short-termism is a universal and pervasive epidemic has supported calls to “throw the baby out of the bathwater”, i.e. abandon the current system – that has led to substantial technological process, rising corporate profits, and diminishing poverty – by mandating workers on boards, making managers less accountable by reducing shareholder rights, and tearing up current corporate forms for untried, untested alternatives.
Instead, diagnosis precedes treatment. Before deciding whether to amputate, a doctor will study whether a condition is local and can instead be spot-treated. Similarly, the optimal response to short-termism depends on how pervasive the problem is, and what the causes are. All the reforms that I have been proposing aim to work within the system, since my reading of the evidence is we do not have an epidemic, and so we do not want to tear up the system that has created many long-term unicorns. Moreover, the specific dimensions to reform should be driven by the evidence, which seems to suggest that buybacks and stock market liquidity are not causes of short-termism, but short-term executive pay and fragmented share ownership may be.