Short-termism: Fact or Fiction?
Last week, I wrote about Lynn Stout’s new book, The Shareholder Value Myth, and her argument that shareholder value maximization should not be the goal of managers in corporate decision making, nor should it be the purpose of corporate operations. In the book, and in her presentation last week, Stout seemed particularly concerned that managers of public companies seem to manage firms with an eye to current stock price and so may take action to increase earnings in the short term at the expense of long term viability. For example, a firm might not invest in research and development in order to keep the cash on the books and enhance current share price without having to take the risk that a long term investment in innovation might not work out. More perniciously, managers may manipulate financial reports in order to boost current stock price in the hopes that next quarter’s numbers will take care of themselves somehow.
If these short-termist tendencies were a pervasive problem, that would be troubling indeed. In some ways, evidence of short-termism seems to be all around. Executives are paid handsomely in the form of stock option awards that allow them to capitalize on sharp increases in stock price. If stock price falls shortly after the executive exercises her options, the executive does not have to disgorge her gain. Executives are under constant pressure to “meet expectations” and the average CEO tenure is relatively short (less than seven years, according to Steven Kaplan & Bernadette Minton). A CEO could well drive up the stock price of one company with a creative display of smoke and mirrors and move on to her next employer before the first one tanks from her failure to plan for its future. If public corporations were being run to seem to flourish today while disaster lurks next year, then our economy would suffer greatly.
Many blame executive compensation, particularly compensation with stock options, for managers’ seeming short-term focus on daily stock prices. (On the other hand, Gregg Polsky and Andrew Lund have argued that incentive compensation may not matter much, given the other incentives managers have to abide by shareholders’ wishes.) Stock options not only focus managers’ attention on stock prices, but they also have the effect of increasing managers’ appetite for corporate risk-taking. Options give managers an incentive to take big risks in the hopes of big returns as they are insulated from losses. Stout pointed out that current executive compensation schemes tie managers’ interests to those of well-diversified shareholders (which is exactly what they were designed to do), and that connection is harmful because if no one has an interest in the corporation’s long-term viability, companies will fail frequently and spectacularly and impose significant social costs in doing so. A well-diversified shareholder can diversify away firm-specific risk, so is not vulnerable to the risk of loss associated with any one firm, but society suffers if public corporations are driven to insolvency by greedy short-term shareholders. With bubbles bursting all around us, how can one argue that short-termism is not a problem?
One argument, given by Jonathan Macey at the panel last week, is that stock prices incorporate the market’s best guess as to the future value of the stock – stock price is supposed to reflect the present discounted value of the firm’s future income stream and so would take into account short-termism by heavily discounting future returns. That is, the price would incorporate the market’s expectation that the company will fail in the near future. Stock prices would have to be systematically wrong to miss the (purportedly obvious, but certainly not secret) costs of short-termism.
Market “bubbles” claim an interesting position on the fence between short term and long term investment strategies. It may seem that a market bubble is an example of short-termism run amok. Investors do things like “flip” houses and turnover IPO shares for huge profits. Opportunists take advantage of irrational exuberance and profit quickly in day trades. Everyone knows this can’t last forever, and even the national news warns us that we are riding a bubble well before it bursts. Indeed, there is nothing irrational about investing in “bubbles” – you just don’t want to be the one to have to turn out the lights.
In his latest paper on short-termism, Mark Roe argues that market bubbles are actually evidence of long-termism. The Internet bubble, for example, was the result of investors’ being extremely optimistic about the long term prospects of Internet companies when there was little reason to believe that the companies could generate economic returns. We are faced now with what seems like a second iteration of the Internet bubble. We are not valuing Internet software companies in the billions of dollars because we think they are going to fail in two years. Investors are willing to pay so much for them because they want to do the modern equivalent of buying Apple stock in 1985 and holding it for 20-30 years. We just don’t know which company will be the next Apple. Similarly, most home purchasers in the 2000s bought houses believing they would continue to appreciate in value over the long term. Even after the market could have realized housing prices would fall off a bit, that perhaps there was a housing bubble, as long as prices were going up, the market was not anticipating a significant drop-off in the near future. If it had, housing prices would have begun falling as soon as the long-term optimism proved misplaced. Why would I buy a house from you for $1 million today if I believe that it will be worth only $600,000 a year from now without any idea of exactly when the fall will occur?
Roe offers other explanations for why short-termism is not really a problem. He notes that institutional shareholders, who make up the large majority of shareholding in public companies, are long-term investors. He also cites evidence that companies with significant institutional investor ownership may over-invest in research and development. If institutional investors are able to influence managers, it seems that they do not encourage managers to make myopic decisions. True very short term shareholders would not be able to exert the same influence because they would not have incentives to try to influence management at all and may not move enough money to seriously influence stock prices.
Still, Stout’s basic point and intuition resonates with me. It seems to me that businesses should be run in ways that will allow them to prosper in the long run. That to do otherwise confounds the expectations of even short term shareholders (because the current stock price should be depressed in the absence of long-term prospects). If shareholders are reaching agreements with executives (through boards) for compensation that pushes executives to race the company toward a cliff, then those agreements are not in the best interests of shareholders. If short-termism is a problem, it is not clear to me that it is one caused by trying to maximize shareholder wealth. Rather, it seems to me that it is one that depresses shareholder returns. Stout blamed shareholder value thinking for lower equity gains over the last 30 years than in the 30 years that came before that. If shareholder returns are depressed, then it seems to me that the shareholder wealth maximization goal has not been reached, not that it was the wrong goal in the first place. The market, through investor action, “understands” many complex pieces of information. Surely it can understand that some investment in R&D is worthwhile for maximizing shareholder value for both short-term and long-term shareholders.