The short-termism of financial markets "" by which is generally meant a damaging focus on dividends and current profits "" has become an article of faith for many in Britain and America. But according to Paul Marsh the arguments are based on misunderstandings and failure to look at the evidence.
He says research finds no support for the proposition that stock markets are short termist, and while investment analysts, fund managers and institutional shareholders sometimes behave in a way that invites criticism they generally take a broader view.
Institutional pressures for high dividend payouts are greatly exaggerated, and in any case external funding for positive NPV projects should be available with well developed capital markets.
Takeover activity is an important feature of corporate control and governance, though there is a cost.
If short-termism owes more to perception than reality, it should nevertheless not be dismissed: if industrialists believe the financial community is guilty of it managers may act accordingly, cutting back on long-term investment.
Short-termism has been a hot issue, for many years, The belief is that Britains and Americas competitive edge has been blunted by a failure to emphasise long-term investment, and this is the fault of myopic financial markets.
Broadly, the short-termism argument runs as follows: financial markets, spurred by impatient investors, are short-term oriented, placing too much weight on current profits and dividends. This obliges companies to do the same, inhibiting long-term investment. For if companies invest in projects without an immediate pay-off, their profits and share price will fall making them vulnerable to takeover.
According to this view, myopia by Wall Street and the City of London has been detrimental to growth and competitiveness in the US and UK, relative to Germany and Japan which have bank-based financial systems. A worry for continental Europe and Asian countries is that, as their financial systems move towards the US model, they too will catch the Anglo-American disease.
The arguments, although widely believed, are unfortunately based on misun-derstandings and failure to examine the evidence. This article aims to set the record straight.
Are stock markets short-termist?
No reliable evidence has yet been presented to support the claim that stock markets are short-termist, or that share prices place too much weight on short-term profits and dividends. Instead, there is a large body of research which suggests precisely the opposite.
For example, if the stock market places too much weight on current dividends, then presumably low yielding stocks are undervalued, relative to their expected future cash flows.
In such a short-sighted world, investors could earn superior returns from buying low yielders and holding them long-term, when true value must out.
But the US and UK evidence indicates that historically, low yielders have not been undervalued, and high yielders, far from being specially prized, have actually been the more lowly valued.
Similarly, if the market undervalues prospects, investors could achieve superior returns by buying growth stocks (i.e shares with high price/earnings ratios, but where the p/e ratios should presumably be even higher), and holding them long-term. However, research indicates precisely the opposite, namely that if anything, long-term growth stocks may have been overvalued.
Finally, if the stock market dislikes companies which invest for the future, we should expect share prices to fall when companies announce increases in capital investment and research and development. But research indicates that such announcements are regarded as good news, and generally results in share price rises. Cuts in investment, on the other hand, coincide with share price falls.
These findings combined with a wealth of other stock market research, provide support for the proposition that the stock market is short-termist. To blame the stock markets pricing mechanism for the alleged ills of US and UK industry is thus to pick the wrong target.
Managerial short-termism
The accusations of short-termism are levelled mostly at the financial markets. Yet, ultimately, short-termism will be a problem only if companies fail to undertake profitable investments, i.e those with positive net present values (NPVs). By definition, therefore. the perpetrators of short-termism must be corporate managers, since they are the ones who are responsible for making long-term investments.
Managers may shun positive NPV investments because the costs (e.g. R&D, product development, plant equipment, strategic marketing, training etc) show up immediately, depressing current profits, while the benefits may take years to show through. Their focus on current profits may be influenced by what they think the financial markets want, but it may also reflect managerial short-termism. The latter can be defined as a tendency by managers to favour short-term independently of any spur from the financial markets.
There are several aspects of managerial practice in the UK and the US which can encourage managerial short-termism:
lRemuneration and reward systems. Traditionally, executive incentive systems have linked remuneration to short-term accounting profit, rather than to long-term value;
lRelatively high rates of executive mobility may shorten managers time horizons within jobs, making them more concerned with short-term results, and less ready to invest long-term;
lThe systems used to appraise new investments could encourage short-termism. Many companies still seem to over-emphasise payback, a notoriously short-termist measure. Others use discount rates which appear far too high.
Managers often argue, however, that any bias they have to short-termism results from pressure from the financial community. They claim that the real culprits for short-termism are the investment analysts, fund managers and institutional investors who encourage short-term orientation.
Investment Analysts
Investment analysts often seem pre-occupied with short-term profit and dividend announcements. However, their concern is entirely rational, since these are key news items, conveying significant information about the future. The way companies manage their profits and decide on dividends ensures that these announcements provide important signals about managements own (inside) knowledge and judgements about the future.
Furthermore, research evidence on p/e ratios confirms that analysts and investors are not just focusing on current earnings. P/e ratios vary widely across stocks, and depend "" as theory indicates they should "" on long-term growth prospects, the retentions needed to finance these, the companys cost of capital and the accounting methods used.
There is, therefore, considerable evidence that analysts take a broad view when valuing shares looking at far more than just current results. Nevertheless, some analysts may convey an unhelpful impression of short-termism through their behaviour, and the questions they ask "" and fail to ask.
Fund managers
Fund managers are also often viewed as short-termist. This is widely attributed to the pressures they themselves face from short-term, quarterly performance measurement. This is misleading, since in reality, the key performance measures and those concerned with fund managers appraisal and selection all stress long"" rather than short-run performance.
Even if this were not so, any concern that quarterly performance measurement prevents fund managers from taking a long-term view would be misplaced.
Managers can improve their short-term performance only by identifying undervalued shares and buying them, and/or over-valued shares and selling them. This is difficult, given the competition they face (as borne out by the many studies which indicate that consistent out-performance is rare). Indeed, the only way they can succeed is through careful analysis of a companys short- and long-term prospects "" something widely held to be a good thing.
To maximise their own short-run performance, fund managers need to be concerned with companies long-term prospects. Any insights the manager has about even the companys very long-term future are incorporated into the share price almost immediately, partly because of competition between investors, and partly because dealing with activity itself alerts others that there may be information around, causing prices to adjust accordingly.
By spotting mispriced shares, fund managers thus help to keep the market efficient. Their short-term actions often reflect long-term views, and their own short-term performance will reflect changes in the capitalised value of the longer term prospects of the shares they hold.
Dividend pressures
It is often alleged that institutional investors place pressure on companies to pay high dividends, and this discourages investment and fosters short-termism. Indeed, the fact that dividend payouts have typically been higher in the UK and US is given as a reason why British and American companies have historically invested less than their German and Japanese counterparts.
In reality, the institutional pressures are greatly exaggerated. But more importantly, the concerns about higher payout are based on a false assumption, namely the companies face a choice between dividends or investment. Well-managed concerns start from the premise that they should invest in all positive NPV projects.
If the cash required for this (plus dividends) exceeds internal resources, they should seek external funding, by borrowing or raising equity. Indeed, the existence of highly developed capital markets, such as those in the US and UK, makes this very straightforward.
One might still question the efficiency of paying out dividends with one hand, and seeking money back with the other via an equity issue. In the UK, the tax provides a rationale for this, at least for tax-exempt investors. For them, high payouts, coupled with periodic equity issues, is tax efficient. At the same time, it may encourage efficient use and recycling of capital, and enhance the monitoring role of shareholders and capital market. Changes to the tax system would undoubtedly alter these incentives, and would have unfortunate consequences for pension funds and other tax exempt investors.
Takeovers and short-termism
While the conduct of analysts, fund managers and institutional shareholders may sometimes give companies the wrong impression, the behaviour outlined above hardly amounts to coercion into short-termism. However, one source of real duress is takeovers.
The concern here is that the threat of takeover may encourage managers to maximise short-term profits and dividends in the hope this will boost share price and keep the predator from the door. This could cause them to cut back on long-term investment.
Such behaviour would make no sense, however, since companies will not bolster their share prices by cutting back on positive NPV investments "" in fact, quite the opposite. Moreover, there is no evidence that companies which invest heavily are more likely to be taken over "" if anything, the reverse is true. Indeed, most of the research on takeovers suggests it is the worse performing companies which tend to be taken over by their better-performing counterparts. Nor is there any persuasive evidence that acquisitions herald cutbacks in investment or R&D.
Furthermore, most acquisitions involve coercion, since they are agreed not hostile. Even where coercion exists, takeovers are what one company one does to another, rather than pressure imposed by fund managers.
More importantly, most acquisitions are predicted on potentially sound industrial logic, and there is much evidence to suggest that shareholders have, on average, gained from mergers, and from the associated efficiency gains.
These findings need qualifications. First, they relate to average behaviour. On average, mergers have increased shareholders wealth, but have failed. Second, the published evidence does not take account of many hidden costs and benefits. For example, failed bids involve substantial costs "" in terms of fees, time and motivation.
Moreover, the possibility to takeover may undermine contractual relationships between investors and employees and managers, making the latter reluctant to invest in company-specific assets and longer-term investments, if they may later be denied the benefits of such investment because of a change in ownership.
But balanced against these costs are the substantial benefits which can flow from the threat of takeovers and the value of keeping managements on their toes. Indeed, in the UK and US, contested takeovers are one of the most effective disciplinary devices available.
This raises an obvious question, namely is there a better way of ensuring effective corporate control? In the past, two of the most successful industrialised nations, Japan and Germany, have managed without this disciplinary mechanism. If more effective corporate culture and governance could yield shareholders the same gains they have achieved from takeover activity at a lower cost, this would be worth striving for.
Is short-termism really a problem?
Short-termism is a problem only if corporate managers are turning down positive NPV projects because of a concern about the short-run impact on reported earnings. This raises two fundamental questions. Do managers behave like this? And, if so, why?
Curiously, despite the extensive debate, there is very little systematic evidence that British and US managers are short-termist. The only direct evidence is anecdotal, and comes from business executives describing their own perceptions and behaviour, but this provides a partial, and sometimes conflicting, account, which is hard to interpret.
Mostly, the existence of short-termism is simply inferred from the fact that British and American companies have invested less than their Japanese and German counterparts over the past 50 years. However, companies in different countries have faced different opportunities. In the earlier part of this period, Germany and Japans higher investment reflected their greater scope for post-war reconstruction and catching-up.
British and American managers may thus not have under-invested. Instead, they may have accepted every project with a positive NPV, but simply found fewer of these on offer.
The UK, which has a worse record than the US, remained relatively unattractive for investment throughout the sixties and seventies Macroeconomic management, including stop-go policies, exchange rate instability, and higher inflation contributed to this. But supply-side factors were probably even more important, particularly those relating to the skills, working practices and productivity of the workforce; and to engineering, product design, marketing and management skills.
Indeed, conventional wisdom needs to be turned on its head. The popular belief is that the UKs lower economic growth rates resulted from too little investment. In reality, both lower growth and lower investment were the consequence of supply-side weaknesses. These depressed the profitability of existing activities, and made new investment less attractive.
A decade of convergence
From the 1980s onwards, the UK and US economies underwent considerable change. The UK experienced numerous supply-side reforms, couple with deregulation and privatisation. In the US, corporate America was restructured.
While on a 50-year view, the UK and US have invested less and enjoyed lower economic growth than Japan and Germany, during the 1980s and 1990s, the gap narrowed, and was sometimes reversed. For the past decade, the American and UK economies have performed as well as, or better than, those of Japan and Continental Europe.
Today, Germany and Japan are cited far less frequently as national exemplars. Partly, this is because both countries face new challenges, but also reflects the fact that countries and companies have already learned much from each other.
Meanwhile, ironically, many of the more successful and progressive companies in Japan, Germany and elsewhere in continental Europe are busy switching their emphasis to shareholder value. At the same time, their financial systems are undergoing deregulation, and are slowly converging toward the Anglo-American model.
Remedies
In spite of these developments, there are still many who cling to the old arguments on short-termism, and to the notion that financial markets are malfunctioning or somehow to blame. While we have seen that this relates to perceptions which have no basis in reality, we cannot dismiss them, lest they become reality.
If industrialists believe the financial community is short-termist, the danger is that they may act accordingly, cutting back on long-term investment.
Another danger lies in the implementation of inappropriate remedies by governments in an attempt to cure a mis-daignosed problem.
Many of the proposals put forward to cure short-termism "" such as higher rates of tax on short-term capital gains, turnover taxes discouraging dividend distribution, or throwing sand in the takeover machine "" are predicted on the false premise that the financial markets are to blame. If implemented, such measures would yield perverse results, by lowering market liquidity, increasing the cost of capital, and reducing economic efficiency.
Measures aimed at closing the perceptional gap, however, seem worthy of serious pursuit. These include better financial education; improving relationships between companies and shareholders; better communications and greater disclosure; selective (and collective) direct interventions by shareholders; closer attention to managerial reward and incentive systems and their link to investment decisions; and more effective corporate governance.
It is important, however, to keep these measures in perspective, and be realistic about what they might achieve. In particular, it would be a greater pity if the corporate sector "" in any country "" became side-tracked from the central issues which all companies share in common "" international competitiveness, market orientation, innovation, quality and excellence "" by further talk about short-termism from the financial markets.
Indeed, there is a real congruence of interests here. The very activities required to enhance business competitiveness, and to improve prospects for, and levels of, investment, are the self-same actions required to enhance share prices, create shareholder value, deter corporate raiders and improve investor relations.
The way ahead for both the financial community and the corporate sector is to focus on managing as if tomorrow mattered.
