April 1, 2019
The Short-Termism Thesis: Dogma vs. Reality
The belief that short-termism (a.k.a. “quarterly capitalism”) in our capital markets and in the management of our public companies is seriously (many would say “fatally”) damaging our economy is so widely accepted it has become a veritable truism. Countless directors and CEOs, prominent institutional investors, leading business associations, renowned lawyers and judges, prestigious academics and think tanks and politicians of all ilk (including in at least one tweet by President Trump) regularly and passionately denounce short-termism and blame it for a myriad of actual and supposed shortcomings of our free market economy. In short, short-termism has achieved the sanctity of dogma—a belief system that is beyond doubt and beyond question.
One of the challenges of the short-termism thesis is identifying what it encompasses. Most versions of short-termism begin with a view that it is the result of investors’ increasingly frantic trading patterns and demands for immediate profits, measured on a quarterly basis. But the asserted consequences of short-termism—that is to say, the problems it creates that need solution—are not as uniform as the perceived cause.
One end of the spectrum blames short-termism and quarterly capitalism for the wide-spread practice of providing quarterly earnings guidance. The concern is that it is far too easy for companies?that provide quarterly earnings guidance to fall into the trap of short-changing its longer-term performance in-order-to “make” the quarter’s guidance, for example by reducing marketing expenses, deferring capital investment or reducing productive headcount. The proffered solution is to abandon quarterly earnings guidance and, in the view of some, to eliminate quarterly financial reporting entirely, in favor of semi-annual reporting as is the norm in the UK. This version of quarterly capitalism, for example, is the focus of the Business Roundtable’s campaign against short-termism highlighted by an interview with Jamie Dimon and Warren Buffet on CNBC.?
On the other end of the spectrum, short-termism is equated with companies eschewing long-term strategies, productive R&D and investment in needed capital improvements in favor of maximizing short-term profits and returning needed corporate capital to shareholders in the form of massive and ill-advised stock buybacks. It is this version of short-termism that has garnered the support of the most vocal opponents of short-termism and quarterly capitalism.
However, three recent papers have credibly exploded the basis on which this far more insidious view of short-termism rests.??All three begin by reprising the popular and pervasive belief that much of the ills and shortcomings of public company performance and the economy more generally are attributable to investors’ (and, often more particularly, activist investors’) demands for short-term results and returns of capital through stock buy backs at the expense of long-term strategic programs focused on R&D-driven innovations, increased investment in plants and equipment and long-term strategies to increase shareholder and stakeholder values.
Professor Mark J. Roe trenchantly describes this pervasive short-term thesis:
“Increasingly rapid stock trading and sharply rising activist pressure on public firms…lead to pernicious economy-wide results: Firms cut expensive capital spending (cheating themselves out of the productive cutting edge). They buy back stock (stripping themselves of cash for investment). And then they drop R&D projects (which cost something today for an uncertain future benefit) or never start them.”
However, as Roe goes on to explain, there is no convincing economic evidence supporting the short-termism thesis. The micro-economic event studies are inconclusive. More importantly, the macro-economic data for the past decade is contradictory to the claims of the most prevalent short-termism thesis. As Roe comments, “the evidence in its [the short-termism thesis] favor is sparse. Indeed, the overall, economy-wide evidence fails to support the “short-termist” view”.
First, while (at least until very recently) capital spending has not risen to pre-2008 levels, this is true of all the developed economies, including those not dependent on the stock market to propel corporate growth. More fundamentally, American companies (as well as those in other developed economies) are not yet fully utilizing (or just beginning to expand) their existing plant capacity. As a result, at least until recently, there has been no economic justification for greater spending on capital resources.
Second, R&D spending in the aggregate has consistently grown since the end of the 2008-2009 recession, not decreased as the short-termism thesis would have it. Moreover, it is clear from the stock market that major R&D investments at the clear sacrifice of current earnings is not a prescription for poor stock price performance: witness, for example, the astounding p/e multiples enjoyed by the FAANG (Facebook, Apple, Amazon, Netflix, Google) stocks notwithstanding their devotion to R&D and product development at the expense of earnings. Another example, of course, is the number of unicorns, such as Lyft and presumably Uber, successfully coming to market notwithstanding their massive record of losses due to enormous investments in their business model. The stock market, in fact, clearly values long-term strategic investments by companies?that it believes have the ability to convert those investments into future earnings growth.
Third, while the aggregate amount of corporate stock buybacks has increased significantly, corporations have also vastly increased their borrowings, effectively reshaping their balance sheets by introducing far greater leverage at the bargain interest rates that have prevailed since 2009. Moreover, as Jesse Fried and Charles C.Y. Wang point out in their article, in measuring corporate cash flows it is imperative to take into account not merely issuances of stock for cash, but also issuances of stock for compensation purposes and mergers (which are economically equivalent to issuances of stock for cash followed by use of the cash to pay employees or buy companies). When these capital flows are viewed in the whole, companies have raised far more cash than they have spent in repurchasing their stock over the past decade.
Finally, the very predicate for the short-termism thesis — frenzied trading of corporate shares — misinterprets the data and thus misdescribes the cause and nature of the large increases in stock market trading. When examined more carefully, these increases are wholly attributable to program trading in all its complex variations not to increasing volatility in the holdings of traditional long investors, such as mutual funds and pension plans whose holding periods have remained constant or in some instances increased over the past few decades.??And whatever one may think of the phenomenon of program trading, it is hard to see any view that would blame allegedly short-term corporate behavior on program traders.
So, where does the evidence leave the prevailing short-term thesis???Far short of the mark, to say the least. It may be an article of faith, but it is not supported by the evidence. This, of course, gives rise to the proverbial $64 million question: Why is the short-term thesis so widely accepted. The answers are far from clear.
One possibility is that it provides a ready and convenient rallying point for corporate America in its defense against the demands of institutional investors (frequently spearheaded by activist investors, but increasingly asserted directly by traditional asset managers) for better corporate performance. In effect, the short-termism thesis can be interpreted as a repackaging of classic management arguments against market-based demands for better performance going back to the 1980s’ diatribes against “corporate raiders”. Indeed, when activist investing first emerged as an investment thesis and asset class a decade ago, it was common, perhaps trite, to compare those earlier activists with the corporate raiders of the 1980s.?
In this view, what started out as a natural defensive reaction by management (and its advisors) against claims of corporate under-performance — that the accusers were seeking short-term benefits at the expense of the companies’ long-term health?— has been sufficiently repeated and amplified by other fearful companies (and their advisors), press coverage, politicians and, inevitably, social media to the point that it has become an article of commonly shared faith for which convincing factual support is not necessary.
Another explanation, alternatively or cumulatively, is that the short-term thesis (particularly its appeal to, and ready acceptance beyond the Wall Street and corporate worlds by, other stakeholders, politicians, and the press) has been spawned and is being driven by the dislocations and disruptions that have occurred in our economy over the past several decades. Seen in this light, short-termism has very long historical roots going back to such movements as Luddism, which too was a protest against very early forms of automation that were destroying entire classes of jobs.
Whatever the explanations for the short-termism thesis, the conclusion to be drawn from its lack of evidentiary basis is that quarterly capitalism (and its perceived handmaidens, activist investors) are not the pervasive culprits that the “true believers” would have you believe. The critical implication of this reality is that activist campaigns, whether viewed from the vantage of the activist or that of the company, should be debated and decided not on the labels, but on the substance. Both the activist and the company should focus not on the longevity of their respective programs, but on their programs’ impact on net present value creation. This, after all, is what shareholders and all other stakeholders should truly care about.
?Roe, Mark J.,?Stock Market Short-Termism’s Impact?(November 2018),?available at:https//ssrn.com/abstract_id=317090; Fried, Jesse M. & Wang, Charles C. Y.,?Short-Termism and Capital Flows?(November 2018),?available at:?https://ssrn.com/abstract_id=2895161; Rattner, Steven, The Myth of Corporate America’s Short-Term Thinking,?New York Times?(July 2, 2018).
?Stockholding duration is commonly measured by aggregating all trades in a given security during a period and dividing by the number of shares outstanding. Thus, trades by program traders count as much as trades by long-term investors. When holdings of long-term investors are viewed separately, the findings are that duration of ownership has remained constant, and in some instances increased, over the past 30 years. The dramatic increase in the size of index investors over this time period further contradicts a narrative that institutional investors buy and sell positions at the drop of a hat depending on the last quarter’s financial performance.?See?Roe at Part III. A. 4.
?I am summarizing the arguments and evidence presented by Professor Roe and Professors Fried and Wang in their respective papers and thus omitting a number of their supporting points, as well as their rebuttals of subsidiary claims made or that could be made in favor of the short-termism thesis.
?Not coincidentally, Carl Icahn and Nelson Peltz and Peter May of Trian were frequently labeled corporate raiders in the day.