Hillary Clinton has made short-term thinking in corporate America — also known as "quarterly capitalism," a reference to the pressure companies feel to meet quarterly earnings predictions — a central issue in her campaign. That issue has been bubbling beneath the surface of policy discussion for years, but it's gained fresh attention as influential investors such as Warren Buffett and Lawrence Fink (of BlackRock, the world's biggest asset holder), and politicians like Vice President Joe Biden, have stepped up to warn of the perils to our economy of turning away from a long-term perspective.
How big of a problem is a short-term business mentality? A significant one. The problem is masked because the US economy still ranks as the world’s largest, and among the most productive. But with short-term pressures on the rise, our future growth and productivity are threatened, with important implications for wages, standards of living, and our general well-being.
When firms focus on the short term, those firms steer profits to shareholders immediately instead of spending money to improve productivity, the greatest driver of economic growth for both companies and our economy. They spend less on research and development for the next great products and services, less on capital spending to improve manufacturing efficiency, less on employee training, and less on environmental and community stewardship. It’s fair to say that a short-term perspective has the potential to undermine the traditional growth engines of the American economy, and bankrupt our future.
More and more of firms’ earnings go to dividends and stock buybacks
The rise of a short-term perspective is reflected in a number of developments, and it's well documented by scholars who have examined the relevant data. Under pressure to keep stock prices buoyant, publicly listed firms are engaged in one of the largest returns of cash to investors in history, via increasing dividends and stock buybacks. (A buyback occurs when a firm repurchases its own shares from the stock market to increase share price and earnings per share).
According to Bloomberg, companies spent 95 percent of their earnings on such share buybacks and dividends in 2014. We are on pace to set the record this year, with $160 billion in share buybacks in just the first quarter of 2016 — all in the face of declining earnings. It’s fairly obvious that when cash is returned to investors at increasing rates, even when a company is earning less, that the money has to come from somewhere. That somewhere is usually long-term investment. Just as it is easy for individuals to put off saving for retirement when the rent comes due or to splurge on a weekend getaway, firms feel pressure to put off long-term investing to make shareholders happy in the short term by boosting stock price.
In itself, there’s nothing wrong with trying to keep shareholders happy — if shareholder interests aligned with a firm’s long-term performance. However, today’s shareholders are not like yesterday’s. Individual investors have largely been supplanted by institutional investors, such as hedge funds and mutual funds, who typically hold on to assets for a shorter period than their predecessors. In 1950, 92 percent of stocks were held directly by investors. By 2006, this figure had dropped to less than a third. In 1940, the average equity was held for seven years. Today it’s less than one year.
In theory, institutional investors ought to be able to value longer-term investments in areas such as research and development or capital equipment that generate future returns. But there is evidence that investors are increasingly and excessively valuing short-term over long-term profits.
An irrational devaluing of future earnings
It’s a fundamental human trait to value today’s investment payoffs more than tomorrow’s. This is not only normal, but rational — the time value of money means that cash in the hand today is worth more than the same dollar amount tomorrow.
However, my research and other recent work show that a short-term focus has become significantly more pronounced in the past 30 years, and that the discount applied by investors to a firm’s future expected earnings cannot be explained by rational models. The excess discount ranges from a few percentage points to almost 30 percent for some firms.
Corporate leaders are aware of investors’ impatience, and they act on it. Surveys of chief financial officers reveal that firms frequently forgo profitable investments in order to make short-term earnings targets. Several factors allow investors to pressure firms to maximize current returns at the expense of the long run: increasing short-term holding periods, shareholder activism, and CEO compensation.
At the extreme end of short-term holdings are momentum, high frequency traders — those who buy shares when prices increase and sell as soon as prices begin to drop. That’s a practice that accounts for about 50 percent of the volume of stock market trades. Clearly, this volatility trading — based on short-term news and random drifts in price — does nothing to reward firms for thoughtful, long-term strategies.
But even those individual and institutional investors who aren't using computer models and trading multiple times are more and more frequently chasing gains by moving in and out of stocks. Firms respond to this turnover by cutting research spending to smooth earnings, which helps dampen share price volatility.
Shareholder activists and poorly incentivized CEOs share the blame
Shareholder activism has also contributed to the new short-term mentality. Such activism has exploded in recent years in the US, with activists seeking boardroom seats, share buybacks, and dividends. (By one measure, such activism is up 80 percent since 2010.) Activist shareholders are sometimes change agents for improved efficiency, but they also frequently pressure firms to return profits immediately, usually at the expense of investments that would fuel returns in future years.
Finally, and perhaps most directly, there is ballooning CEO compensation. When compensation is tied to stock prices in the near future, as it often is, managers focus excessively on short-term profits. With compensation, we get what we pay for: When firms compensate with shares that vest in the near future, we can expect that CEOs will do whatever they can to ensure those shares are more valuable in that same time frame.
The shortsightedness of a failure to invest in capital and research spending is self-evident. But there are many decisions that firms might make differently if they considered longer time frames. For example, how many firms have sent jobs overseas, chasing cheap labor, only to later discover that the advantage was fleeting and another move was required soon after? General Electric, AT&T, and even Apple have found, at least in some cases, that the costs of pushing jobs overseas ultimately outweighed any initial wage savings in terms of transportation, rising wages abroad, lack of quality control in the supply chain, and difficulties coordinating product development with manufacturing.
Reflecting on this newfound realization in corporate America, the CEO of GE, Jeffrey Immelt, wrote in 2012 that "separating design and development from manufacturing doesn’t make sense." Add the prospect of losing intellectual property, when foreign manufacturers rip off the designs of US companies, and the long-term logic of outsourcing looks even more dubious.
Short-termism also means too little investment in workers’ skills
Other decisions that prop up short-term profits yet threaten our future prosperity include failing to invest in employee development, neglecting the role that our communities have in our collective success and well-being, and using our natural environment in unsustainable ways. Failure to invest in these areas cost firms and our society in the long term. Paying attention to stakeholders who are not shareholders can yield long-term rewards for the firm by reducing risk, improving employee morale, and increasing community engagement and support.
Hillary Clinton’s proposals do a decent job of identifying the drivers of US corporate short-termism. Her proposed solutions, though, are tepid. Clinton says she would attack the problem by changing the capital gains tax rates to be closer to marginal income tax rates for stocks held fewer than two years. (Marginal tax rates currently range from 10 percent to 39.6 percent, depending on income.) Under her plan, the capital gains rate would drop to the current rate of 20 percent only if the asset was held for six years, instead of the current one-year requirement.
Clinton further proposes to provide tax incentives for investments in communities that are experiencing difficult transitions — for example, where factories have closed due to outsourcing or changes in market conditions. She suggests a review of regulations on shareholder activism, proposes new measures to improve transparency on executive compensation, and puts forth a requirement for companies to disclose share buybacks on a daily basis, rather than quarterly. All of these measures would move us in the correct direction, but they don’t go far enough.
A more aggressive plan to combat quarterly capitalism
I appreciate that a presidential candidate has identified a truly significant, but thus far largely neglected, economic topic. But by focusing largely on transparency and penalizing short-termism instead of supporting long-term perspectives, we miss potential solutions that can harness forces already working toward long-term thinking. In my opinion, we should:
- Encourage development of long-term accounting performance measures to provide better information to long term investors, who seek companies with strategies focused well beyond the next quarter but lack the metrics to find them easily. Along these lines, companies should clearly articulate their strategies for long-term success so investors can better value a firm’s long-term prospects. Providing a long-term vision and defining appropriate metrics for measuring progress toward this vision are steps every firm should take. Some companies have a jump-start on this: Google declines to provide quarterly earnings guidance, stressing long-term goals instead.
- Provide financing for manufacturing facilities under threat of outsourcing or shutdown — money that could be used to fund turnarounds, employee buyouts, and conversions to worker-owned cooperatives. Greater employee ownership can lead to better job stability, greener environmental performance, and a longer-term perspective. In one noteworthy case in Chicago, employees of a window factory, faced with imminent closure, bought the company and created the New Era Windows Cooperative, keeping jobs and a community intact. To those who balk at such government intervention, we would do well recall that the unemployed have little income to spend to contribute to the economy. A growing and thriving middle class benefits all.
- Go further on the tax reforms for capital gains and reward true long-term holdings by dropping the capital gains tax rate for stocks held 10 years or longer to levels below the current 20 percent rate. Such a move would impact both outside investors as well as company management that is compensated in shares, helping to place greater value on future returns.
- Eliminate the tax deductibility of interest on corporate loans used to fund stock buybacks and dividends. Such returns of cash to investors were always intended to come from retained earnings, not borrowed funds. We should not be providing tax incentives for firms to borrow money to pay shareholders instead of investing in the future.
- Require public firms to provide not just basic details of executive compensation, but full transparency on the long-term and short-term compensation of CEOs along with metrics on how the compensation of top managers compares with wages within the firm. Requiring companies to publicize the ratio of CEO wages to the wages of the lowest- or median-salaried employee within the firm is an excellent starting point. Under the 2010 Dodd-Frank financial reforms, the SEC was instructed to establish a rule requiring firms to report the ratio between CEO pay and the median company wage. However, as of 2016, this rule has still not been implemented. Firms are required to comply with this rule for the fiscal year starting January 2017, which means we won’t see this information until reporting occurs in 2018. Further, exceptions to the rule mean that not all firms have to report. But we know that transparency has tremendous power to change behavior: Witness the positive impact the EPA’s release of data on toxic emissions had on emissions by public companies.
For my own part, as a professor in a business school, I also recognize the need to instill in our graduates a sense of duty to all stakeholders — employees, communities, and the environment, as well as customers and investors — as the key to sustainable success in all senses of the phrase, in addition to the usual critical thinking skills and analytical toolbox that we currently provide.
With steps to reframe our policies toward a long-term perspective that reflects our collective values and goals we want to achieve as a society, we can let the long-term thinkers better shape the market and invigorate our economic engines of progress.
Rachelle C. Sampson is an associate professor at the Robert H. Smith School of Business at the University of Maryland.
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