Short-termism is one of the frequently invoked criticisms of the management of publicly listed firms, asset managers, and individual shareholders.
Critics allege that over the past few decades changes in the structure of financial markets and investor behavior have aligned into a system that encourages managers to focus on short term profits, at a potential cost to long term investment and, potentially, even to longer run economic growth.
The time horizon of investors certainly has narrowed. Back in the 1970s, the average holding period for a US listed equity was around five years. But nowadays it is closer to ten months. If shareholders, on average, are not expecting to be holding the firm’s equity in a year’s time, they might not be especially keen on embarking on costly programmes of capital spending or research and development which could eat into available cashflow now and not provide any benefits for years to come. Senior management, who often have a great deal of their own remuneration directly tied to or exposed to the underlying share price are no doubt keenly aware of this. There may be cases where they perceive a good quarter or two of short term results will be more supportive of the share price – and hence their own wealth – than actions which are, arguably, better for the health of the firm in the medium term.
Some critics have aligned on the idea that the requirement on publicly listed firms to provide quarterly updates on their earnings and operations is part of the problem. It is notable, for example, that few privately held firms choose to publicize quarterly results. One argument sometimes made in favor of taking struggling firms private, is that it will allow management the time and space, free from the immediate pressure to hit quarterly targets, to take longer term decisions and embark on a restructuring.
Research published in 2005 by John R. Graham, Campbell R. Harvey, and Shivaram Rajgopol provides some very useful underpinning to the debate. The authors surveyed 401 executives and conducted in-depth interviews with a further 20 to try and understand what kind of factors drove decision making. The results were striking. The majority viewed earnings per share as the key measure of performance rather than cash flows. That was not a surprise. More surprisingly, a majority of managers would avoid initiating projects that had a positive net present value (that is to say one which generated value) if it meant missing the current quarter’s expected earnings. Furthermore, around three quarters of those surveyed were also prepared to give up on economic value in order to smooth reported quarterly earnings figures.
The argument that managers used to justify this sort of decision making was that missing expectations in a quarterly earnings report would reduce the predictability of future earnings and hence increase uncertainty. Given that investors tend to dislike uncertainty this would reduce stock prices. In other words, in the view of the decision makers surveyed, it was sometimes better for the share price to miss out on economic value in the long-run in order to smooth earnings in the short run.
Is the answer then to drop the requirements for quarterly earnings reports and give managers the space to focus on the longer term? The Clark Center’s Finance Expert Panel was surveyed on exactly this topic last week. It is fair to say that they are not convinced by the case.
Asked whether allowing firms to report quarterly rather than annually would top executives putting more weight on long-term investments, 73% of respondents (weighted by confidence) either disagreed or strongly disagreed.
Asked whether such a change would, on net, benefit shareholders 84%, again weighted by confidence, either disagreed or strongly disagreed.
Squaring the strong views of the panel with the research is not as difficult as it first appears. For a start, a quarter is, in the grand scheme of things, not that different to a year. Especially in the context of the much longer timeframes involved in some research and investment projects.
What is more, even if there is a real economic cost associated with quarterly reporting and earnings smoothing measures abolishing the requirement would not be cost free. It would come with both a loss of information about short term performance for shareholders and a material increase in information asymmetry between management and a firm’s ultimate owners. That is to say, that whilst there is already a gap between what those managing a firm know and its operations and prospects and the information available to those holding the equity, loosening reporting requirements would make that gap larger. That opens potential larger problems in the longer run.
In the end, managers feeling pressured into hitting short term targets is not economically helpful. But it may be better than giving them freer reign. And as several panel members were keen to point out, the real focus from investors nowadays tends to be less on the actual quarterly results themselves and more on the forward-looking guidance managers issue alongside them.
The panel has spoken clearly, dropping quarterly reporting is not in the long run interests of firms or shareholders.
