The Cause of Corporate Short-Termism
The tension between managing for the long term and delivering good results for the next quarter is one of the greatest challenges corporate executives face. While CEOs talk about focusing on long-term value creation, they often fail to resist the lure or pressure of short-termism.
The debate over how to solve the problem of short-termism in corporate America has been going for 30 years. Short-termism started in the 1980s with the concept of “maximizing shareholder value,” or stock price performance and dividends. It pushed companies to focus on immediate gains.
Management guru Peter Drucker summarized the root cause of the problem 30 years ago in one sentence:
“The need to satisfy the pension fund manager’s quest for higher earnings next quarter, together with the panicky fear of the [corporate] raider, constantly pushes top managements toward decisions they know to be costly, if not suicidal, mistakes.”
Today, the pressure from Wall Street and investors still leads many to short-term thinking, which in turn has become an excuse for many executives, according to Gary Pisano, professor of business administration at Harvard Business School.
“A lot of managers have a hard time managing for the long term, so they like to blame Wall Street. It is a ‘the devil made me do it’ type of excuse,” he said.
Public-company managers blame the pressures they face to focus on short-term financial performance. However, there are many sophisticated investors who pursue long-term value creation even at the expense of short-term earnings and resist artificial efforts to meet earnings targets, according to an article co-written by McKinsey & Company partner Tim Koller.
“It’s worth recalling that short-term investors are usually a minority of a company’s shareholders. Overall, they own only around 25 percent of shares held by U.S. companies,” the article states.
Companies for the Long Term
Research conducted by McKinsey and the nonprofit organization Focusing Capital on the Long Term (FCLT) found that companies with a long-term focus perform better financially compared to their peers.
To identify a set of long-term companies, McKinsey assessed firms within a sample of 615 companies on their patterns of investment, growth, earnings quality, and earnings management over 15 years. Using this methodology, nearly 27 percent of the sample was classified as long-term companies.
The research shows the long-term companies outperformed their peers on all financial metrics, including revenue, earnings, and economic growth. They delivered greater shareholder returns, gaining $7 billion more in market valuation on average. And most importantly, they created nearly 12,000 more jobs on average than their peers.
“Had all U.S. publicly listed firms created as many jobs as the long-term firms, the U.S. economy would have added more than 5 million additional jobs over this period,” the McKinsey report stated.
However, despite all the negative outcomes, short-termism is still on the rise.
According to a survey by McKinsey, 87 percent of executives and directors said they feel most pressured to demonstrate strong short-term financial performance.
The pressure resumed during the 2008 financial crisis and has continued to rise since then, according to McKinsey.
Companies can avoid the pressure of short-termism through effective communication.
CEOs and CFOs spend an excessive amount of time meeting investors to explain their quarterly results. However, long-term investors don’t care about the short-term results; instead, they seek consistency and transparency from managers in communicating their long-term strategy.
“Investors want to learn how a CEO makes decisions, whether the company’s approach is aligned with long-term value creation, and whether the whole management team is singing from the same song sheet,” the McKinsey report stated.
According to a survey among investors conducted by McKinsey, 23 out of 24 long-term investors rated management credibility as one of the most important factors in making investment decisions.
According to Pisano, effective communication with investors is vital, and there are many good examples.
“Look at Tesla. It loses money but there’s a bet on the future. Investors have a lot of patience with Tesla. … It is a matter of how companies position themselves,” he said.
Companies need to work hard to shape their investor base and help investors understand what their business model is and why it is a long-term game, Pisano said.
Venture capitalists, private equity firms, and even hedge funds can have fairly long time-horizons, according to Pisano.
Another reason that drives short-termism is stock-based compensation, which is at odds with long-term growth.
In the United States, stock-based compensation on average accounts for 81 percent of executives’ salary, according to research published in 2016 by William Lazonick and Matt Hopkins of the Academic-Industry Research Network.
With so much compensation dependent on stocks, executives are incentivized to massage the quarterly numbers to boost share prices.
“Depending on the day, [the executives] point the finger at a range of culprits, including market pressure, economic uncertainty, and investors,” states the McKinsey article.
“But it’s time for executives to take a harder look at themselves.”