# Short-termism of U.S. Companies is Once Again under the Spotlight

TSURU Kotaro
Program Director and Faculty Fellow

The short-termism and quarterly capitalism of U.S. companies have suddenly come under the spotlight. As one of the pillars of her economic policies, Hillary Clinton, the leading Democratic candidate for the U.S. presidential election, is advocating measures to encourage companies to engage in business activities from a long-run growth perspective. In particular, she is calling for imposing higher taxes on short-term speculative investors as well as on self-serving corporate managers, those seeking to reap large profits by boosting quarterly earnings and then selling company shares received as executive compensation. In other words, Clinton is proposing to introduce progressive taxation on short-term capital gains to apply a higher tax rate to capital gains on shorter-term holdings.

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Although problems with short-termism had been pointed out a long time ago by some economists including John Maynard Keynes, it was only about a quarter century ago that they were brought to light. Back then, the difference in the time frame under which top corporate managers manage their companies was cited as a big reason why U.S. manufacturers were falling behind their Japanese and German counterparts in international competition. A 1992 article by Michael E. Porter, a business management professor at Harvard University, is a leading example.

Also in the sphere of economics, short-termism came under scrutiny in the late 1980s against the backdrop of a rising wave of hostile takeovers in the United States. Jeremy C. Stein, then-finance professor at the Massachusetts Institute of Technology (MIT), theoretically showed that the presence of significant takeover threats tends to induce managerial myopia, leading corporate managers to boost current profits to drive up stock prices over a short time frame by postponing necessary investments. Meanwhile, Harvard University Professor Lawrence Summers et al. argued that hostile takeovers undermined the competitiveness of U.S. companies by breaching implicit contracts that had been long established between companies and their stakeholders (employees, etc.) and thereby decreasing company-specific investments that would be possible only when such implicit promises are kept.

The debate on short-termism subsided in the 1990s with a reversal in competitive relationships between Japanese and U.S. companies but was revived in the wake of the global financial crisis in 2008 and 2009. Criticism over short-termism in banks' behavior persists. Some argue that the root cause of the financial crisis may be found in the structure of executive remuneration that is designed to amplify bank managers' inclination to focus on short-term results at the cost of long-term growth. Others say that the pace of the post-crisis recovery of the U.S. economy has been slow because banks have been using their amassed internal reserves to buy back their own shares or distribute dividends to shareholders so as to drive up share prices, instead of making necessary investments for future growth. The table below lists the top 10 U.S. companies based on the amount of common stock repurchases. It shows that they spent amounts equivalent to their net income on buybacks.

Table: Top 10 U.S. Companies in Common Stock Repurchases in 2004-2013
Rank Company name A: Common stock
repurchases
($billion) B: Cash dividends ($ billion)
(A+B) / Net income(%)
1 Exxon Mobil 217 840 84
2 IBM 116 260 113
3 Microsoft 113 77 119
4 Cisco Systems 72 5 110
5 Procter & Gamble 72 47 118
6 Hewlett-Packard 65 9 168
7 Wal-Mart Stores 64 40 73
8 Pfizer 62 65 137
9 Intel 58 31 107
10 General Electric 57 87 89
Source: William Lazonick (2015) "Stock buybacks: From retain-and-reinvest to downsize-and-distribute," Brookings Institution

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Evidence-based analysis is of utmost importance in addressing short-termism. In what follows, I will provide an overview of the findings from empirical analyses of U.S. companies, starting with those that examined the effects of stock-based compensation schemes for senior executives, such as those utilizing stock options.

A 2015 paper by London Business School Professor Alex Edmans shows that publicly-traded companies are inclined to reduce capital investment, research and development (R&D), and advertising expenses when the earliest exercise date for executive stock options approaches so as to prop up their company's stock prices, looking to exercise their stock options and reap the proceeds immediately.

Meanwhile, in his 2014 paper, Washington University in St. Louis Associate Professor Radhakrishnan Gopalan examined the extent of managerial short-termism as induced by their compensation package as a whole, focusing on the fact that the length of time before each component of executive pay becomes vested and exercisable varies from one to another. He showed that executive pay tends to be designed to provide a longer-term perspective in companies with greater growth opportunities, higher proportion of long-term assets, more intensive R&D investment, lower risk association, and better stock performance.

Meanwhile, excessive pressure from shareholders and analysts demanding the achievement of forecasted earnings on a quarterly basis could drive corporate managers to become more short-term-oriented. In their 2005 paper, Duke University Professor John Graham et al. interviewed more than 400 corporate executives and found that 78% of them would give up promising investment projects—even those having significant positive net present value (NPV)—if such investment is likely to prevent them from delivering forecasted earnings in a given quarter.

Indeed, in a 2006 paper, Cornell University Professor Sanjeev Bhojraj showed that firms engaging in earnings management that beat equity analysts' forecast by discretionarily cutting expenses have been outperforming non-manipulating firms with fairly good but less-than-forecast earnings results in price-earnings ratios. Regarding the effects of equity analysts, a 2013 paper by University of Georgia Assistant Professor Jie He et al. shows that firms covered by a larger number of analysts generate fewer and less impactful patents. However, we need to take a balanced view, as some empirical studies show that firms providing quarterly earnings forecasts are less likely than those not doing so to engage in earnings management.

The ultimate way for managers to escape short-termism is to take their company private. In a 2014 paper, University of California, Los Angeles (UCLA) Professor John Asker found that public firms, as compared to private firms, invest considerably less and are approximately 75% less responsive to changes in investment opportunities. These tendencies are more salient for firms whose stock prices are more sensitive to earnings news.

An article in the October 24, 2015 issue of The Economist maintains that signs are emerging to indicate the decline of listed U.S. companies as conflicting interests between shareholders and managers, short-termism, and stricter regulations for public companies impose costs. Usually, start-ups seek to eventually go public or sell themselves to a public company. However, more and more start-ups are opting to stay private now that they can raise funds more easily than ever without giving up equity. As a result, the number of companies listed on the U.S. stock exchanges has decreased by half since 1996, although the decrease is partly attributable to mergers and consolidations. The article also notes that the average time to initial public offering has lengthened from four years in 1999 to 11 years now.

Thus, taking or keeping a company private is one way to address short-termism, but what about public companies? Should managers be guarded against pressure from shareholders so as to enable them to focus on long-term growth? Concerns are being voiced about an increase in institutional shareholdings, a phenomenon commonly observed in advanced economies. Empirical findings to date suggest that institutional investors are not necessarily making managers shortsighted.

In a 2015 paper, Harvard University Professor Lucian A. Bebchuk et al. examined more than 2,000 cases of activist hedge funds' interventions in the management of investee firms during the period since the mid-1990s. They found that investee firms' performance improved in the third through fifth years following the time of interventions, which indicates that those firms did not necessarily sacrifice long-term growth for short-term profits.

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Is short-termism an absolute evil that must be rooted out? Not necessarily, according to Harvard University Professor Mark Roe. In a 2013 paper, he pointed out that today's corporate managers are faced with the greater need to plan for the short run than ever before now that everything is moving faster in the 21st century against the backdrop of technological innovation, the penetration of information technology, and globalization. He maintains that long-term investments made from a decades-long perspective, as seen in the natural resources industry, are luxuries that are not available to other industries.

Corporate governance imposed by creditor banks is one reason why Japanese companies used to be able to maintain a long-term perspective. However, what provided the foundation for all of that is the sustained high economic growth that Japan enjoyed for years. Since this premise no longer holds today, Japanese companies have no choice but to struggle to strike a balance between short-termism and long-termism.

>> Original text in Japanese

* Translated by RIETI.

January 18, 2016 Nihon Keizai Shimbun

March 10, 2016

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