Rational short-termism

The Labour-commissioned Cox report (pdf) argues that short-termism is widespread, and a disincentive to invest and develop new products.However, I fear it under-rates the possibility that short-termism is often rational.

The problem here is one of uncertainty, in the sense of unknown unknowns.Think of any company you know reasonably well. On a short-term horizon - one or two years - you probably have a fair idea of its SWOTs or five forces, or any other way of analysing the firms' prospects.But on a long-term horizon - ten or 20 years - you don't have a clue, not least because for very many businesses it's impossible to forecast whether they'll be brought low by technical change (which by nature is unpredictable at long horizons) or bad management. For a long time Polaroid seemed a sound company, until digital cameras came along; Nokia was doing OK until the iPhone appeared; RBS and GEC did well for years until bad takeovers and strategy killed them. And so on.

Company death rates are high, and their chances of dying can change unpredictably.Whereas risk is roughly quantifiable - under reasonable assumptions it increases with the square root of time - uncertainty is not. Faced with massive uncertainty, it is surely reasonable for investors not to want to commit to long-term investment.

In fact, there's one piece of evidence which suggests that, far from being too short-termism, equity investors haven't been short-termist enough. This is that value stocks - generally, those which offer short-term cashflows - have tended to out-perform glamour ones, which claim to offer growth. This suggests that investors have often been too long-termist, paying for future growth which hasn't materialized.

There are two possible objections to this which I don't think are convincing.

"Short-termism isn't ubiquitous: look at much of Asia." I suspect, however, that insofar as private (as opposed to state) investors there are long-termists, it's because uncertainty is mitigated by the optimism bias; in a fast-growing economy, animal spririts improve.

"Warren Buffett has succeeded by taking long-term investments." True. But they have been in companies which have good short-term cashflows and which can be monitored by short-term results. Buffett tends not to invest in startups or "growth" stories.

I don't say all this to rubbish the Cox report. Instead, it is to suggest that policies to encourage long-termism should be seen another example of anti-nudge; it can sometimes be a good idea to encourage irrationality. The best way to get finance flowing to new and small businesses is to have big dose of irrational exuberance.

Comments

[paulc156]

Irrational exuberance! That seems to be behind the thinking of the coalition who insist that green shoots are undeniable and that robust growth will resume any time now...just wait...you'll see.

[Alex]

Nokia was pretty much OK for a long time after the iPhone appeared. The iPhone is an example of persistence; the first couple of generations weren't that much better, in some ways worse, than the classic Nokias (N95, E61i, E71 frex). But Apple stuck with it and kept iterating on the design and developing the supply chain, and eventually they stretched away from the 3GS onwards.

The short-termist counterexample is Motorola - after the huge hit of the RAZR V3 they just kept churning them out, doing more and more colours and daft things like the Maria Sharapova special, and also losing their grip on quality in pursuit of volume, while Nokia, Apple, Samsung, RIM, SE etc looked towards the smartphone future.

[Anonymous]

Options theory suggests itself as a possible way of extending investment time horizons.

[Kokiri]

I'm completely unconvinced by this.

I would argue that institutional investors are chiefly short-term oriented (by which I mean that they hold shares for short periods of time) because their incentives are (at least perceived as) short-term - they get a bonus/fired based on short term returns, and the funds grow/shrink based on short term results.

The philosophy of the successful, long-term investors that I've known has acknowledged that you can't really tell what's going to happen with any accuracy, but you stack the odds in your favour by buying what is cheap (i.e. value stocks, although 'growth at the right price' is also in there), and being patient.

Calling investing in perceived high growth stocks a long-term strategy is a bit of a sleight of hand, since few of these investors are buying and holding the stocks for the long run. Rather they are buying what is perceived as having good prospects (usually because of good short term performance) without regard for the fact that this growth is usually priced into the stock (so the weight of expectations lies on the downside). This triumph of popularity over price is precisely what I would consider short-termist.

[Andrew]

The irony is that were collective exuberance to break out, and if it is predictably effective, then it would no longer be individually irrational to join in.

Agree with kokiri that ineffective investment in growth stocks isn't attributable to a long time horizon, and value investing *requires* a long time horizon, measurable cash flows or not.

[Andrew]

Under performance of glamour stocks relative to cash flow stocks only tells you of overoptimism about growth over the examined period.

It doesn't give you any information about investor time horizons.

If the chances of glamour stock growth are uncorrelated then you can express a long-horizon view on a single stock to a short term investment in a basket of many such stocks.

If that basket underperforms relative to cash flow stocks, it was an unfortunate decision, but nothing to do with time horizon.

If growth is well correlated between these stocks, and depend on some macroeconomic or technological factors, then the growth investors have just been unlucky over the period. You can't say they were irrational without actually examining their reasoning.

[Luis Enrique]

It's all rather complicated because we have a situation in which investors who care about the long term try to divine information about it from short term performance, so managers who care about the share price worry about the short term because of what it signals about the long term.

When a company misses its numbers, an investor will place some probability on that just being a short term glitch that leaves the long term value essentially intact, and some probability on it being the first sign things are going pear shaped and current long term expectations are too optimistic. So reacting to short run news is compatible with caring about the long run

The most damning evidence re. short termism are those surveys in which a majority of CFOs say they'd turn down a positive NPV project if it caused them to miss short term targets. But even that isn't so clear cut. But presumably if the CFO had a but more time, they could incorporate the costs of the project into their earnings guidance, so they won't miss their numbers.

[Keith]

I am not sure that this is a matter the Opposition should worry about.

Unless you are going to Nationalise the big firms and then require them to plan investment over fifteen year time periods, like the Swiss Railways! How would a Government do any thing practical about investment by firms? This is all predictably pious.

[Will Davies]

You're right, but isn't there another lesson to be taken from this - that equity markets are too powerful. This is the Will Hutton critique of short-termism. It would also be an argument many Schumpeterians would make, who favour properly engaged forms of private equity (as opposed to the tax-dodging asset strippers we actually have) and relational banking. One way of overcoming the uncertainty of the future is dialogue and learning. If stock markets don't support that type of relationship, then build another type.

[Metatone]

Good comments today. I'd note that uncertainty is massively overplayed in modern business because it's a convenient excuse of bad management. In reality most of the companies generally cited (including Polaroid and Nokia) had a sight of that uncertain future, but put off dealing with it because of short-term pressures from equity markets.

RBS and GEC are also much more disasters of risk than uncertainty.