Short-termism: what's the problem?

There’s a widespread consensus that corporate short-termism is a problem. Many have welcomed Donald Trump’s call to end quarterly reporting in the hope that it might lengthen planning horizons; yesterday’s report from the IPPR cited short-termism as one reason for the UK’s lack of investment and innovation; and Richard Murphy has decried the “transient enterprise.”

I disagree with all this. I side instead with Sam Dumitriu and Larry Summers: short-termism is not a problem. Four facts make me say so:

 - If stock market investors were short-termist, they’d under-price growth stocks and over-price those offering near-term cashflows. In fact, more often than not they’ve done the opposite. Growth stocks have under-performed value ones in the UK over the last 30 years*. That suggests investors have been too long-termist.

 - The profits to innovative activity have been low: William Nordhaus estimates that firms have captured only a “minuscule fraction” of the overall benefits of innovation**. This suggests that low innovation might be due to a realistic assessment of its pay-offs rather than to irrational short-termism.

 - Suresh Nallareddy and colleagues show (pdf) that the introduction of quarterly reporting in the UK had “virtually no effect on investment decisions, as proxied by capital expenditure; levels of plant, property, and equipment; R&D, and intangible assets”.

 - Charles Lee and Salman Arif show that when firms do increase capital spending, it leads to lower GDP growth and more corporate earnings disappointments. This suggests that low capital spending is rational.

In fact, it might be that a reason for low innovation and investment is not that companies are too short-termist but that they are too long-termist. A good reason not to invest is the fear that profits will be bid away by future, cheaper, technologies. Uncertainty is much greater about the long-term than the short-term: firms can know who their rivals are today, but have no idea who they’ll be in (say) ten years’ time. And uncertainty is a reason not to invest. This is especially the case if Rosewell and Ormerod are right, and that companies have no idea about the future.

Plenty of firms are niche businesses, filling a gap in the market. But niches can exist in time as well as space. Profits are not persistent. Corporate death rates are high. This isn’t simply because many are badly managed (though they are (pdf)). It’s also for a reason pointed out by Peter Rousseau and Boyan Jovanovic. Firms, they say, embody specific vintages of organizational capital – the best practices and technologies at the time they were founded. Sometimes, though, better vintages come along, so firms must adapt or die. Adaptation, though.is difficult***; you can’t teach an old dog new tricks, as Gooners watching Petr Cech this season know. Rational bosses, knowing this, might be loath to expand.

What looks like short-termism might therefore be a reasonable response to the reality of creative destruction – something which is a central feature of a healthy, competitive economy.

None of this is to deny that bosses have plundered ailing companies such as Carillion and BHS. The problem in these cases, however, is not their irrationality but their excessive power.

Now, many people might interpret this denial of short-termism as a problem as a defence of capitalism. It’s not. Quite the opposite. We could just as well draw exactly the opposite inference: maybe low investment and innovation are deep-rooted features of modern capitalism which are not so easily eliminated by tweaks to corporate governance.   

* By 1.8 percentage points per year in total returns, if we compare the FTSE 250 high yield and low yield indices.

** Apple is an obvious exception to this. This is because Steve Jobs genius was not so much as an innovator as in being a creator of brand power.

*** Ironically, Whitbread – the firm cited by Richard – is an exception to this.

Comments

[Luis Enrique]

I have heard accounts of firms cancelling investments in the short run to hit earnings targets. OTOH we have Telsa, a long-term bet if ever there was one. So maybe shorttermism is a problem for some firms, sometimes, in some respects, and maybe it makes to try and fix that?

[Dave Timoney]

Small businesses may well have planning horizons no greater than reporting periods, and they may also defer investment if they fund it out of free cash or operating profit, but I'd be very surprised to find this going on in a larger business, let alone a listed company. Large-scale investments are usually funded by debt and have no short-term impact on earnings.

As the charge of short-termism is typically levelled at big businesses, I'd suggest something else is going on here. The term is typically used by politicians (and think-tanks like the IPPR) as a synonym for an antipathy towards planning, with the inference that this should be coordinated. For financial journalists, it usually acts as a euphemism for executive looting. For executives, it is a ready defence against market expectations.

I doubt that short-termism, in the sense of a habitual and widely-shared attitude, really exists. It's just rhetoric.

[Nicholas Gruen]

Thanks for the helpful list of references supporting a persuasive case

I always think that when people say short-termism, they're really complaining about the idiocies of managerialism.

It certainly IS true – wouldn't you agree? – that investment managers are index huggers and that is mostly crazy pathology.

If they have a 'strategy' – that is if their schtick is that they're not just selling the index – they should be proud of diverging from it, sometimes on the downside so the superiority of their strategy can demonstrate itself over time.

Of course it's mostly delusion either in the manager or the sucker buying the units or both.