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RESEARCH BRIEF: Short-term thinking leaves long-term value on the table
Takeaway: Firms that can justify and communicate longer term investments may be able to stake out a better total return over time and a better competitive position in the long run.
With the ever growing access to information and fast pace of life, the pressures on companies to deliver immediate results have intensified. Some researchers have called this the “era of quarterly capitalism.” This study examines the evidence that the pressure to return value on a short time horizon can cause investors to select deals that return more initially even if the long-term returns of a deal with a less aggressive up-front payout would pay more over time.
The short-termism debate is not new – it dates back to the times of the Classical economists, Keynes and Benjamin Graham. The first empirical tests for short-termism began in the 1960s when studies found that investors typically expected full payback on their investments within three to five years (for comparison, the average life of plant and equipment was 30 to 50 years). A CFA (Chartered Financial Analysts) symposium in 2006 concluded that “the obsession with short-term results by investors, asset management firms, and corporate managers collectively leads to the unintended consequences of destroying long-term value, decreasing market efficiency, reducing investment returns, and impeding efforts to strengthen corporate governance.”
These short-term expectations by investors have impacted companies. A 1995 survey of CEOs at Fortune 1000 firms found that companies applied much higher discount rates to future cash flows (around 12 percent) than the equity holders’ average rate of return or the return on debt. A 2005 study of 401 executives found that in their desire to satisfy investors, managers would reject a positive-net present value (NPV) project that lowered quarterly expectations and 75 percent would give up economic value in order to smooth earnings. A 2011 PwC survey of FTSE-100 executives found that the majority of them would chose to get a low return sooner than a high return later. The study suggested annual discount rates of more than 20 percent.
To test the extent of short-termism and its consequences, the authors conducted a statistical analysis using data from 624 firms listed on the U.K. FTSE and U.S. S&P indices over the period 1980-2009. The main findings include: 1. There is statistically significant evidence of short-termism in the pricing of companies’ equities; 2. This is true for all industrial sectors; and 3. Short-termism has increased over the recent past.
What are the economic and social implications from such short-termism? An increase of excess discounting of 5-to-10 percent per year can significantly impact the investment choices that companies make every day. Long-duration projects such as infrastructure and alternative technology or supply chain management initiatives that require more time to implement (offering the biggest long-term value and future growth) would suffer disproportionately.
Implications for business people: The short-term thinking in investment decisions can affect many projects with longer term performance goals. In order to be successful, it is critical that the incremental return of these initiatives is projected and communicated. Firms with long-term strategies should become more actively involved in public policy discussions to advocate for a longer view and investment horizon.
If citing please refer to the original paper: “The Short Long”, a speech by Andrew G Haldane, Executive Director, Financial Stability, and Richard Davies, Bank of England, 29th Societe Universitaire Europeene de Recherches Financieres Colloquium, May 2011