Month: September 2018

What Really Drives “Short-Termism”?


What Really Drives “Short-Termism”?

Earlier this month, the CEO of Pepsi Co. suggested to President Trump that eliminating quarterly reporting (and shifting to biannual reporting) would reduce the pressure on managers to focus on the short-term. As impulsive as Elon Musk, the president bought this view hook, line, and sinker and tweeted his proposed shift to the world (and a probably startled SEC).

But what will be the actual impact? Those who have a law and economics orientation will predictably respond that widening reporting frames will present investors with greater uncertainty and risk, with the result that stock prices should decline (and the cost of capital should increase). Some corporate managers will point to offsetting cost savings from reduced reporting, but cost savings are trivial in comparison with even a small stock price decline. Nonetheless, the argument that moves more managers is that, under six-month reporting, they can focus more on the long-run. Yet, this argument may be precisely backwards; that is, the shift to six-month reporting is more likely to exacerbate than alleviate this problem.

The empirical research in this area (while limited) tends to show that financial managers will indeed sacrifice long-term shareholder value in order to meet a quarterly earnings forecast. In a well-known study, three respected financial economists surveyed 401 senior financial executives and posed a hypothetical problem to these executives: If they saw they were likely to fall short of a quarterly earnings target, would they cancel or delay an investment or project with a positive net present value (“NPV”)?(1) The majority conceded that they would. In addition, more than three-quarters of the surveyed executives agreed that they would sacrifice shareholder value (by deferring NPV investments) to smooth earnings—apparently because they believe that missing the earnings target (or experiencing earnings volatility) will cause a stock price drop.

So, there is a problem (which my neoclassical friends in the law and economics field tend to ignore). But does a shift to less frequent reporting help or hinder? If we shift to six-month reporting, financial managers may face even greater pressure to meet their earnings target (or the consensus forecast). After all, impatient investors will have waited longer and faced greater uncertainty. The failure to “meet your forecast” would cast even a greater cloud on management’s reputation and competence.

Consider the problem this way: If it were possible to report earnings on a monthly basis (or—and this is sheer fantasy—a weekly basis), missing the monthly or weekly target would not mean that much. A short fall in one week could be offset by a compensating gain in the next week. But a failure to meet a six-month forecast could not be corrected until the annual audited results were posted some eight or nine months later (when the issuer filed its Form 10-K). Thus, self-interested managers will be even more incentivized to sacrifice NPV projects to meet the earnings target.

Ironically, logic thus suggests that the narrower the reporting frame, the less that the long-run will be subordinated to the short-run. To be sure, nothing here is certain. The UK moved from six-month reporting to quarterly reporting in 2003, and then moved back to six-month reporting in 2013. No one has detected any measurable change in capital investments on either of these shifts. Still, cultures and pressures may be different on opposite sides of the Atlantic, and there is both much greater use of incentive compensation in the United States and much greater pressure from activist hedge funds focused on the short-run. These factors may incline managers in the U.S. to focus more on the short-run to please the market.

Some other impacts do seem more certain. Under a six-month reporting cycle, information asymmetries will increase, and this will make insider trading even more profitable (and probably even more predictable). Stock volatility seems also likely to increase in the face of greater uncertainty.

So what should be done? Probably the simplest and best answer would be for financial managers to give less guidance about future earnings. Once a financial manager makes a forecast, he has effectively pledged his reputation and needs to protect it by manipulating earnings. Hence, less in the way of earnings forecasts implies less pressure on managers. The SEC and the stock exchange could discourage forecasting in a variety of incremental ways, but, of course, they cannot prohibit forecasts.

Can the SEC simply shift from quarterly to six-month reporting? This is a legal question that may cause the SEC to assert its powers under Section 36 of the Securities Exchange Act of 1934. Section 36 (“General Exemptive Authority”) authorizes the SEC to “exempt any person, security, or transaction, or any class or classes of persons, securities or transactions, from any provision or provisions of this title or of any rule or regulation thereunder…” But exercise of this authority requires the SEC to find “that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.” To date, the SEC has used this provision only sparingly. Suppose then that such an exemption is granted by the SEC, based on cost savings justifications and the claim that it will protect investors from short-termism. Suppose next that a large group of institutional investors (including the Council of Institutional Investors) sues, claiming that the SEC’s exemption is very inconsistent with the “protection of investors.” How much deference should the SEC get?(2) Indeed, does this exemption even qualify for Chevron deference? This is a short column that will not attempt to resolve the current status of Chevron deference, but my bet would be that a conservative Supreme Court would back a conservative SEC.

But maybe I am just a pessimist.

John C. Coffee, Jr., is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

(1) See John R. Graham, Campbell R. Harvey and Shivaram Rajgopal, The Economic Implications of Corporate Financial Reporting, (available at (2005). This study later appeared in the Journal of Accounting and Economics in 2005).

(2) If one wishes to read more on this topic, see Daniel T. Deacon, Administrative Forbearance, 125 Yale L.J. 1548 (2016); Lesley Chen, The SEC’s Forgotten Power of Exemption: How the SEC Can Receive Deference in Favor of Internal Whistleblowers Even When the Text is Clear, 67 Emery L. J. 1043 (2018).

Ending quarterly reports will not stop corporate short-termism

Requiring less information would favour better-connected professional investors

Progressive critics and chief executives decry what they see as a myopic market’s pressure to cut back on investment and increase dividends and share repurchases

Larry Summers has written a remarkable piece in the September 3, 2018 issue of the Financial Times, which can be found here by subscription.

President Donald Trump has asked the US Securities and Exchange Commission to investigate moving public companies to a six-month rather than three-month reporting cycle to combat an excessive corporate focus on the short term.

Progressive critics and chief executives alike decry what they see as a myopic market’s pressure to cut back on investment and increase dividends and share repurchases. In her 2016 presidential campaign, Hillary Clinton proposed raising capital gains taxes for investments held for less than six years to combat short-termism.

Few ideas command such widespread support as the notion that companies should be induced to concentrate more on the long term. Unfortunately, while there are important ways in which corporate governance can be improved, the idea that a myopic market forces companies to forgo highly attractive investment opportunities is unsupported either by logic or evidence.

It is no surprise that the idea is attractive to many. Just as my students often suggest that the grading system forces them to study a particular syllabus rather than pursue their intellectual passions, managers prefer to avoid frequent accountability for results. The former chief executive of GM, Rick Wagoner, who presided over tens of billions of dollars of unsuccessful investment during the 2000s, was a leading voice against market-generated pressures for short-termism.

There is also an apparent worker interest in resisting payouts: employees at existing companies naturally prefer them to retain cash and grow, while the potential new groups that could be financed out of cash payouts do not yet have workers.

But popularity is not the same thing as validity. A variety of facts about market behaviour belie the systemic short-termism thesis. First, there are large numbers of companies, of which Amazon is only the most prominent example, that trade at huge multiples to current profits because of credible long-term plans.

There are now hundreds of unicorns — private start ups valued at more than $1bn — almost all of whom have little or no profits. This suggests that investors are happy to buy into credible, long-run corporate visions.

Second, many studies have now confirmed that companies where cash flows are highest relative to stock prices earn the highest returns. If, as the short-termism thesis suggests, these companies were over-valued, one would expect them to earn abnormally low returns rather than unusually high ones.

Third, private equity firms and venture capitalists expect companies they own to report on a monthly basis. Capable chief executives set a similar standard for divisions within their company. Otherwise they fear that problems will fester without being addressed. If companies with a sole owner in possession of a professional staff are expected to report frequently, why should not the same be true for public companies?

Fourth, companies differ greatly in their management quality. It is natural that those with better management and more opportunities will reinvest more of their profits and earn higher returns over time. To infer — as many advocates of the short-termism, including a 2017 McKinsey study, do — that this proves all companies should invest more, is to commit the obvious fallacy of confusing correlation with causation.

Reducing the frequency of corporate profit reporting would make big surprises and drastic market moves more likely. It would also allow managers to wait longer before they revealed large problems. Think of how much longer it would have taken for the issues at GE to become clear if the company reported only every six months.

Less frequent reporting would favour professional investors who are in constant touch with management over those whose information would be even more limited than it is today. In an age of big data and transparency, moving towards less would be a very odd step.

What, then, should be done? The rules limiting activists’ ability to distort corporate behaviour should be updated. More transparency on share accumulation would protect ordinary shareholders. At the same time, new restrictions should be imposed to prevent corporate activists from voting as shareholders in companies where they have divergent economic interests from other stockholders — because, for example, they used the options markets to hedge their risk.

Wise corporate leaders should give a sense of their long-term vision on at least an annual basis. Investors who insist on such information are only being reasonable.

The writer is the Charles W. Eliot university professor at Harvard and a former US Treasury secretary.

Corporate Finance and Sustainability

The Case of the Electric Utility Industry

In our last article from the (JACF Winter issue) we discuss how although the electric utility industry is in transition, it still needs to move faster for the country to meet its emissions goals. The industry has historically moved cautiously, but policies and regulatory approaches must avoid unintentionally reinforcing the status quo. Incentive-oriented policies and redesigned regulations must balance environmental sustainability with economic sustainability. The authors draw on well-established corporate finance principles to guide more effective policies. Shareholder-focused utility executives must make investments conditioned by three elements: (1) the return on equity the utility can expect to make on each project; (2) the investors’ required return on equity capital for each project; and (3) the size of the investment.

The well-established economic value added (EVA) model can assist policy analysis: V=(r-k)I; where V is the shareholder value created, r is the return on equity, k is the return investors require if they are to invest in the stock, and I is the scale of the project. Any new incremental V translates into higher stock prices.

All three elements of their model (i.e., risk, return, and scale) require attention by regulators and policymakers to create value for shareholders. The authors show how the right state policies could create powerful incentives for shareholder focused utility executives to support such transitions.

Authored by Steven Kihm, Seventhwave; Peter Cappers, Lawrence Berkeley National Laboratory; Andrew Satchwell, Lawrence Berkeley National Laboratory; and Elisabeth Graffy, Arizona State University

Global Trade – Hostage to the Volatile US Dollar

Global Trade – Hostage to the Volatile US Dollar

Brian Kantor says that (JACF Winter issue) every financial manager ought to have a multi-decade historical perspective on foreign exchange rates to appreciate how quickly and dramatically rates can change. Managers should understand how domestic politics influences central bank policies and, ultimately, foreign exchange rates, even if unintentionally. Longer-term historical perspectives are a necessary part of a solid decision-making foundation.

He provides a summary foreign exchange history from the perspective of the South African Rand (ZAR) and the US dollar (USD). What is most remarkable about such exchange rates, perhaps, is not just the variation around established trends but the tendency of apparently well-established trends to reverse completely. Kantor explains that, since 1970, the global economy has had to cope with flexible exchange rates that do not necessarily trend to Purchasing Power Parity “equilibrium.” This is a highly unsatisfactory feature of the global financial and trading system.

The chance of a reintroduction of genuinely fixed exchange rates seems very small, however. Business decision-makers will have to cope as best they can with unpredictable real exchange rates.

Authored by Brian Kantor, Investec