Month: March 2019

Who Are the Short-Termists?

Who Are the Short-Termists?

In the second article of our Fall 2018 issue we present an edited version of Wei Jiang’s keynote address at the Financial Management Association’s Annual Conference last October. Wei begins by noting that shareholder turnover in U.S. public companies has increased sharply during the past four decades, rising from a low in the mid-1970s of around 10%—which implies an average holding period of 10 years—to its current level of over 350%, or a holding period of some three or four months.  But this increase in average share turnover in recent decades has also been accompanied by a remarkable growth of long-term investors. 

In a recent study, the author and two colleagues used quarterly holdings information from Form 13F to identify short-term investors—which they defined as having annualized turnover rates over 100%, implying a holding period of less than a year—and long-term investors—those with a turnover rate below 33%, with holding periods longer than three years.  Defined in this way, the presence of long-term institutional investors in the average public company’s shareholder base has more than doubled since the early 2000s.

What’s more, in an attempt to determine whether the market encourages corporate short-termism by putting too high a discount rate on—and so undervaluing—earnings or cash flows that are expected to appear in the distant future, the author points to the findings of two studies by others. In the first of the two, an examination of the pricing of a relatively new derivative known as “dividend strips” shows that the implied discount rate for such “incremental” dividends has actually been higher than the rate applied to the long-term residual value, suggesting that the market undervalues near-term cash flows relative to more distant ones. The second of the two cited studies reports that companies with high levels of R&D spending—in other words investments with distant payoffs—are fairly priced in the sense that their future stock returns are comparable to those earned by other companies in the same risk class.

In response to the claim that shareholder activists force companies to pursue near-term profits at the expense of the corporate future, the author cites her own study (with two colleagues) that examines the stock returns of targeted companies from three years before the announcement of an activist’s taking a position in the stock to three years after. What they find is that the targets significantly underperformed the market and their competitors in the period leading up to the activists’ involvement—and that, after a 5% jump in share prices in response to the announcement, the average performance of the targets was roughly equivalent to their competitors’ during the next three years. And, as if reflecting this 5% net gain, the operating performance of these companies, as measured by ROA, improved significantly during this three-year period.

To be sure, there is some evidence that activists discourage corporate R&D. But, as the author (and her three co-authors) shows in a study published this past year in the Journal of Financial Economics, although corporate spending on R&D does fall (by an average of $15 million per company) in the year following the appearance of activists, R&D as a percentage of total assets remains unchanged, reflecting the tendency of companies to sell assets; and the smaller R&D function becomes more productive, accounting for 15% increases in both new patents and citations during the next three years.

Authored by Wei Jiang

Are U.S. Companies Too Short-Term Oriented? Some Thoughts

Are U.S. Companies Too Short-Term Oriented? Some Thoughts

In the first article of our Fall 2018 issue Steve Kaplan notes that today’s widespread criticism of U.S. companies as shortsighted and ever willing to sacrifice their future for near-term profit is by no means new. As the author of this article shows, such charges of short-termism have a long history that goes back at least 40 years. But as he goes on to point out, if these claims were warranted, then the effects we have been warned about all these years would surely have shown up by now.

But it is difficult to find evidence of such effects. For example, a short-term orientation has not been reflected in any erosion of corporate profitability over time. As the author reports, the ratio of U.S. corporate profits as a percentage of U.S. GDP has not only been on a generally upward trend since the early 1980s, but has never been higher than in the past few years. And corporate spending on R&D has also gone up sharply during this period, from 1.1% of GDP in 1977 to 1.7% in 2016. What’s more, evidence of short-termism has not shown up in either higher amounts of investment, or higher rates of return, by venture capitalists and private equity firms, which are both in a good position to profit from widespread corporate failure to pursue valuable growth opportunities.

Nor do stock market investors appear to encourage corporate short-termism, given their willingness to fund IPOs of companies with no previous earnings, and to assign high price-earnings multiples to companies, like Amazon and Tesla, whose reported earnings have been modest at best. What’s more, the fact that today’s P/E and CAPE ratios are at relatively high levels suggests that the market continues to expect significant rates of growth by U.S. companies.

Some critics, to be sure, have argued that the high level of corporate buybacks and other distributions of cash, when combined with today’s near-record corporate cash holdings, provide clear evidence of a widespread failure of companies to invest in their future. But as the author notes, such distributions in fact represent a fairly small fraction—only around 20%—of after-tax corporate net income after infusions of new debt and equity capital are also taken into account.

Authored by Steve Kaplan