A lot has been written about the impact of short-termism on the US economy. (See, for example, this PubCo post, this PubCo post and this PubCo post) This post from The Harvard Law School Forum on Corporate Governance and Financial Regulation, “How Economic Attention Deficit Disorder Infected the Corporate Boardroom,” looks beyond the impact to try to understand what has been driving this “epidemic” of short-term thinking.
The author, the Executive Director of the Investor Responsibility Research Center Institute, begins with the evidence that the disease has taken hold: he first notes an academic study showing that “three quarters of senior American corporate officials would not make an investment that would benefit a company over the long run if it would derail even one quarterly earnings report.” Other studies he cites have demonstrated “that corporate officials and institutional investors commonly over-discount the future, meaning that they don’t fully appreciate returns on investments that are more than a few months away.” The result is that, as one commentator cited in the post observes, “long-duration projects [suffer] disproportionately… including infrastructure and high-tech investments.” Short-term thinking has even affected the investing public: “In the 1930s, when the modern regulatory framework of our markets was established, the average holding period of a New York Stock Exchange traded stock was 10 years. By 2010 it was down to six months.” The author characterizes this phenomenon as “an epidemic of Economic Attention Deficit Hyperactivity Disorder.”
But what is the cause? Why have we stopped investing for the long-term? And how did the “epidemic” infect the corporate boardroom? The author focuses on three “underlying contextual issues”: the “legal underpinnings” of capital markets regulation, the business model of the investment management industry and the prevailing culture of that industry. These three factors, he contends, “often escape attention exactly because they are chronic and omnipresent rather than acute and sporadic. As a result, we tend to accept them as the background against which short-termism plays out, rather than examine them as causes which contribute to Economic ADHD.”
First, after observing that the public capital markets are really organized less around investing than around trading, the author attributes that organizing principle to “the legal architecture of our capital markets, which is built on disclosure to help trading markets, not on corporate law to help owners steward their investments.” How did that happen? The author posits that this perspective grew out of a shift from state to national regulation of corporate securities. Following the market crash and the Great Depression, he observes, there was a clamor for national regulation of securities; until that time, corporations were governed largely by state corporate and blue sky laws. To impose regulation on a national basis, however, required a jurisdictional basis, and that basis was interstate commerce. As a result, he argues, the “national regulatory regime centers on disclosure so as to facilitate a market for securities sales and trading, not corporate stewardship.”
According to the author, the development of the investment industry business model is attributable to the invention of modern portfolio theory (MPT), which popularized the concept of “diversification, allowing investors/traders to hold ‘riskier’ individual assets. But MPT also accelerate[d] the trend towards trading by focusing on securities, rather than on the companies [that] issued them. For example, MPT judges the relative return and risk of … individual securities against that of the market overall. From there it was a minor step to investment managers judging how well they did by comparing their performance to that of the market.” Because “the price movements of both the market and the managers’ portfolios can be measured continuously, they were…. An entire industry of performance measurement sprang up to compare investment managers’ performance month-to-month or quarter-to-quarter. As the amount of money those managers attract is materially affected by those short-term, market-relative returns, and as investment managers are paid based on how much they have in assets under management, the pressure to ‘beat the market’ on a quarterly basis is intense.” He notes that, even though most active traders trail the market, they continue to rapidly turn their portfolios, driven by market, macroeconomic and behavioral reasons: “Faced with ever changing situations and pressed for outperformance on a real-time basis, investment management houses have a hard time sitting still.” Moreover, he contends, the legal/regulatory structure and MPT have also together shaped the interpretation of fiduciary duty for investment managers to encourage “investment managers, acting on behalf of beneficial owners, to maximize short-term financial results. Longer term sustainability issues were regarded as either irrelevant to fiduciary obligation or even, at times, as antithetical to it.”
Compounding those two factors, in the author’s view, is the focus of the “dominant investing culture” on short-term trading, as evidenced, among other things, by the ratings for those “hyperactive television shows promoting trades for that day” and the millions of hits on the search “buy and hold is dead.”
But how did this epidemic “jump from the trading floor to the board room”? According to the author, the vehicle for transmission was executive compensation: “In trying to tie executive compensation to performance, we accepted that performance meant short-term stock market (price) performance, rather than anything more fundamental to the company.” Exhibit A for this contention, he argues, is Section 162(m) of the tax code, which created an exception from the $1 million cap on deductibility of compensation for “performance-based” compensation. Section 162(m) made it relatively easy for stock options and SARs to qualify as “performance-based” under the exception, even though the “performance” in question was just “linked to the equity market’s price-setting mechanism—a mechanism designed to establish trading prices, not to run companies.” By “reducing the incentive to invest in [net present value] positive projects so as to reduce market price volatility, ” he maintains, “we have unintentionally contributed to the hollowing out of American productive capacity.”
Although he acknowledges the logic of suggestions such as ending quarterly guidance and changing compensation performance measures to better focus on drivers of a company’s future growth rather than stock market price, the author believes that, to solve the real problem, the three underlying factors he has identified should be addressed. Promising solutions in his view include recognition of fiduciary duty as including consideration of longer-term sustainability issues, changes in the way investment managers are paid and adoption of a “stewardship code” for the investment management industry.
SideBar: In the same vein is the 2016 corporate governance letter from the CEO of BlackRock asking corporate CEOs, instead of using their annual communications to shareholders to report only on the past year’s achievements, to “articulate management’s vision and plans for the future” by “lay[ing] out for shareholders each year a strategic framework for long-term value creation. Additionally, because boards have a critical role to play in strategic planning, we believe CEOs should explicitly affirm that their boards have reviewed those plans. BlackRock’s corporate governance team, in their engagement with companies, will be looking for this framework and board review.” [bold in original] (See this PubCo post.)
And the author sees some hopeful signs as current initiatives focused on re-orienting public capital markets to investing and long-termism gain traction. But whether any of these remedies will force the “disease” into remission remains an open question.