In this study, consulting firm McKinsey raises the question of why so many companies seem to be ensorcelled by their short-term investors, which own only about 25% of the shares of U.S. companies, while failing to address — or perhaps even understand — the needs of their long-term holders, which own 75% of U.S. shares. While it’s true that short-term investors probably make the most noise, that noise, McKinsey contends, may be distracting managements from aligning with the types of investors that will have the greatest influence on share price over the long term. Perhaps some of the pressures to emphasize short-term financial performance could be avoided or at least mitigated by building alliances with sophisticated long-term investors?
According to the study authors, “short-term investors and their proxies, sell-side analysts, are the most visible participants on quarterly earnings calls and in contacting companies for the insights upon which they trade. The pace and volume of those trades may often dominate a company’s daily trading activity.” But these investors account for only a quarter of shares. Long-term holders, on the other hand, account for 75% of U.S. shares, which breaks down to 33% retail investors, 17% index funds and 25% long-term institutional holders. In a prior study, McKinsey argued that companies would be better off focusing on this last group, sophisticated long-term institutional holders, referred to as “intrinsic investors.” These investors, which “base their decisions on a deep understanding of a company’s strategy, its current performance, and its potential to create long-term value,” may also be more willing “than other investors to support management through short-term volatility”:
“With their deep understanding of a company’s intrinsic value and their willingness to make large investments, they often see even bad news, in the short term, as an opportunity to increase their holdings of a company whose strategy and management they support. That gives companies more room than many managers realize to make decisions that create long-term value—even at the risk of short-term volatility. This also benefits all long-term shareholders by keeping share prices in line with a company’s intrinsic value and preventing prices from falling too far out of line, relative to the company’s peers.”
To conduct the study, McKinsey (along with a program of the Aspen Institute) surveyed and interviewed CFOs of public companies and a group of intrinsic investors, with an average holding period of six years. McKinsey reported that “the consensus of the group was that all public-company CEOs, CFOs, and corporate boards should be doing what they can to attract and retain a critical mass of intrinsic investors in order to blunt the effects of short-termism and best support a strategy of long-term value creation.”
But how best to do that? McKinsey’s research yielded four suggested approaches to creating better relationships with these long-term investors:
Pursue long-term value even at the expense of short-term earnings. Studies have shown that, when asked to choose among strategic options, corporate managements would often not make a long-term investment if it would hurt quarterly results. (See, for example, this PubCo post.) From all appearances, this result is a reaction to pressures from short-term investors. Perhaps, the study suggests, companies should heed their intrinsic investors instead: intrinsic investors “overwhelmingly favor decisions that lead to long-term value creation even at the expense of short-term earnings shortfalls.” In one scenario, the intrinsic investors surveyed were asked about potential responses to a change in foreign exchange rates that led to a significant decline in short-term profits. More than three-fourths of the intrinsic investors in the study “said they would be neutral if the company took no action and simply reported lower profits. On the other hand, nearly two-thirds said they would take a negative view of an order for across-the-board cost reductions. Intrinsic investors realize that companies can’t control or predict exchange rates and don’t want companies to take arbitrary cost-cutting actions to meet current earnings expectations that may hurt the business later. [McKinsey] then asked, assuming exchange rates stayed the same, whether the company should accelerate cost cutting in the following year to keep its earnings rising, even if long-term revenues could be negatively affected. Nearly all viewed this negatively.”
Proactively structure investor communications. With respect to communications, intrinsic investors indicated that they wanted the management to educate them more about the company’s business and strategy, competitive forces and the “concrete actions the company is taking to realize its aspirations—including efforts to ensure it has the talent to succeed.” Investors also wanted to learn how the CEO makes decisions, whether the management team is on the same page as the CEO and whether the company’s “approach is aligned with long-term value creation.” They claimed to be able to see through elaborate efforts to “sell” them and did not want to be fed what the management guessed the investor wants to hear. Building management credibility was key, and that involved earning “trust and respect by not trying to sugarcoat.” Managements were also advised to consistently focus on the long-term horizon, zooming in as necessary: “It’s all about the horizon. Long-term investors don’t need a lot of detailed guidance about quarterly numbers. They need clarity, consistency, and transparency from managers in communicating strategic priorities and their long-term expectations.”
Resist artificial efforts to meet earnings targets. Studies have shown that companies will often defer investments in value-creating activities, such as R&D and capital equipment, to meet short-term earnings targets. However, the study observes, “[m]ost long-term institutional investors deplore such moves.” Only 12% in the study
“thought it was important for companies to consistently meet or beat consensus estimates for revenue or earnings. They realize there are too many factors outside management’s control to consistently meet the consensus. Most of them say they are satisfied with a company sometimes beating estimates and sometimes missing, as long as the company is making progress toward its long-term goals. That’s consistent with previous McKinsey findings that more than 40 percent of the companies that miss their consensus earnings estimates actually see their share prices rise, despite the conventional wisdom that missing analysts’ estimates invariably leads to major stock-price declines. And when stock prices do fall precipitously, it’s almost always because of other bad news that was conveyed at the same time as the earnings release.”
According to the study, intrinsic investors disfavor quarterly guidance; they were generally much more concerned about announcements of factors that could impact long-term performance — smaller investments in R&D in favor of stock buybacks, sharp declines in employee or customer satisfaction, data indicating the company is not adequately addressing environmental or social issues or questionable supply-chain practices creating reputational risk — than an announcement that the company planned to discontinue quarterly guidance.
Rethink management’s approach to quarterly earnings calls. According to McKinsey, “[m]ost intrinsic investors don’t like quarterly calls and find them a waste of time.” The vast majority “preferred one-on-one meetings and less frequent but more long-term-focused investor days or strategy conferences.” But what they objected to was not the call itself — rather, it was “the quality of the quarterly calls as practiced today.” What does that mean? It means that they objected to the scripted speech that they could just as easily have read themselves; they objected to the vastly disproportionate number of questions from sell-side analysts in the Q&A period, who were just “trying to enhance their quarterly earnings models rather than trying to understand how what happened in the quarter affects the long-term value of the company.” Here are some suggestions from McKinsey to remedy this situation:
- Provide detailed information in advance and minimize the amount of time spent on information that is already in the press release; most of the intrinsic investors surveyed favored eliminating the reading of scripted comments.
- Focus instead on the Q&A, eliminating repetitive questions, minimizing short-term-oriented questions and reducing “sell-side modeling questions, such as ‘what is next quarter’s tax rate.’” To that end, almost 2/3 of intrinsic investors surveyed favored asking investors or analysts to submit questions in advance: “[t]hat helps companies give prominence to the questions asked most frequently and prioritize those that are most relevant to interpreting the quarterly results as indicators of long-term performance. To prevent management from avoiding important questions, a portion of the call could be devoted to questions asked ‘live.’” This practice would require some type of time gap between the earnings announcement and the quarterly call.
- Give precedence to the company’s long-term strategy before discussing the short-term results. Put the short-term results into the context of the long term.