Since the financial crisis, political figures, academics and financial industry participants increasingly decry the rise of “short-termism” in U.S. stock markets. Short-termism, as usually defined by its proponents, is an ongoing trend of corporate myopia. In which corporate managers, driven by investor demands, focus on near-term earnings and stock price maximization at the expense of long-term value creation.
The details of the story vary, but the core argument remains the same. Investors want quick profits in their holdings. In response, publicly traded U.S. corporations slash research and development spending and forego other long-term investment opportunities. Those near-term savings instead are funneled into share repurchases. Buybacks create a short-term pop in the stock.
CEOs and other executives benefit from generous stock option grants. Activists and short-term traders take quick profits and move on. But future profits and innovation are sacrificed, meaning long-term investors, workers, customers and the rest of the economy suffer.
This tantalizing narrative appeals to a surprising cross-section of figures in U.S. business, media, academia and politics. But there’s a simple problem with the narrative: there’s strikingly little evidence that it’s actually true.
How Short-Termism Works (If It Does)
As the name implies, the supposed driver of short-termism is an investor base increasingly focused on short-term results and price maximization. Accordingly, some data suggest that investors are, or at least could be, less interested in long-term returns.
Most notably, the average holding period for U.S. stocks has shrunk noticeably. Indeed, investors in 1960 usually owned a stock for a full decade. The figure now is only a few months.
In addition, activist intervention in U.S. stocks has risen sharply. These activists often, though not always, are agitating for moves that drive short-term value creation.
Asset sales are a common demand, as seen recently with companies as different as e-commerce specialist eBay (NASDAQ:EBAY) and brick-and-mortar retailer Bed, Bath & Beyond (NASDAQ:BBBY). Activists usually look to maximize margins as well — which most often requires spending cuts. Once an activist wins (or, usually, settles), businesses are sold, margins expand and the activist moves on, leaving a smaller and weakened company behind.
Notably, short-termism blames investors, not executives. It’s shareholders who demand quick profits. Executives have no choice but to respond.
The Quarterly Earnings Problem
Quarterly earnings themselves support the short-termism take. This earnings season is no different:
- Twitter (NYSE:TWTR) lost over $6 billion in market value in a day after revenue disappointed in its third quarter and the company’s fourth-quarter guidance was weaker than analysts expected.
- UnitedHealth Group (NYSE:UNH) added $17 billion to its market capitalization in a single day. The key driver? Higher-than-expected earnings— and thus profit margins — from the country’s largest health insurer.
- Texas Instruments (NASDAQ:TXN) dropped 7.5% after its earnings report, a decline which wiped out $9 billion in equity value. Two days later, Intel (NASDAQ:INTC) — another leader in the same industry — gained roughly the same amount on a percentage basis. That jump created paper wealth of $18 billion. Wouldn’t a market focused on long-term industry fundamentals lack such enormous moves?
Recent earnings results aside, short-termism feels like a market-wide problem. After all, every week multiple stocks add or lose billions of dollars in market value after earnings. The reactions — and, possibly, overreactions — of the last month are not unique to 2019 trading.
And those billion-dollar moves come in response to often-minute changes in expectations. A stock can miss consensus earnings estimates by a penny or two and yet lose 10% or 15% of its value.
Surely these moves, and the many like them, show that the market’s focus is measured in quarters, not years. As such, opponents of corporate myopia cite these moves as support for the case that corporate managers must be responsive to the market’s near-term focus.
Executives and Progressives Unite
The case against short-term thinking retains a wide swath of adherents, many of whom fall under the “strange bedfellows” description.
Jamie Dimon and Warren Buffett, CEOs of JPMorgan Chase (NYSE:JPM) and Berkshire Hathaway (NYSE:BRK.A,NYSE:BRK.B), respectively, wrote an op-ed in the Wall Street Journal just last year entitled “Short-Termism Is Harming the Economy”. Larry Fink, CEO of exchang-traded fund (ETF) giant BlackRock (NYSE:BLK) made a similar argument back in 2016.
Last year, another well-known U.S. CEO railed against the market’s short-term focus. Tesla (NASDAQ:TSLA) CEO Elon Musk last year announced he would take the company private. (That never occurred. In fact, Musk settled with the Securities and Exchange Commission last year, amid allegations that the announcement was fraudulent.)
As Musk put it in an email to employees, going private was “all about creating the environment for Tesla to operate best.” He complained that “being public … subjects us to the quarterly earnings cycle that puts enormous pressure on Tesla to make decisions that may be right for a given quarter, but not necessarily right for the long-term.”
Few better descriptions of short-termism have been written.
Politicians agree. U.S. Senator and Democratic presidential candidate Elizabeth Warren, rarely one to take the same side as corporate CEOs, last year introduced the Accountable Capitalism Act. Warren’s press release didn’t cite short-termism by name. But it argued that in the past ten years, nearly all corporate earnings were returned to shareholders, “redirecting trillions of dollars that could have gone to workers or long-term investors.”
Two days later, President Donald Trump echoed his 2016 rival, Hillary Clinton, and perhaps his 2020 opponent, in floating the idea that quarterly earnings reporting be abolished.
Academics and Writers
Several academic papers, too, have found evidence of short-termism. A widely-cited study from 2005 by John Graham, Campbell Harvey and Shiva Rajgopal found that nearly 80% of CFOs admitted they would sacrifice long-term value to meet near-term estimates.
A 2014 paper — authored by John Asker, Joan Farre-Mensa and Alexander Ljungqvist — found that public firms “invest substantially less” than their private counterparts.
Meanwhile, opinion pieces on the prevalence of short-termism are are not hard to find, particularly in the decade since the financial crisis. After all, that crisis itself would seem to be proof of the dangers of a short-term focus.
As evidence, both columnists and academics have pointed to Citigroup (NYSE:C) CEO Chuck Prince’s infamous 2007 quote. “As long as the music is playing, you’ve got to get up and dance,” Price told the Financial Times that year. “We’re still dancing.” Soon after, the music stopped playing. The U.S. economy plunged into its biggest financial crisis in 70 years.
The Right Prescription
To be sure, not all adherents to short-termist theory see the mechanics as the same. Nor do they offer the same remedies. Warren and other progressives, for instance, long have criticized share repurchases, rather than focusing on reporting requirements.
Indeed, last year, a group of 20 Democratic senators (plus one Independent, Senator Angus King), including Warren, asked the SEC to look into share repurchase regulations. Specifically, the senators asked for a review of Rule 10b-18. That rule was adopted in 1982. It effectively reversed the prior characterization of share buybacks as market manipulation. Repurchase activity has risen ever since.
Executives (and presidents) have taken a different tack. Trump echoed calls elsewhere for a move to semi-annual financial reporting to limit the occurrence of post-earnings volatility. Dimon and Buffett wrote that companies should “reduce or eliminate” quarterly earnings guidance, to help guide investors away from a near-term focus.
Neither CEO likely supports limits on share buybacks. In fact, both JPMorgan Chase and Berkshire Hathaway repurchased shares last year. Dimon’s JPMorgan Chase, following regulatory approval, trumpeted a $29 billion repurchase program just this year.
But the differing remedies still assume the same underlying problem. Investors want results now. They will punish stocks, and executives, who don’t deliver.
The response from progressives is to limit the ways in which in cash can be returned. The response from executives often is to limit the frequency of the events used by Wall Street and institutional investors to measure a company’s performance. Neither proposed solution seems to allow for another potential explanation: short-termism isn’t a problem to begin with.
The Market’s Most Valuable Companies
The case for short-termism, on its face, seems logical, if not compelling. But Mark J. Roe, the David Berg Professor of Law at Harvard University, is among many academic skeptics of the theory. In a 2018 paper, “Stock Market Short-Termism’s Impact,” Roe highlighted the five most valuable companies as of Sept. 19, 2018. They were (and in fact still are):
- Apple (NASDAQ:AAPL)
- Amazon (NASDAQ:AMZN)
- Microsoft (NASDAQ:MSFT)
- Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL)
- Facebook (NASDAQ:FB)
These five market darlings all invest heavily in the same R&D which short-termist critics claim is being shortchanged. Alphabet, in fact, specifically breaks out an “Other Bets” segment containing businesses for which it expects years of losses. Amazon consistently trades near-term profits for long-term revenue and market share growth.
Investors don’t shun those strategies. Rather, they embraced them. Alphabet’s core “Other Bet,” self-driving startup Waymo, receives huge valuation estimates from Wall Street analysts. That’s despite the fact the business likely won’t generate profits for at least a decade.
Meanwhile, Amazon announced in conjunction with its Q3 earnings report that it would spend $1.5 billion in the fourth quarter alone on one-day shipping. AMZN stock dropped less than 2% on the news, which included a disappointing sales forecast for Q4. It’s returned 1,400% in a decade during which time it never has prioritized near-term earnings or returned a penny to shareholders.
Even the cheapest of the group, AAPL stock, dispels the argument. The market still assigns AAPL stock a reasonable earnings multiple. Why? Because investors worry that the iPhone will be commoditized. Those investors may be wrong; but if so, in making an uncertain long-term projection, not having a short-term focus.
Better Examples Against Short-Termism
The market’s largest, most widely held, and most widely covered stocks all dispute short-termism, rather than prove its existence. But they’re not even the best examples.
In fact, despite Musk’s complaints about the “quarterly earnings cycle,” Tesla might be the best counterargument to short-termism.
Tesla, in its 17 years of operation, never has turned a full-year profit. (To be fair, it likely will do so in 2020.) And yet the market values Tesla equity at $57 billion. Its market capitalization surpasses those of Ford (NYSE:F) and General Motors (NYSE:GM), both of which trade at less than 7x forward earnings.
How can that discrepancy occur in a short-termist market? Simply put, it can’t. Investors focused “only on the next quarter” would be paying up for the near-term cash flows — and immediate dividends — of F and GM. They would be heavily discounting the distant positive cash flows of Tesla.
Examples elsewhere litter the market. Software companies have moved to subscription billing instead of larger upfront payments that would boost near-term cash flow. Investors value those companies on a metric literally called “lifetime value.” The sector has been one of the best-performing in the entire market this decade.
Growth has outperformed value. High-multiple stocks have outperformed their cheap counterparts. How are those multi-year trends possible in a market focused only quarter-to-quarter?
Where Are the Long-Term Effects?
Market valuations aside, there’s another core problem with the short-termist argument — It’s been made for decades. University of Chicago professor Steven N. Kaplan noted in a 2017 paper that short-termist critiques have been made going back to the 1970s. The same year, The Economist highlighted a 1936 quote from famed economist John Maynard Keynes that described investor time horizons as “three months or a year hence” — in 1936.
Decades later, there’s no evidence that past concerns about short-termism were justified. Research and development spending has continued to increase. As Kaplan points out, corporate profits as a percentage of the economy have been on a steady rise.
If public corporations in 1982 or 1992 were foregoing profitable long-term value, surely current profits would be falling. If they were, or are, slashing R&D, that spending would be down.
Admittedly, capital expenditures have been softer since the financial crisis. In his paper, Roe argues that the weakness is a worldwide phenomenon, and one likely due to the crisis and the ensuing recovery. To support the argument, he makes a key point. In other developed nations with smaller stock markets, the trend has been the same. That dispels the argument that public investors are driving lower capex spend across the economy.
Are Stock Buybacks Bad?
As far as share repurchases go, there are legitimate concerns. Buyback activity has increased significantly since the 1982 rule change, and has been particularly aggressive over the past decade. Not all of those repurchase programs have been wise.
As CNBC noted last year, firms like GE (NYSE:GE), IBM (NYSE:IBM) and Citigroup have had particularly poor track records in terms of allocating capital to buybacks. Corporate boards in general have proven to be poor market timers. Repurchase activity often ramps at market peaks and dwindles at market bottoms.
But that alone does not mean that investors are driving those repurchases. More broadly, the claim by Warren and others that capital allocated to share repurchase has been “misdirected” ignores one key fact.
Roe noted in his 2018 paper that much of the increased buyback activity has been funded by debt. That could be a risk, as he noted in an interview. In a recession, “Too much debt in too many companies’ capital structures is not going to be a good thing,” the professor argued. “We’ll have more bankruptcies than we deserve.”
That’s an individual company problem, however, not an economy-wide one. And the higher debt disproves the argument that companies are spending cash flow on buybacks instead of research and development and/or capital expenditures. R&D and capex spend remains intact. Rising repurchase activity simply reflects higher debt, and lower equity, in public company capital structures.
Again, that might create broader risk to markets and even the economy in a downturn. But that’s not the critique made against short-termism. The argument from Warren and her adherents is that buybacks are crowding out long-term spending. That’s simply not true. Instead, due to low interest rates, U.S. public corporations choose an “all of the above” approach: capex, R&D and buybacks.
Yes, Short-Term Thinking Exists
To be clear, short-termism does exist in some forms. Investors overreact to earnings. Companies manage those reports. Stocks become mispriced. Banks and their investors badly erred during the financial crisis.
And as the op-ed from Buffett and Dimon shows, corporate executives do believe that short-term pressures exist. Even Roe admitted in the interview that the aforementioned study of CFOs who focus on quarterly earnings was the “most convincing” data point in favor of the theory. “If CFOs are saying that they are focused on the short term, who are we to second-guess them?” he asked rhetorically.
But the professor also noted several qualifications to the results — including a low response rate — that suggested that CFO sensitivity to quarterly earnings may not be quite as high as the headline number suggests. And it’s worth noting that the study was published in 2005. If 80% of CFOs were materially impacting the long-term potential of their businesses fourteen years ago, surely the cumulative impact of those decisions would be appearent by now. Yet in either the broad economy or in the equity markets, there’s little, if any, evidence of damage at the moment.
Again, short-termism doesn’t focus on the fact that executives or investors can be impatient or short-sighted. That’s not up for debate: all humans are fallible.
Rather, it’s an argument that investor impatience is creating a significant, ongoing, negative impact on the broader economy and on corporate profits. But it’s an argument that looks exceedingly thin in the context of a stock market near all-time highs and corporate profits that continue to grow.
What This Means for Investors
To be clear, an argument against short-termism isn’t an argument that equity markets are intrinsically correct. They’re not. Bubbles still happen. Managers still make poor decisions. Investors may well focus too much on quarterly reports instead of long-term opportunities.
Disputing short-termism also doesn’t require that stocks are cheap. Investors may be properly focused on long-term cash flows, yet incorrect in valuing those cash flows. Many investors fear that the U.S. stock market, with the S&P 500 closing recently at another all-time high, is too expensive. Valuations in growth stocks are among the highest ever seen. Value investors long have complained that the likes of AMZN are ridiculously priced. Even the use of price-to-revenue, instead of profits, as a valuation metric suggests a market where, as some put it, “earnings don’t even matter.”
That may all be true. But were it to be true, the problem wouldn’t be short-termism. It can’t be.
A market in which investors are overvaluing distant cash flows from a SaaS growth story or an electric vehicle manufacturer by definition is not short-termist. In fact, it’s precisely the opposite.
As Roe put it in the interview, the valuations assigned to growth stocks, and the market’s largest names, contribute to the “general gut sense of why we should be suspicious that short-termism is a deep economic problem.” Short-termism in theory comes from investor demands. But valuations for a decade now have shown that investors demand long-term growth over near-term capital returns.
Why the Short-Termism Theory Stays Popular
If the evidence for short-termism is so thin, why does the theory remain so widely held? There’s one potential reason: it’s attractive to a number of constituencies.
Politicians can criticize corporations without criticizing rank-and-file employees. The idea that share buybacks are “taking” money from employees or the broader economy can be used to justify increased regulation.
Executives can deflect blame from their own decisions. If quarterly earnings guidance, as Dimon and Buffett argue, is the problem, then perhaps the earnings themselves aren’t. And if executives are just responding to investor demands, then short-sighted decisions aren’t the fault of management or the board. (Critics of short-termism never seem to make clear exactly why executives have to listen to investors.) Meanwhile, the notion of short-termism provides an excuse for executives to argue that they should ignore their own myopic shareholders. That in turn justifies consolidating their own power.
Investors can find comfort in the argument as well. A post-earnings plunge in a stock isn’t an errant investment decision. Instead, it’s the fault of a perennially short-sighted market.
And for all of the above, short-termism creates an attractive target. As Roe told me:
“There’s been a lot of unhappiness with Wall Street since the financial crisis, in particular … It’s easier to criticize [Wall Street] by saying, ‘they’re not real, long-term capitalists. They’re short-term traders that we really don’t have to protect.’ It becomes an easy way to criticize Wall Street — they’re not delivering the goods and they’re short-term.”
Indeed, as Roe writes at the conclusion of his paper, short-termism may well be a political reaction to upheaval in the broader economy. “Fear of short-termism is a tool to attack the shareholder-oriented, profits-based goals of the large corporation.” That in turn suggests that the accuracy of the short-termism theory itself is “politically and socially unimportant.”
A Solution to a Nonexistent Problem
Whatever the cause of short-termism’s longevity, the theory doesn’t appear to be going anywhere. And that could be a risk.
For one, investors who believe in the theory could make poor decisions in response. Short-termism dictates that stocks should rally significantly off near-term catalysts like dividend increases or share buybacks. That’s not always or even usually the case, however. A long-term focus (as the likes of Buffett and Dimon well should know) still seems to be the best way for investors to attack the market.
Second, regulatory changes in response to the perceived problem of short-termism could cause real and negative effects. Roe told me that “individual investors should be particularly wary” of a move to semi-annual reporting, as that would give an even larger informational edge to institutional investors.
More power for executives might decrease the relative importance of quarterly earnings reports. It could also lead to “empire-building.” Executives can grow their businesses, and their compensation, without doing so in a way that creates value.
Short-termism is a tempting theory. But the evidence increasingly suggests it isn’t real. And so, the danger of short-termism isn’t investors and executives destroying value. The danger lies in those parties believing it — and destroying value in trying to fix it.
As of this writing, Vince Martin has no positions in any securities mentioned.