The Risks and Rewards of Short-Termism

By EILENE ZIMMERMAN    NOV. 4, 2015

The debate has been raging in various forms for the last 30 years — whether corporate short-termism is a problem and, if it is, is it hurting American businesses and the economy? Short-termism is exactly what it sounds like: companies managed for the short term, with decisions driven by the need to meet shareholder expectations about quarterly earnings and stock prices.

This year it has spilled into the presidential campaign, with Hillary Rodham Clinton recently decrying “quarterly capitalism” and proposing some changes in the tax code to encourage more long-term investments by companies and individuals. She and others have criticized practices that put a priority on share buybacks and dividend payments over sources of long-term growth like wage increases, investment in research and employee development.

Yet activist investors like Nelson Peltz of Trian Partners, Daniel S. Loeb of Third Point and William A. Ackman of Pershing Square have become a force to reckon with, buying large stakes in public companies in an effort to gain seats on their boards and push for changes like buybacks and corporate breakups.

Proxy fights for board seats rose to 94 in 2015, from 82 in 2014, according to the market data firm FactSet. All but three this year involved activist investors. And a 2013 survey of C-level executives by the consulting firm McKinsey & Company found that more than 60 percent felt that pressure to deliver short-term financial performance had increased over the last five years.

The resignation in October of DuPont’s chief executive, Ellen J. Kullman, is the latest example of shareholder activism at work. Ms. Kullman fended off a board challenge by Mr. Peltz’s Trian Fund Management, which wanted four seats on DuPont’s board because the chemical company had repeatedly missed financial targets. The public battle, however, took a toll and Ms. Kullman stepped down less than two weeks later, even though she had successfully led DuPont through the global recession.

Mr. Peltz’s plan for DuPont involved shutdowns at its central research labs and splitting up the company. “Fully a third of their products now are recent results of this incredibly productive and legendary R&D operation that produced Kevlar and nylon,” said Jeffrey A. Sonnenfeld, senior associate dean for leadership programs at Yale School of Management. “But you can get a short-term pop from breaking up assets that have long-term value. If large enterprises operate with a short-term trader’s mentality, then we won’t have any healthy organizations.”

This strategy, Mr. Sonnenfeld added, destroys brand value and causes companies to sell valuable assets “at fire sale prices during cyclical economic downturns.”

Mr. Sonnenfeld and other academics, as well as legal and financial experts, have repeatedly warned of the perils of short-term management. So why does it persist?

One clue may be a survey of more than 400 financial executives conducted a decade ago. The majority of managers said they would avoid starting long-term projects if it meant falling short of the current quarter’s earnings. And more than 75 percent of executives acknowledged that for a short-term lift in share price they would sacrifice long-term economic value.

Kevin Laverty, a retired associate professor of business strategy at University of Washington in Bothell, wrote one of the first academic research papers to use the phrase “short-termism” and examine the phenomenon. The paper was published in 1996, but Mr. Laverty began researching it in 1991. “Wall Street was asking the same questions back then,” he said.

In the 1980s, many companies expressed concern that stock market pressure for short-term profits and the threat of hostile takeovers were forcing them to abandon long-term projects. Many observers at the time blamed what they called management “myopia”— decisions that enable companies to pursue short‐term gains at the expense of long-term strategies — for managerial incentives based on quarterly profits and stock prices. Mr. Laverty said the debate continued because there had not been any agreement on whether short-termism was a problem. “I think it goes back to human nature,” he said. “Why do people seek immediate gratification rather than looking to the long term?”

Robert C. Pozen, a senior lecturer at M.I.T. Sloan School of Management and a nonresident senior fellow at the Brookings Institution, said: “Many investors put money into Google, Amgen, Amazon, so clearly these investors aren’t afraid of making long-term investments. On the other hand, there are companies that make money and squander it making long-term investments, like Hewlett-Packard under Carly Fiorina. But if this is a problem, then what do we do about it? There’s a lot of cluttered and clouded thinking about it.”

Another scholar of short-termism, Judith F. Samuelson of the Aspen Institute, said the fundamental question in all this was “are corporations bound to serve any shareholders that own your stock today, as much as their long-term investors?” Ms. Samuelson, who is executive director of the Business and Society Program at the institute, says that for a long time now corporations have operated as if the shareholder is king. That, she said, is “a wealth-destroying idea and one that is not embedded in the practices of the best run companies.”

Not everyone is convinced. Mark J. Roe, a professor at Harvard Law School, is not ready to demonize short-termism and activist investors. He said some of the consequences of activist investor efforts have been good for companies. “On average I think activist investors are probably a good thing, with some problems,” Mr. Roe said. “The good thing is that managers and boards can get complacent and rest on their laurels. Activist investors can give them a kick when they aren’t moving fast enough.” However Mr. Roe is not a fan of those investors pushing companies to borrow more so they can deduct more interest from their tax bill. “I don’t think we should be producing wealth by creating more leverage and a bigger tax deduction,” he said. The way to fix the problem is not to stop activists, he added, but to change the tax code so that debt and equity are taxed equally.

Jeremy C. Stein, a professor of economics at Harvard, wrote a paper in 1989 on short-termism, which he called “myopic corporate behavior” at the time. He said there was plenty of evidence that short-termism existed but the magnitude of its effect was unclear. “I would not be comfortable saying we should really discourage people from maximizing the stock price or discourage activist investors,” Professor Stein said. “It may be that activist investors get people more focused on the short run. It may get companies underinvesting in certain things, but the general pressure could also make them more efficient.”

What do we do about short-termism then, if it is a problem?

Mr. Pozen of M.I.T. said the corporate world needs to rethink how it compensates executives, specifically the period of time against which performance bonuses are given. “If you look at most companies, it’s one year,” he said. “If you pay people based on one year’s compensation, they will manage for a one-year horizon.”

Martin Lipton, a partner in the law firm Wachtell, Lipton, Rosen & Katz, recently called on the Securities and Exchange Commission to eliminate quarterly reporting requirements for American companies. But Mr. Pozen said it’s not the reports, but the guidance that companies release along with reports that is problematic. “The guidance predicts what is going to happen the next quarter, and that focuses everyone on the next quarter.” In a speech she gave in July, Mrs. Clinton outlined ways she would combat short-termism, including taxing capital gains on a sliding scale and requiring gains from the sale of stock to be taxed like ordinary income for two years (but only for those in the top tax bracket).

Mr. Sonnenfeld of Yale said what was needed were “boards with stronger backbones” against activist hedge funds. He again pointed to DuPont. “Even though they had just won a proxy battle the board panicked, all because of a highly vocal activist investor,” he said.

Mr. Pozen recalled many institutional investors complaining at an investment conference in March about being long-term investors in a world of short-term returns. “These people own 60 to 70 percent of the stock in most public companies. They ought to be able to get those companies to be long-term oriented,” he said. Activist investors, Mr. Pozen pointed out, cannot win proxy fights without the support of institutional investors. Institutional investors talk the talk, he said, “but they need to walk the walk.”