Note: Companies vs investors, is it possible to reconcile short and long terms?
Balancing short and long term for investors and companies
As Georges Bernanos said: “We do not submit to the future, we make it.” 1 Short-term time horizons have always existed for both companies and investors; maximising short-term profit requirements, almost constant company finance benchmarking, calculations of the variable amount of compensation depending (generally) on stock market criteria, and high-frequency trading – all this to say: the financialisation of the economy – have emboldened a “short-termist” dictatorship. What is more, radical changes in the availability of information and the instant ability to share it worldwide, have largely increased the negative perception of “the short-term”, which has come to be considered as harmful for the economy in its omnipresence.
According to Milton Friedman’s doctrine from the 1970s, the manager of a company has “one and only one social responsibility towards its shareholders: to use its resources and engage in activities designed to increase its profits”2. This doctrine, which focuses on maximising profits for shareholders, seems to be questioned today. The growing expectations of civil society, in particular, are shaping the “new” role of companies: positively contributing to their ecosystem, being aware of the impacts of their activity on stakeholders (including employees, suppliers, customers, investors, subcontractors, NGOs, academics, etc.), being sincere in all of their actions and written materials, as well as including environmental, social, and societal issues in their strategies.
We can define short-termism as a situation in which certain company stakeholders – primarily investors, managers, and members of the Board of Directors – display a systematic, but sometimes contrived, preference for strategies providing quicker gains at the expense of long-term value creation. Short-termism as a whole must be viewed as a social process, in which a given behaviour is emboldened by the reaction of others3.
Despite the overwhelming consensus on the definition of short-termism, researchers are not able to agree on how to empirically illustrate the substandard nature of these decisions. The big question remains the same: how do we demonstrate whether short-term decisions are detrimental to long-term value creation? As, once a short-term decision is made, it is impossible by definition to ascertain what the effects of a different, long-term decision could have been.
In order to understand the situation, we asked ourselves the following question: if the “long-term” represents a performance factor, then why do some company stakeholders favour short-termism?
Is the long term a performance factor ?
According to several recent studies, the long-term represents a performance factor for companies. A McKinsey study 4 was carried out in 2017 on this subject: using a data set from over 600 companies in the United States over the 2001-2015 period, researchers created a Corporate Horizon Index based on 5 key factors: investment models, growth, quarterly management, quality, and profit management. This index made it possible to isolate companies qualified as “long-term” in order to gauge their performance : they exceeded that of “short-term” companies on both economic and financial indicators.
First of all, the study notes that the revenue of “long-term” companies increased cumulatively by on average 47%, with less volatility. Profits also increased by 36% on average, and economic profit by 81%. “Long-term” focused companies invested more than others: they spent almost 50% more than others on R&D over the 2001-2014 period and did not cut this budget during the financial crisis. Their spending in this area increased annually by 8.5% on average, compared to 3.7% for other companies. These “long-term” companies also demonstrated improved financial performance over time: on average, their market capitalisation increased by $7 billion, and the total return for their shareholders was 50% higher. They also created 12,000 additional jobs on average.
So, what key factors make these companies different? Numerous studies have confirmed that taking into account gender balance 5, diversity 6, and moreover environmental, social and corporate governance (ESG) criterions 7 directly correlated to stock market performance and above-average results. It is thus essential to include extra-financial criteria both in corporate strategies and in investors’ investment decisions.
It should be noted that three-quarters 8 of the managers of European companies believe that overlooking sustainable development in their strategy will negatively affect their company’s ability to create value in the long term. While at the same time, more than three-quarters9 of investors say that ESG criteria are or are becoming increasingly important in their activities — almost two-thirds of investors claim their investment framework is in line with the Sustainable Development Goals (SDGs).
Why do some company stakeholders favour short-termism?
Several stakeholder categories can be identified within companies: employees, executive managers, managers or top executives, and the Board of Directors. By setting aside employees – who have an obvious interest in their company’s sustainability – several reasons resulting in a short-termist attitude within these categories of stakeholders can be identified.
First and foremost, it is surprising to note that according to a joint study by Focusing Capital on the Long Term Global and McKinsey, 40% of managers (Boards of Directors and Management Teams) label themselves as being among the main sources of short-term pressure. 87% of respondents stated feeling major pressure to demonstrate substantial financial performance within two years 10.
Secondly, short-termism can result from the use of biased evaluation methods for investment projects – methods based solely on financial data – which then lead to an underestimation of extra-financial benefits (e.g. training, reputation, etc.) 11. The potentially erroneous understanding of extra-financial benefits and risks can also influence this type of decision. The predominantly financial view of companies and shareholder returns has participated to the rise and spread of MBA training. Indeed, the heightened expansion of the concept of “shareholder capitalism” since the 1980s has intensified investors’ focus on quarterly performance and on the maximisation of short-term shareholder returns through dividends and buyouts.
It is also necessary to take into account the objectives and ambitions that are specific these categories of stakeholders, including financial incentives and time horizons in particular. Opportunists have been able to reject long-term investment projects in order to fixate on more profitable short-term alternatives, thus allowing them to maximise their objectives. Executive compensation policies have too frequently favoured short-term financial returns, which also matched the personal interests of managers with high turnover rates. These financial incentives blend with an assortment of psychological pressures that encourage managers to favour the short-term, such as a need to quickly prove themselves in order to establish or maintain their reputation, or even a natural preference for investments with immediate returns rather than risky projects with distant profits.
Investors are the second category of stakeholders that, according to numerous studies, are responsible for short-termism. They make up a varied and disparate population, including institutional investors, asset managers, asset owners, hedge funds, private equity, activist shareholder, traders, individual shareholders, and employee shareholders, that interacts both with itself and other financial stakeholders in the market, such as financial and extra-financial rating agencies, merchant banks, financial analysts, etc. Some investors are able to encourage managers to artificially inflate performance indicators or modify the company’s strategy with a view to encouraging short-termism; others, however, promote investments in future growth mechanisms and support the market value of companies with modest immediate profitability but major potential.
All of these stakeholders pursue investment strategies with wildly different objectives. These multifaceted expectations hike the pressure on the company. One can generally observe several common factors: a greater or lesser aversion to risk; a preference for short-term due to pressure on management companies from certain asset owners to steadily outperform the market; a (still limited) inclusion of extra-financial factors that create value in the long term; earnings indexed according to short-term financial targets; the dilution of responsibility in investment decisions due to an excess of intermediary influencers.
However, an array of other factors that explain current managers’ inclination to favouring the short-term should not be overlooked. We must note the major pressure of a highly competitive and increasingly unpredictable market. Competition is therefore cited by 51% of managers 10 as a determining factor in the need to demonstrate short-term financial performance. The digital revolution, the energy transition, the risk of uberisation, and geopolitical risks, to name but a few, are all reasons that compel managers to constantly reassess their strategy. Their responsiveness is crucial to their survival in a world that has become increasingly uncertain.
Short termism – as discussed in this document – is not an isolated phenomenon that only investors or companies can be held responsible for. It reflects more generally the complex and interdependent interactions of numerous stakeholders with varied interests and means of action. They prop each other up and self-fuel a negative momentum: competitive environments, short-term reporting, and a continuous flow of information all incite companies to establish short-term objectives and indicators, and to reward short-term decisions, abandoning long-term opportunities. In response, investors and the market also react within a short-term time horizon, and vice versa.
However, it must be noted that the short-term cannot be neglected, as it is necessary in order to adapt to a world being run in so-called VUCA mode: Volatility, Uncertainty, Complexity, Ambiguity But its dominance is not compatible with the sustainability requirements of today’s companies. It must therefore be returned to its rightful place: that of a management indicator, an adaptability and agility variable for the company with regard to future challenges.
The short-term does not obstruct the long-term, but is a necessary condition for constant progress. Being able to anticipate a company’s future challenges –demographic and social changes, environmental challenges, major technological developments, artificial intelligence, and economic developments – means harnessing all of the company’s potential, in particular through the use of intangible assets.
The systemic nature of short termism calls for a holistic approach, with new processes to steer principal stakeholders towards more long-term objectives. Management represents a powerful lever for change within companies, with its role being to anticipate and thus enable short-term management with a consistent long-term time horizon.
Combining overall performance and positive externalities requires a stable reconciliation of individual and collective interests, company and society, short and long-term time horizons, while also bolstering collective responsibility throughout the investment chain.
by the Board Experts members