Long-termism pays
Some time ago, I wrote about the strong positive reactions stock markets exhibit these days to actions that advance short-term goals at the expense of long-term value. There is, of course, nothing new under the sun, but it is fascinating to collect the evidence on a broader scale to get a feeling as to how much short-termism influences the decisions of corporate leaders.
Take for instance a study done by John Graham, Campbell Harvey and Shiva Rajgopal published in 2005. Amongst academics, the study is quite well-known, but not so much in investment and banking circles, for reasons that become obvious when you read the following excerpt from the abstract of their paper:
“We survey and interview more than 400 executives to determine the factors that drive reported earnings and disclosure decisions…A surprising 78% of our sample admits to sacrificing long-term value to smooth earnings.”
Additional surveys by FCLT Global show that 61% of executives say they would cut discretionary spending in order to avoid earnings misses and 47% would delay new projects in order to avoid missing earnings estimates.
In 2017, a joint study by the McKinsey Global Institute and FCLT Global found that companies operating with a long-term mindset outperform their peers. Between 2001 and 2017, company revenues of long-term oriented companies outpaced their peers by 47% and corporate earnings outpaced peer earnings by 36%. Long-term corporate behaviour in this study was measured by focusing on companies with high and consistent investment rates, relying less on earnings accruals and earnings reflecting more closely actual cash flows and a bigger focus on fundamental value creation, such as revenue growth, rather than typical analyst measures, such as earnings per share.
But all these studies could do in the past was establish correlation, not causation. It is unclear whether companies do better because management has a long-term orientation or if this is just coincidence. In comes Alex Edmans from London Business School and his colleagues Vivian Fang and Katharina Lewellen. They studied how many shares owned by the CEOs of companies were about to vest in the coming quarter. The trick of this study is to recognise that company CEOs and other insiders tend to sell their company shares as soon as the lock-up period is over simply because they tend to have a large concentrated position within their portfolios in those stocks. The desire to diversify their personal wealth makes them sell their company stocks as soon as they can, independent of the performance of the stock. But, of course, the bigger the package of shares that will become vested, the bigger the incentive of CEOs to “tweak” earnings in order to create a short-term boost to the share price.
And this is what the researchers found. The more shares or stock options CEOs have vesting in a given quarter, the more they cut investments before the vesting period. Also, the more shares or options they have vesting, the more likely it is that the company will manage to barely meet analyst earnings, indicating that earnings are indeed massaged more if the CEO faces a big pay-out in the next three months.
Furthermore, the more stocks and options the CEOs have vesting in the next quarter, the more aggressively the company will buy back shares and engage in more and bigger M&A activities. And while cutting costs and buying back shares can be both beneficial and detrimental in the long run, the research shows that the share buybacks and M&A activities engaged in these circumstances lead to lower long-term value and are detrimental to the company’s long-term prospects. Something to keep in mind when you celebrate the rally in shares right after a surprise earnings announcement together with a massive share buyback program.
Firms focused on the long-term exhibit better performance
Source: McKinsey Global Institute, Fidante Capital.