Curbing Short-Termism in Corporate America

In a related paper, Robert Pozen, nonresident fellow with the Brookings Institution, lecturer at Harvard Business School, and former vice chairman of Fidelity Investments, evaluates numerous policy approaches to reduce short-termism. 

The protest against short termism in corporate America is rising. Business and political leaders are decrying the emphasis on quarterly results—which they claim is preventing corporations from making long-term investments needed for sustainable growth.

However, these critics of short termism have a skewed view of the facts and there are logical flaws in their arguments. Moreover, their proposals would dramatically cut back on shareholder rights to hold companies accountable.

The critics of short termism stress how much the average daily share volume has increased over the last few decades. Although this is factually correct, this sharp average increase is caused primarily by a tremendous rise in intraday trading.

Intraday traders should not significantly influence the decisions of corporate executives about their business plans or allocation of expenditures. These traders are not interested in corporate fundamentals; they are trying to exploit fleeting price differences among related securities markets.

The critics of short termism also are alarmed by the expanded role played by activist hedge funds, which press for changes in corporate policies or leadership. The critics allege that activist hedge funds want quick changes so they call sell out for quick profits.

However, the data do not support this homogeneous view of activist hedge funds. These funds deploy a wide diversity of strategies. On average, they hold their big positions for 1-2 years. On average, the corporate changes they get adopted have positive effects for 2-5 years.

To be successful, activist hedge funds must persuade other investors to support their programs for corporate change. Activist hedge funds hold a small percentage of a company’s shares; most are owned by institutional investors like mutual funds and retirement plans.

Looking carefully at the business plans and financial reports, these institutions have different views about long-term strategies depending on the circumstances. For example, institutional investors support long-term research programs of biotech firms that have shown they can deliver. But institutional investors do not support long-term plans for expansion or acquisitions that they believe are unlikely to succeed.

To combat the perceived threat from day traders and hedge fund activists, critics of short termism have proposed substantial reductions in the rights of shareholders to have a voice in fundamental corporate issues. Some critics of short termism have even suggested terms of 3 or 5 years for corporate directors. Such long terms, combined with ability to issue poison pills, would immunize poorly performing companies from takeovers.

Other proposals are more narrowly designed to address the adverse dynamics of short term trading. For example, the paper supports limits on “empty voting”—whereby an investor temporarily buys a lot of votes just before a shareholder meeting without actually owning a lot of shares.

Most importantly, the paper stresses the need to lengthen the time horizon for awarding executive compensation. The measurement period for cash bonuses and stock grants is usually the prior one year, yet a one-year measurement period encourages corporate executives and investment managers to take a short-term approach. If we want these executives and managers to have a longer perspective, we should base their cash bonuses and stock grants on their performance over the prior three years, not one year.

Similarly, executives and managers are generally allowed to exercise stock options and immediately sell the shares obtained. They can also sell all of their restricted shares as soon as they vest. These practices can lead to efforts to push up the stock price for a few days in order to realize short-term profits. To promote a long-term perspective, holders of stock options and restricted shares should be required to hold for a period of 3 to 5 years the shares they obtain through executive compensation programs.

Finally, the paper recommends that all public companies stop the issuance of earnings estimates for the next quarter—for instance, a company might say “we estimate the company will earn $1.23 per share next quarter.” Such projections of quarterly earnings just aggravate the tendency of many Wall Street analysts to focus on short term results. If corporate executives feel they have to provide earnings guidance, they should offer a broad range of earnings estimates for the next year instead of a specific EPS number for the next quarter.