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Op-Ed

The Misdirected War on Corporate Short-Termism

Robert C. Pozen

A clamor is rising against “short termism”—judging a company by its performance over the past quarter, rather than the past few years. BlackRock CEO Laurence Fink and Delaware Supreme Court Chief Justice Leo Strine, for example, recently joined the Business Roundtable and others in decrying the strong pressures for short-term results exerted by daily stock traders and activist hedge funds. Critics claim that these pressures prevent executives from making long-term investments needed for sustainable corporate growth.

There are pressures on and incentives for corporate leaders to put the short term ahead of the long term, but not necessarily from activist hedge funds or stock trading. And some proposed remedies for short-termism would undermine the economic interests of shareholders.

The current attack on short termism is premised on the sharp increase in the average daily trading volume of stocks over the past few decades. The primary cause has been a relatively small group of day traders, including the notorious high-frequency traders who buy millions of shares and sell them a millisecond later. These traders care not a whit about corporate fundamentals or business plans; they are trying to exploit slight pricing anomalies that arise because of technical differences in securities markets. Thus corporate executives should not be pressured by higher daily trading volumes to avoid good long-term investment spending.

Critics of short-termism are even more alarmed about activist hedge funds that may lobby corporations to pay higher dividends, for example, or sell unprofitable divisions. They claim these funds push for a quick boost in corporate earnings in order to sell their shares for a quick profit.

The data do not support this uniformly negative view. Activist hedge funds display a broad array of strategies and time horizons. On average, they hold a company’s stock for one or two years, according to various empirical studies. Yet according to a recent McKinsey study of 400 activist campaigns over the past decade, the median campaign was launched when the company was on the decline and led to higher shareholder returns relative to peers for at least three years.

To win proxy contests, activist hedge funds must persuade other shareholders to support the changes they advocate. The funds usually hold a relatively small percentage of a company’s shares; the overwhelming majority are owned by institutional investors such as mutual funds and pension plans.

Activist hedge funds have won roughly half of the proxy contests they’ve entered, as institutional investors have carefully distinguished among long-term plans depending on a company’s specific circumstances. These institutions backed activist campaigns to increase dividends at companies like Apple with huge hoards of cash. But they’ve also supported multi-year research programs of biotech firms like Amgen that have shown they can deliver.

To thwart the perceived threats of short-termism, critics have proposed measures that would reduce the legal rights and economic interests of all shareholders. Martin Lipton, a prominent opponent of activist hedge funds, has recommended that U.S. corporate law adopt a new norm—that corporate directors be elected to five-year terms, rather than the usual one-year term. Such long tenure, combined with existing anti-takeover defenses, would effectively insulate the leadership of chronically under-performing companies.

There is a better approach: Boards should measure and reward the efforts of corporate executives and portfolio managers by looking at the organization’s performance over the past three years. At present, most firms distribute cash bonuses and stock grants on the basis of the prior year’s results. This approach does encourage top executives to favor short-term results over long-term growth.

At the same time, the top executives at both public companies and asset managers should be required to retain for three to five years half of the shares they receive through stock grants and options. At present, these people can usually sell all their shares as soon as they vest or the options are exercised. This is an inducement for top executives and managers to push up the company’s stock price for a few months so they can sell at a temporary high.

While there are reasonable concerns about corporate short-termism, their remedies should be narrowly tailored. Most of these concerns can be addressed by adopting longer periods for executive compensation. But we should not overreact to day traders or hedge funds by dramatically reducing the legitimate rights and financial interests of all shareholders.

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