In the 20th-century, companies were predominantly capital intensive and competed on cost efficiency. Those with the most efficient factories could manufacture goods more cheaply than their rivals, and became market leaders. The 21st-century company is different: competitive success depends increasingly on product quality and innovation. These, in turn, hinge on a company’s intangible assets, such as human capital and the capacity for research and development. Building such competencies requires significant and sustained investment.
However, unlike buying a factory, the fruits of intangible investment may take several years to appear. The immediate consequence of training workers or researching a new drug is lowered earnings. It follows that managers who are trying to maximize short-term earnings may be under-investing in their company’s future.
Vision for the future
This problem of “managerial myopia” is well known, but commentators have tended to propose piecemeal solutions focusing on one particular determinant when the problem is, in fact, holistic: it depends on how managers are paid, how shareholders evaluate companies and how regulators mandate corporate disclosure, among other factors. I’d like to tackle these three elements in turn.
Starting with compensation for chief executives, the typical debate is about the level of pay. Is it fair for CEOs to be paid 300 times as much as the average worker, or for their salaries to have risen sixfold since 1980? While the level of pay is politically charged, much more relevant for a company’s long-term health is the horizon of pay – whether it is vested in the short or long term. In their 2014 paper Equity Vesting and Managerial Myopia, Alex Edmans, Vivian W. Fang and Katharina A. Lewellen find that, in years when CEOs have significant equity vesting, they typically cut R&D, advertising and capital expenditure, and by doing so exactly meet or narrowly beat earnings targets.
In addition to avoiding good long-term actions, myopic CEOs may also undertake bad short-term actions, such as writing subprime loans to generate immediate income, then selling their shares before the loans become delinquent.
Caps on bonuses or the level of pay, or higher income taxes for the rich, are politically appealing. However, a much more effective way of preventing future crises may be for boards to increase the vesting period of stock and options, and to scrutinize investment decisions particularly carefully in times when managers have significant vesting equity.
Sell first, ask later
Turning to shareholder structure: basic finance theory teaches us that there are benefits to diversification. Indeed, in the United States, the “prudent man rule” requires institutional investors to choose their assets as a prudent man would. But diversification doesn’t just reduce risk, it also reduces the investor’s skin in the game. Since investors have such a small stake in each company, they have little incentive to monitor it. They will evaluate corporate performance using easily accessible measures, such as earnings, and not spend the time and effort necessary to analyse corporate culture or customer satisfaction. Thus, rather than figuring out whether low earnings may actually result from desirable long-term investment, “the market sells first and asks questions later”.
In his 1998 paper The Influence of Institutional Investors on Myopic R&D Investment Behavior, Brian Bushee finds that dispersed investors pressure managers to cut R&D to meet short-term earnings targets. Edmans, in contrast, argues that large shareholders who have incentives to do their own research and analyse a company’s intangible assets and growth prospects, rather than just focusing on short-term earnings, induce companies to invest for the long-term. Warren Buffett is a prime example. Instead of diversifying and spreading themselves too thinly, shareholders should hold meaningful stakes and be invested, both figuratively and literally, in a company’s long-term future.
Why honesty isn’t always the best policy
Finally, one response to the financial crisis and corporate scandals is to force companies to disclose more information. Doing so, the argument goes, will prevent them from carrying out destructive actions that are hidden from shareholders and regulators. Indeed, Sarbanes-Oxley, Regulation Fair Disclosure, and Dodd-Frank in the US have all increased disclosure requirements. However, regulation can only force disclosure of “hard” (i.e. tangible, verifiable) information, such as a company’s earnings. “Soft” (i.e. intangible, unverifiable) information, such as the level of a company’s employee engagement, cannot be credibly disclosed. In their 2015 paper, The Real Costs of Financial Efficiency When Some Information Is Soft, Edmans, Mirko Heinle and Chong Huang show that mandatory disclosure will induce companies to focus on hard information at the expense of soft, for example by cutting investment to boost earnings – just as publicizing pupils’ test results may encourage teachers to teach to the test.
Indeed, at the time of its IPO, Google announced that it would not provide earnings guidance because such disclosure would induce short-termism. The founders’ letter stated: “We believe that artificially creating short-term target numbers serves our shareholders poorly.” Porsche was expelled from the German M-DAX stock market index in August 2001, after refusing to comply with its requirement for quarterly reporting, claiming that such disclosures would lead to myopia. Taylor Begley, in the 2014 paper The Real Costs of Corporate Credit Ratings, shows that companies cut R&D to meet financial thresholds set by credit ratings agencies, and that this lowers the number and quality of future patents.
I am not arguing that short-term bonuses, shareholder diversification or increased disclosure requirements are never appropriate. As with most practices, all of these have both costs and benefits. Instead, I hope to highlight important costs that should be considered by policy-makers and practitioners – costs that are particularly relevant to the long-term future of the 21st-century company.
Image: People are reflected on a graph showing the U.S. dollar and Japanese yen rate in Tokyo July 3, 2013. REUTERS/Issei Kato