Companies that manage for short-term gain rather than long-term growth have been blamed for everything from popularizing celebrity CEOs to causing a significant chunk of the current financial crisis. Now new research findings suggest that short-termism might have negative effects on these companies themselves and their investors.
There's another surprise in the research: short-termism might not be as widespread as we think, and a substantial number of corporations are rising to the challenge. "One important takeaway is that firms with long-term horizons exist," says Harvard Business School Assistant Professor George Serafeim, coauthor of the working paper Short-termism, Investor Clientele, and Firm Risk, with HBS doctoral candidate Maria Loumioti and Assistant Professor Francois Brochet. "We tend to make sweeping statements and overgeneralize," Serafeim says. "Many companies are being managed for the long term."
The research team was interested in several issues: Do short-term companies attract a particular kind of investor? Is investing in these firms riskier than investing in companies with longer-term time horizons?
“We tend to make sweeping statements and overgeneralize. Many companies are being managed for the long term."
Their first order of business was to determine a method for categorizing companies on the short-term/long-term continuum. The answer came in the very words used by executives to discuss their own companies. Brochet, Serafeim, and Loumioti studied transcripts of 70,042 earnings calls—conference calls where executives discuss quarterly results with investors, analysts, and the media—that were held by 3,613 firms during 2002-2008. This involved searching for 14 terms used by management such as "latter half" and "weeks" that would tip off a short-term view, versus 15 words or phrases such as "long term" and "years" that would suggest a longer time horizon approach.
The researchers then compared their list of companies on both ends of the spectrum with the companies' actual financial and stock performance, studying indicators such as return volatility, the length of time investors held a firm's stock, and the cost of capital.
The results showed that short-term companies attracted short-term investors (bringing with them a whole new set of performance pressures on executives) and that the financial and strategic performance of these companies was more volatile—and riskier—than that of the long-termers.
The team also identified industries that appear to be short-term-oriented (banking, electronic equipment, business services, and wholesale) and long-term-focused (beverages, retail, pharma, and medical goods). Companies, too, were categorized by outlook. Short-termers included Cisco, Goldman Sachs, and Chevron, while the longer horizon outfits included Coca-Cola, Ford, and Nordstrom.
The results have implications both for investors and for company executives. We asked Brochet and Serafeim to discuss their findings in this interview, conducted via e-mail.
Q: In general, what relationship did you find between companies you identified as short-term-oriented, their investors, and the behavior of their stocks?
Francois Brochet: Overall, we found a positive association between the horizon over which firms communicate and the investment horizon of their shareholders. In addition, short-term-oriented firms appear to have more volatile stock returns and higher estimated cost of equity capital—that is, greater risk. While the presence of long-term-oriented investors appears to mitigate the positive association between firms' short horizon and the volatility of their stock, this does not apply to the association between short-termism and cost of capital. We interpret this as evidence that our short-termism measure captures a dimension of non-diversifiable risk in the economy.
Q: What is the big takeaway here for investors, especially those seeking to invest in companies with longer-term perspectives?
George Serafeim: One important takeaway is that firms with long-term horizons exist! We tend to make sweeping statements and overgeneralize. While significant short-termism exists, there are organizations that have developed a long-term-oriented approach through formal (e.g., incentive systems) or informal institutions (e.g., building the corporate culture over time and employee selection).
The finding that more long-term-oriented firms have lower volatility and cost of capital has implications for capital allocation. Investors who care about the volatility of their portfolio should factor in their decisions the time horizon of the corporation. That generates a need for more data that help investors separate companies that are short-term-oriented versus long-term-oriented. Developing a robust data infrastructure that separates companies could have profound implications and incentivize companies to become more long-term-oriented.
Q: What is the lesson for corporate leaders as they seek to balance the need for long-term strategy with short-term results demanded by the market? Should they be concerned that short-termism appears to increase investor risk?
Serafeim: Many times corporate leaders complain that the market is short-term-oriented. Again, this is a general statement that fails to recognize that investors differ in their time horizons as well. Business leaders should be aware that focusing on the short term will attract short-term investors, further reinforcing a short-term managerial attitude.
Communicating a long-term vision for the business and providing both narrative and quantitative information is an integral part of building a sustainable organization that has a long-term-oriented investor base. For example, adoption of integrated reporting could be a step in this direction. Integrated reporting provides a holistic picture of the business describing the economic, environmental, and social performance of the corporation as well as the governance structure that leads the organization. By embedding environmental, social, and governance (ESG) data into financial reports, a company achieves an effective communication of its overall long-term performance.
Q: Many blame short-termism for the resource misallocation that played a significant role in the financial crisis. Can you explain this reasoning, and what your research might hold for policymakers or others who want to guard against this from happening again?
Brochet: Short-termism arises because of market participants' preference for investment decisions that yield short-term profits but not necessarily long-term profits (or worse, the short-term benefits come at the expense of long-term value creation). This phenomenon does not come out of the blue, but is attributable to fundamental frictions in capital markets related to the uncertainty of future outcomes. The longer the horizon over which a project is supposed to pay off, the greater the uncertainty. Hence, investment decisions and compensation contracts tend to converge toward more short-term, observable metrics that encourage corporate managers and professional money managers to maximize short-term performance.
For example, in the years leading up the financial crisis, companies like New Century Financial or Countrywide Financial built their success by incentivizing their employees on volume--to sell as many mortgages as possible with little regard for quality—and the stock market rewarded them handsomely for their spectacular growth. In that case, short-termism manifested itself through the myopic underweighting of the long-term adverse consequences associated with the high credit risk of many mortgage holders and the possibility of a halt to rising home prices.
As our research suggests, short-termism is pervasive enough to be associated with non-diversifiable risk, so we believe that any effort to mitigate its effect on resource allocation would have to come from a joint effort on behalf of a variety of capital market agents: corporate leaders, investors, and policymakers. Although this is pure conjecture, we believe that any worthy regulatory effort should focus on facilitating firms' focus on the long term rather than reprimanding short-term orientation per se.
Q: You identified industries and companies that lie on either side of the short-termism spectrum. What do you make of your results?
Serafeim: Overall, we found that larger firms, growth firms, and more profitable firms tend to be more long-term-oriented. In contrast, firms with a more volatile business model and cash flow profile tend to be more short-term-oriented. However, even after trying to explain the variation in short-termism across companies, we can explain with observable factors about 30 percent of the variation. The rest of the variation can be attributed either to "noise" in our measurement of the dependent variable or to idiosyncratic factors that contribute to the time horizon adopted by an organization.
Business leaders need to understand these firm-specific characteristics that allow or detract from the creation of a long-term management perspective.
Q: How does your research add to the literature?
Brochet: We add to the literature in several ways. First, as a practical matter, we have come up with what we believe is a direct measure of short-termism. Second, we have found that our short-termism proxy captures a risk factor that has real implications for the economy, based on its association with companies' stock prices. And third, we build on a recent strand of literature that explores the information content of conference calls, an important venue for publicly listed companies to communicate with investors. Prior research has largely focused on quantitative disclosures within conference calls (namely, earnings guidance), while other papers have analyzed properties of management's communication such as tone (i.e., relative optimism) through textual and vocal analysis.
Q: What are you working on now?
Brochet: One of the themes underlying my research is the effect of individuals on the corporate information environment. Following up on our project, I am investigating the extent to which individual executives, mainly CEOs and CFOs, affect their company's short-termism and other properties of their communication, such as reliance on quantitative versus qualitative data. Additionally, I am examining the behavior of other conference call participants, such as sell-side analysts. The overarching goal of this line of inquiry is to gain an understanding of what the root causes of short-termism are. My hypothesis is that short-termism can be traced to some extent to individual traits of capital market agents. Identifying those traits can help business educators and recruiters in preparing corporate leaders to set a "tone at the top" that promotes long-term value creation.
Serafeim: I am working on a big research project under the banner "Innovating for Sustainability." Professor Bob Eccles and I have created an MBA elective course, an Executive Education program, and a doctoral seminar on this topic. We define sustainability as "a corporate strategy, operations, and governance structure and process that create consistent and long-term economic, environmental, and social value."
Every major company is grappling with the meaning and application of sustainability in relation to its industry and business model. Similarly, more and more institutional investors are incorporating sustainability into their resource allocation decision-making process. As a result we are seeing the emergence of a new view of the role of the corporation in society, one that simultaneously meets shareholders' and other stakeholders' objectives. This new model is only beginning to emerge, but some of its outlines are already clear such as a longer-term time horizon, more holistic performance measurement and reporting, more active corporate governance, and greater engagement with shareholders and other stakeholders.
Achieving sustainability—for corporations, investors, analysts, information intermediaries, and other forms of organizations—often requires innovations, both major and minor, in processes, products, and business models in order to optimize both financial and nonfinancial (e.g, ESG) outcomes.
My research seeks to understand how these processes, products, and business models need to change at both the organization and the market level in order to drive long-term performance and create a sustainable society.