Andrew Haldane and Richard Davies of the Bank of England have released a very useful new paper on short-termism in the investment arena. They contend that this problem real and getting worse. This may at first blush seem to be mere official confirmation of most people’s gut instinct. However, the authors take the critical step of developing some estimates of the severity of the phenomenon, since past efforts to do so are surprisingly scarce.
A short-term perspective is tantamount to applying an overly high discount rate to an investment project or similarly, requiring an excessively rapid payback. In corporate capital budgeting settings, the distortions are pronounced:
Most recently, in 2011 PriceWaterhouseCoopers conducted a survey of FTSE-100 and 250 executives, the majority of which chose a low return option sooner (£250,000 tomorrow) rather than a high return later (£450,000 in 3 years). This suggested annual discount rates of over 20%. Recently, Matthew Rose, CEO of Burlington Northern Santa Fe (America’s second biggest rail company), expressed frustration at the focus on quarterly earnings when locomotives lasted for 20 years and tracks for 30 to 40 years. Echoes, here, of “quarterly capitalism”.
This table illustrates in a more concrete fashion how investment myopia leads to projects with longer-term results being misrated:
Haldane and Davies argue the effect is significant:
First, there is statistically significant evidence of short-termism in the pricing of companies’ equities. This is true across all industrial sectors. Moreover, there is evidence of short-termism having increased over the recent past. Myopia is mounting.
Second, estimates of short-termism are economically as well as statistically significant.
Empirical evidence points to excess discounting of between 5% and 10% per year.
The result is that projects with long-term payback, beyond the 30 to 35 year timeframe, are treated as having no value. No wonder we don’t fund basic science, infrastructure, or climate change related projects.
The writers point out the first order bad effects: good projects don’t get funded, and those projects are often the ones with the highest potential for broad social impact (would we ever build the US highway system now?). But the knock-on effects are if anything more pernicious. The fact that most investors employ overly high discount rates produces is the same result you’d see with oligopoly pricing: overly high returns with restricted output. And this is consistent with the picture we see in most of the world. Perversely, the corporate sector has been a net saver for nearly a decade in the US, longer than that in some other economies. As we wrote with Rob Parenteau last year:
Over the past decade and a half, corporations have been saving more and investing less in their own businesses. A 2005 report from JPMorgan Research noted with concern that, since 2002, American corporations on average ran a net financial surplus of 1.7 percent of the gross domestic product — a drastic change from the previous 40 years, when they had maintained an average deficit of 1.2 percent of G.D.P. More recent studies have indicated that companies in Europe, Japan and China are also running unprecedented surpluses.
The irony is that China, with its command economy, is more willing to make long-term investments than capitalist economics which rely on the supposedly superior wisdom of having the capital markets play a dominant role in the pricing of risk funding. Now I’m of the school that China will likely have a bad stumble; there’s ample evidence that its unprecedented level of investment, which is fueled by lending, is scoring lower and lower returns. But the West’s short-sightedness increases the odds that this massive gamble might work out pretty well by moving into the type of projects that myopic capitalists are unwilling to take on.
Haldane and Davies prefer minor interventions to dirigisme:
Transparency: The lightest touch approach would be to require greater disclosures by financial and non-financial firms of their long-term intentions – for example, their
long-term performance, strategy and compensation practices. For financial firms, this might include metrics of portfolio churn. This could be accompanied by a programme of educating managers, investors and advisors of their fiduciary responsibilities.
Governance: A more intensive approach would involve acting directly on
shareholder incentives through their voting rights. For example, fiduciary duties could be expanded to recognise explicitly long-term objectives. More concretely, shareholder rights could be enhanced for long-term investors, perhaps with a duration-dependent sliding scale of voting rights.
Contract Design: There have been various attempts over the past few years to make compensation contracts more sensitive to long-term performance and risk. This includes employment contracts conditioned on long-term performance, or with deferral or clawback. Changes in the compensation instrument can also help – for example, remunerating in equity is better than in cash and remunerating in junior or convertible debt might be better than either.
Taxation/Subsidies: Authors have suggested a variety of ways in which government could penalise short-duration holdings of securities, or incentivise long duration holdings, using tax and / or subsidy measures. These measures differ in detail, but the underlying principle is to link them to the duration of an investor’s holdings or the length or nature of a company’s investment.
We have a peculiar desire in America to pretend that we have unfettered capitalism when, even before you consider the banking industry boondoggle, we have a remarkable amount of industrial policy by accident, via lots of special interest receiving subsidies and tax breaks. We’d do much better to try to put some of it on a more rational footing and implement broad-based programs of the sort Haldane and Davies suggest. But we may need to lose more ground to advanced economies before complacent CEOs and their various message validators are willing to consider more radical changes in how we do business.