All of the main UK political parties are agreed—short-termism is a bad thing. Ed Miliband has spoken of the “short-termism that blights British enterprise.” The coalition government set up a review team, headed by John Kay, the economist, which recently proposed some solutions to the problem. Everyone, it seems, is out to “Get Shorty.” But what exactly is short-termism? How big of a problem is it? And what could be done to lean against it?
Short-termism is far from being a new phenomenon. The earliest economists saw it as an intrinsic component of human nature. We are apt to act like “children who pick the plums out of their pudding to eat them at once,” wrote Alfred Marshall, the father of classical economics, in 1890. Or as AC Pigou, another prominent economist, noted in 1920: “Our telescopic faculty is defective.”
A century on, recent scientific evidence has suggested that the classical economists had it about right. Neuroscientists, studying and imaging the highways and byways of the brain, have discovered that patient behaviour is associated with one region of the brain (the pre-frontal cortex), impatient behaviour with another (the even less intuitive, mid-brain dopamine region). Humans are, quite literally, in two minds.
Over the past half century, a wealth of financial information has become available: from annual to near real-time reporting; from year-long to micro-second investing. Like Martini-drinkers of the 1970s, that has enabled trading “anytime, any place, anywhere,” typically at a diminishingly low cost. This technological shift, like the web, may have shortened our attention spans, retuning our minds to a shorter wavelength. It has encouraged impatience.
Certainly, investors appear to have become considerably more impatient over recent years. Fifty years ago, the average length of time a share was held by a UK or US investor was around seven years—today, it is less than seven months. Surveys of those making investment decisions tell a similar tale. Most investment managers seem to believe their mandates encourage short-termism, with almost three-quarters of them rebalancing their portfolios at least once per quarter. Dominic Barton at McKinsey has called this “quarterly capitalism.”
If all of this short-term churn was confined to consenting adults who were trading in financial markets, perhaps it would not much matter. But it is not. Excessive churn potentially destroys value for end-savers and end-investors. On average, actively managed portfolios underperform passive, sit-on-your-hands strategies, largely because the former gather transaction costs and the latter do not. These costs are borne by end-savers in the form of management fees and sub-standard portfolio performance.
Short-termism in financial markets can also raise the cost of funds for companies undertaking long-term investment projects. Cash flows, which accrue at distant points in the future, get too heavily “discounted”—in effect, ignored—by financial markets seeking nearer-term gratification. This myopia can mean that investment projects yielding high long-term returns, such as research and development programmes, are at risk of being rejected by investors.
Along with Richard Davies at the Bank of England, I have recently estimated the scale of that “excess discounting” of future cash flows among US and UK companies over a 20-year period. On average, returns one year ahead are discounted by financial markets around 5-10 per cent “too much.” In other words, investors behave as if a promised payment tomorrow of £100 is worth only £90, and as if a £100 promised payment the day after tomorrow is worth only £81. For future projects, that can have a dramatic impact.
Imagine a project that provides an annual income stream of $10 and requires a $60 initial investment. If the “true” discount rate is 8.5 per cent per year, this project repays the initial outlay after nine years. A rational company would undertake it. But with excess discounting of just 10 per cent per year, investors would believe the project would never break even and reject it.
Investment behaviour by companies fits these facts. A survey of the Chief Financial Officers of over 400 companies in 2005 found that, in order to meet their quarterly earnings numbers, more than three-quarters of them would reject investment projects that enhanced the long-term value of their firms. If they are to be believed, quarterly capitalism is seriously inhibiting long-term investment.
In the UK, that should be a real cause for concern. In 2008, the UK was bottom of a league table produced by the Organisation for Economic Cooperation and Development (OECD) (Chart 1, published in 2010). Measures of research and development (R&D) spending are even more discouraging. A recent survey of the top 1000 R&D firms in the UK found that investment rates among UK-owned firms were almost half those of foreign-owned firms.
A recent study of 100,000 US firms suggests that short-term pressures on publicly quoted companies can have a dramatic impact on investment rates. Private firms, which operate without the pressure of having to supply numbers each quarter, were found to invest two and a half times more than otherwise identical publicly quoted firms. And when investment opportunities arose, investment by privately owned companies increased three and a half times more than publicly owned equivalents.
All of which begs the public policy question—what should be done? The Kay review contained some excellent ideas, including the empowerment of asset managers. Putting more power into the hands of the patient-minded is the right thing to do. For example, a respectable case can be made for rewarding long-term shareholders with extra voting rights. That is already the case in France, where shareholders holding a security for at least two years often have their voting rights doubled.
Those extra ownership rights could, in principle, be reinforced by creating financial incentives for long-termism. For example, loyalty bonuses could be awarded to shareholders and staff based on length of tenure. These schemes already operate in successful companies such as L’Oréal, the cosmetics manufacturer. Alternatively, capital gains rates on project cash flows could be made duration-dependent, tapering off according to the length of the holding period.
Investment is tomorrow’s growth. That is as close to a fact as you will ever find in economics. There is compelling evidence that short-termism is slowing investment today and so growth tomorrow. In the current environment, that is something we can ill afford. That defective telescope needs repairing.