by Cydney Posner
In this February 2017 article in the Harvard Business Review, “Finally, Evidence That Managing for the Long Term Pays Off,” a team from McKinsey and associated consultants attempt to prove empirically what has often seemed intuitively must be true — that companies that manage for long-term value creation, those that can put aside the pressures of quarterly expectations, actually deliver superior results. What did they find? That if the whole economy had performed at the same level as the companies in their study that followed a long-term strategy, “U.S. GDP over the past decade might well have grown by an additional $1 trillion [and the economy would have] generated more than five million additional jobs over this period.”
If a long-term perspective leads to better results, why is it then that, in recent surveys, “61% of executives and directors say that they would cut discretionary spending to avoid risking an earnings miss, and a further 47% would delay starting a new project in such a situation, even if doing so led to a potential sacrifice in value”? In addition, as manifested in the significant increase in share buybacks in recent years, 65% say that they have experienced increased pressure for short-term results.
SideBar: Data compiled by S&P and Bloomberg show that companies in the S&P 500 spent 95% of their earnings on repurchases and dividends in 2014, including spending $553 billion on stock buybacks (which can drive increases in EPS), leaving little for alternative uses of capital, such as long-term strategic investment in productive assets, including investment in R&D. (See this PubCo post.) But that trend may be reversing, as suggested by this article from the WSJ, which discusses a decline in share buybacks in the first quarter of 2017: “First quarter share repurchases among S&P 500 firms that have released data are tracking 24% lower than those companies reported a year earlier, according to S&P Dow Jones Indices. [Other analysts have reported that] year-to-date activity is tracking at the lowest pace for any comparable period since 2013, and is down almost 30% from the same period a year earlier.” One commentator cited in the article suggested that the “‘mentality might be shifting a little bit, from high shareholder returns to growth and investment.’”
SideBar: In this study, also from McKinsey, the authors raise the question of why short-term forces seem to be so powerful: why do so many companies seem to succumb to pressure from their short-term investors, which own only about 25% of the shares of U.S. companies, while failing to address — or perhaps even understand — the needs of their long-term holders, which own 75% of U.S. shares. While it’s true that short-term investors probably make the most noise, that noise, McKinsey contends, may be distracting managements from aligning with the types of investors that will have the greatest influence on share price over the long term. Perhaps some of the pressures to emphasize short-term financial performance could be avoided or at least mitigated by building alliances with sophisticated long-term investors? See this PubCo post.
In their study, the authors examined 615 non-finance companies with results reported continuously from 2001 to 2015 and with market caps over $5 billion in at least one year, a sample that accounted for about 60%-65% of total U.S. public market capitalization over this period. All companies were evaluated “only relative to their industry peers with similar opportunity sets and market conditions.” The proportion of long-term and short-term groups were “approximately equivalent, so that the differential performance of individual industries cannot bias the overall results.” The authors emphasized that their findings were “descriptive,” and did not necessarily show causation.
It turns out that assessing the impact of short-termism on performance is a complicated endeavor, in large part because it’s not easy to determine what a “short-term view” really means: “‘short-termism’ does not correspond to any single quantifiable metric. It is a confluence of so many complex factors it can be nearly impossible to pin down.” That said, to do precisely that, the authors considered five financial indicators:
- “Investment. The ratio of capex to depreciation. We assume long-term companies will invest more and more-consistently than other companies.
- Earnings quality. Accruals as a share of revenue. Our belief is that the earnings of long-term companies will rely less on accounting decisions and more on underlying cash flow than other companies.
- Margin growth. Difference between earnings growth and revenue growth. We assume that long-term companies are less likely to grow their margins unsustainably in order to hit near-term targets.
- Earnings growth. Difference between earnings-per-share (EPS) growth and true earnings growth. We hypothesize that long-term companies will focus less on things like Wall Street’s obsession with earnings-per-share, which can be influenced by actions such as share repurchases, and more on the absolute rise or fall of reported earnings.
- Quarterly targeting. Incidence of beating or missing EPS targets by less than two cents. We assume long-term companies are more likely to miss earnings targets by small amounts (when they easily could have taken action to hit them) and less likely to hit earnings targets by small amounts (where doing so would divert resources from other business needs).”
Applying these indicators, the authors found a divergence into two broad groups: a “long-term” group of 164 companies (about 27% of the sample), and a remaining group of 451 companies (about 73% of the sample).
SideBar: Why has short-termism taken hold? There are many points of view on the reasons, with blame attributed to, among other things, executive compensation (see this PubCo post and this PubCo post), pressure from Wall Street to increase quarterly EPS (see this PubCo post), traders’ compensation (see this article in The Atlantic), the “legal underpinnings” of capital markets regulation and the business model and prevailing culture of the investment management industry (see this PubCo post), caselaw regarding directors’ fiduciary duties (see this PubCo post), and, perhaps most significant, hedge fund activism. As suggested in this NYT DealBook column, the activist playbook is certainly not limited to buybacks and dividends: “[a]s activist hedge funds take aim at companies left and right from their spreadsheet-laden war rooms in Manhattan’s glass towers, their expertise is financial engineering, not running companies. And so the activists love to argue for sales, split-ups, stock buybacks and other financial machinations. The idea is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.” See this PubCo post.
According to the authors, the “differences were dramatic.” Among the long-term group, “average revenue and earnings growth were 47% and 36% higher, respectively, by 2014, and market capitalization grew faster as well.” Moreover, the long-term group seemed “to maintain their strategies during times of economic stress. During the 2008–2009 global financial crisis, they not only saw smaller declines in revenue and earnings but also continued to increase investments in research and development while others cut back. From 2007 to 2014, their R&D spending grew at an annualized rate of 8.5%, greater than the 3.7% rate for other companies.” Looking at “economic profit” — that is, “profit after subtracting a charge for the capital that the firm has invested (working capital, fixed assets, goodwill)” — the authors found that, from 2001 to 2014, the long-term group increased their economic profit by 63% more than the remaining group and that, by 2014, “their annual economic profit was 81% larger than their peers, a tribute to superior capital allocation that led to fundamental value creation.”
Although stock prices for the long-term group suffered more during the financial crisis, the authors found that, following the crisis ,the long-term group “significantly outperformed, adding an average of $7 billion more to their companies’ market capitalization from 2009 and 2014 than their short-term peers did.”
From a societal perspective, the authors determined that the long-term group “added nearly 12,000 more jobs on average than their peers from 2001 to 2015. We calculate that U.S. GDP over the past decade might well have grown by an additional $1 trillion if the whole economy had performed at the level our long-term stalwarts delivered — and generated more than five million additional jobs over this period.” Moreover, they estimate, “[p]rojecting forward, if nothing changes to close the gap between the long-term group and the others, then the U.S. economy could be giving up another $3 trillion in foregone GDP and job growth by 2025.”
The authors end on a hopeful note: “real change is possible.” What’s the evidence for that? The authors look to a 14% subset of the long-term outperformers. It turns out that these companies initially scored as part of the short-term group, but, over the 15-year period, were able to transform their behaviors to become scored as part of the more successful long-term group. Unfortunately, the authors don’t specify what actions these particular companies took, but they do offer some general suggestions for effective “interventions” to persuade companies and managements to adopt a more long-term vision and strategy, including “creating investment mandates that reward long-term value creation,…techniques for ‘de-biasing’ corporate capital allocation, [and] rethinking traditional approaches to investor relations and board composition.”
SideBar: The CEO of one significant investor, BlackRock, has attempted to create just such an investment mandate. In his 2016 corporate governance letter to CEOs, the BlackRock CEO asks CEOs of portfolio companies, instead of using their annual communications to shareholders to report only on the past year’s achievements, to “articulate management’s vision and plans for the future” by “lay[ing] out for shareholders each year a strategic framework for long-term value creation. Additionally, because boards have a critical role to play in strategic planning, we believe CEOs should explicitly affirm that their boards have reviewed those plans. BlackRock’s corporate governance team, in their engagement with companies, will be looking for this framework and board review.” [bold in original] He envisions this framework as encompassing “how the company is navigating the competitive landscape, how it is innovating, how it is adapting to technological disruption or geopolitical events, where it is investing and how it is developing its talent. As part of this effort, companies should work to develop financial metrics, suitable for each company and industry, that support a framework for long-term growth. Components of long-term compensation should be linked to these metrics.” See this PubCo post.