By Alex Edmans, Vivian W Fang, Katharina Lewellen © voxEU.org
Alex Edmans, Professor of Finance at London Business School (on leave from The Wharton School, University of Pennsylvania); Research Associate, ECGI; and CEPR Research Fellow
Vivian W Fang- Assistant Professor at Carlson School of Management, University of Minnesota
Katharina Lewellen- Associate Professor of Business Administration at the Tuck School of Business, Dartmouth College
This article was originally posted on Vox EU: http://www.voxeu.org/article/getting-companies-invest-long-term
Competitive success of firms
In the 20th century, firms were predominantly capital-intensive and competed on cost efficiency. Companies with the most efficient factories could manufacture goods more cheaply than their rivals, and became market leaders.
The 21st-century firm is different. Nowadays, competitive success depends increasingly on product quality and innovation. These, in turn, hinge on a company’s intangible assets, such as its human capital and R&D capabilities. 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 impact of training your workers or researching a new drug is to lower earnings. Thus, a manager pressured to maximise short-term earnings may underinvest in his company’s future.
This problem of ‘managerial myopia’ is well-known, but commentators have typically proposed piecemeal solutions focusing on one particular determinant. Instead, the problem is holistic:
- It depends on how managers are paid,
- How shareholders evaluate companies; and
- How regulators mandate corporate disclosure (among other factors).
We’d like to tackle these three elements in turn.
How managers are paid
Starting with CEO compensation, the typical debate is about the level of CEO pay. Is it fair for CEOs to be paid 300 times the average worker, or CEO salaries to have risen six-fold since 1980? However, while the level of pay is a politically-charged subject, much more relevant for a company’s long-run health is the horizon of CEO pay – whether it vests in the short-term or long-term. In Edmans et al. (2014), we find that in years in which the CEO has significant equity vesting, he typically cuts R&D, advertising, and capital expenditure, and by doing so exactly meets or narrowly beats earnings targets. In addition to avoiding good long-term actions, myopic CEOs may also undertake bad short-term actions – such as writing sub-prime loans to generate immediate underwriting income, and then selling their shares before the loans become delinquent. Angelo Mozilo, the former CEO of Countrywide, sold $129 million of stock shortly before the start of the financial crisis.
Caps on banker bonuses and 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 scrutinise investment decisions particularly carefully in years in which managers have significant vesting equity.
The role of the shareholder structure
Turning to shareholder structure, basic finance theory teaches us about the benefits of diversification. Indeed, in the US, the ‘prudent man rule’ requires that institutional investors choose their assets as a ‘prudent man’ would, which involves reducing risk through diversifying. But diversification doesn’t just reduce risk, it also reduces the investor’s ‘skin in the game’. Since the investor has such a small stake in each firm, she has little incentive to monitor it. She will evaluate firm performance using easily-available measures such as earnings, and not spend the time and effort necessary to analyse its 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”, as the adage goes. Bushee (1998) finds that dispersed investors pressure managers to cut R&D to meet short-term earnings targets. In contrast, Edmans (2009) shows 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 firms to invest for the long-term. Warren Buffett is a prime example. Instead of diversifying and being spread too thinly, shareholders should hold meaningful stakes and thus be invested – both figuratively and literally – in a company’s long-run future.
Finally, one response to the financial crisis and corporate scandals is to force firms to disclose more information. Doing so, the argument goes, will prevent them from taking 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. Edmans et al. (2013) show that mandatory disclosure will induce companies to focus on hard information at the expense of soft, e.g. by cutting investment to boost earnings – just as publicising 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 as such disclosure would induce short-termism. Their founders’ letter stated that “we believe that artificially creating short term target numbers serves our shareholders poorly”. Porsche was expelled from the German M-DAX index in August 2001 after refusing to comply with its requirement for quarterly reporting, claiming that such disclosures would lead to myopia. Begley (2014) shows that firms cut R&D to meet financial thresholds set by credit ratings agencies, which in turn worsens the number and quality of future patents.
We are 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, we hope to highlight important costs that should be considered by policymakers and practitioners – costs that are particularly relevant to the long-term future of the 21st century firm.
Begley, T (2014), “The Real Costs of Corporate Credit Ratings”, Paris December 2014 Finance Meeting EUROFIDAI-AFFI paper.
Bushee, B (1998), “The Influence of Institutional Investors on Myopic R&D Investment Behavior.” The Accounting Review, 73(3):305-333.
Edmans, A (2009), “Blockholder Trading, Market Efficiency, and Managerial Myopia.” Journal of Finance, 64(4):2481-2513.
Edmans, A, V W Fang, and K A Lewellen (2014), “Equity Vesting and Managerial Myopia ,” CEPR Discussion Paper DP10145.
Edmans, Al, M Heinle, and C Huang (2013), “The Real Costs of Disclosure”, CEPR Discussion Paper DP9637.
To view the original article posted on Vox EU visit: http://www.voxeu.org/article/getting-companies-invest-long-term