As the psychologist Abraham Maslow once said: “If the only tool you have is a hammer, you tend to see every problem as a nail.” This rings true of the financial markets using short-term financial measures to drive all investment decisions regardless of time period.
The recent speech by William Donaldson, the former Securities and Exchange Commission SEC chairman’s recent speech to the CFA Institute, the financial analysts body, was a wake-up call for the investment community to put an end to this trend: “I hope that investors will begin to change, particularly when they see the value of an investment in a company that is managed for the long term.”
The evidence supporting Mr Donaldson’s perspective is irrefutable. Numerous studies show that most the majority of a company’s value is determined by its long-run performance. For years, The best investors , including the legendary Warren Buffett, have understood this. And yet, today the majority of the investment community(made up of investment managers, company executives, pension fund managers and trustees, investment consultants and the research community) now consistently act as though in ways that give the impression that the long term simply does not matter anymore. For example, The average mutual fund in America turns over 100 percent of its portfolio every 11 months and quarterly earning targets are an obsession with research analysts.
Most disturbing, In a recent paper by the US National Bureau of Economic Research, a non-profit, non-partisan US research 78 per cent of the financial executives surveyed said they would give up economic value in exchange for smooth earnings, and 55 per cent of managers would not avoid initiate a project with a very positive return if it meant falling short of the current quarter’s consensus earnings.
This short-term orientation has significant negative repercussions for the global economy – in essence, the market is short on long. – in essence, the entire market is short on long. If businesses are forgoing value-creating investments to manage short-term earnings, this will damage our economic vitality in the future. A short-term perspective hinders innovation and research and development, R&D investments, diminishes investment in human capital, encourages financial gymnastics and discourages leadership.
How do we reverse this trend towards the dominance of short-termism? First, the investment community must embrace genuine long-term thinking. This means truly managing portfolios with an long-term investment horizon of roughly (i.e. 5 five years, or through a business cycle. To do this, portfolio managers and analysts need to systematically take account of a number of factors that are not routinely monetised on balance sheets today – including sustainability issues – as opposed to solely focusing on short-term financial returns. This means Sustainability research means analysing is the analysis of the implications for shareholder value implications of long-term economic, environmental and social challenges. They include future political or regulatory risks, the alignment of management and board with durable long-term company value, quality of human resources capital management, risks associated with governance structure, the environment, corporate restructurings/mergers and acquisitions, branding, corporate ethics and stakeholder relations.These extra-financial issues clearly affect a company’s ability to enhance shareholder value, create a competitive advantage and generate sustainable returns over the long-term.
Second, management must aggressively move away from the current obsessive focus on meeting quarterly earnings per share targets and instead concentrate on what McKinsey, the consultancy, refers to as the “healthy company”. It should and take care to keep its businesses in what the Harvard Business School describes as the “zone of sustainability”. Corporations must execute on short-term fundamentals and plan for long-term value creation.
Chairman Donaldson said: “To state an obvious but often overlooked fact – quarterly earnings do not reflect companies’ long-term viability. Identifying the factors that will drive long-term growth – such as personnel, strategy, financial strength and flexibility, internal corporate governance, innovation, and customer service – may be more difficult to quantify but they offer a more accurate and complete portrait of a company’s future”.
Third, the research community must go beyond current approaches to servicing long-only investors and must also be careful to not just service hedge funds. They can do this by developing research products addressing complex and widely misunderstood long-term issues. These extra-financial issues truly provide an opportunity for the sell side to differentiate itself and add value. In support of this trend, The Enhanced Analytics Initiative (EAI), a consortium of fund managers and asset owners, encourages sell-side research into important material, extra-financial issues. Furthermore, many numerous corporate executives are keen to have their shareholders aligned with their long-term thinking and are increasingly communicating their long-term value-creation strategies to Wall Street and the City.
Capital markets and capitalism are at a critical juncture. The domination of short-termism across our financial system will stifle innovation, damage our economies, further impair our pension systems and ultimately erode our standard of living. We are not against hedge funds; they have a role to play in capital markets. However, the long-term investment community, which represents the significant majority of total investable assets, must adopt truly long-term thinking. Company management and the research community must also look to return to the long-term. Our livelihoods and, more importantly, those of our children and grandchildren ’s livelihoods, depend on it.