How bad a problem is “quarterly capitalism”?

by on July 27, 2015 at 12:21 am in Data Source, Economics, Uncategorized | Permalink

We’re going to be hearing more about this topic I suspect, so let’s start by looking at some of the evidence.  For now I’ll turn the microphone over to Xuemin (Sterling) Yan and Zhe Zhang (pdf):

We show that the positive relation between institutional ownership and future stock returns documented in Gompers and Metrick (2001) is driven by short-term institutions. Furthermore, short-term institutions’ trading forecasts future stock returns. This predictability does not reverse in the long run and is stronger for small and growth stocks. Short-term institutions’ trading is also positively related to future earnings surprises. By contrast, long-term institutions’ trading does not forecast future returns, nor is it related to future earnings news. Our results are consistent with the view that short-term institutions are better informed and they trade actively to exploit their informational advantage.

And here is from the Geoff Warren 2014 survey (pdf):

The link between investor short-termism and corporate myopia is not clear cut – While there is some evidence in support of such a link, it is by no mean compelling. Laverty (1996) examines arguments on the existence of short-termism, and points out there is: (1) no clear evidence of flawed short-term oriented management practices; (2) only mixed evidence that stock market myopia encourages corporate short-termism, noting for instance findings of positive stock market reactions to long-term investment by some papers; and, (3) an absence of empirical support for the supposed influence of ‘fluid capital’ on corporate behaviour.

Results of a survey of company management by Marston and Craven (1998) also question the extent to which institutional investors are short-term in focus. While their survey uncovers a perception that sell-side (broking) analysts are focused on the short-term, company management did not consider this the case for buy-side analysts and fund managers. When asked if the buy-side was too concerned with short-term profit opportunities, only 21% agreed while 53% disagreed.

There is more evidence to consider, but I will start by introducing the idea that the standard anti-publicly traded company tropes are not self-evidently true, or at the very least we do not know them to be true.

1 paul July 27, 2015 at 12:41 am

While capitalism is one of the few economic systems that has worked, it doesn’t mean that it cannot be improved. It should be clear to most most people that the current version is malfunctioning. Far too much power in far too few hands. No consideration for the less well off. Also apparently far too rigid to carry out enough innovation android look further than the next quarter’s results. Another problem is that it has created an obscene amount of wealth for some people which is in no relation to their efforts to create it. So, let’s welcome new ideas in an attempt to make things better.

2 Dzhaughn July 27, 2015 at 3:09 am

You can become more than a record player, paul.

3 Harun July 27, 2015 at 3:11 am

“it has created an obscene amount of wealth for some people which is in no relation to their efforts to create it.”

So its really easy. Go ahead. Show us.

4 BC July 27, 2015 at 3:38 am

It’s strange that some people view an economic system’s ability to create wealth as a bug not a feature.

5 Moreno Klaus July 27, 2015 at 9:07 am

If there was no poverty, you would be totally right…

6 Moreno Klaus July 27, 2015 at 9:16 am

…because this system also creates losers, and this does not necessarly mean lazy or stupid, as most of the well-educated , well-off nerds in this blog seem to think…

7 TMC July 27, 2015 at 9:27 am

Wealth creation is just that, creation. The wealthy did not take away from the poor. As most accounts I’ve read state that the producers of things only capture 5% of the total value added, they have transferred much more wealth to others that they have produced. Before taxes.

8 FUBAR007 July 27, 2015 at 12:36 pm

Wealth creation isn’t the issue. Wealth distribution is. But that, strictly speaking, is not a systemic economic problem. Rather, it’s a systemic social/political problem.

The purpose of capitalism is not to provide for the people. Its purpose is survival of the fittest, to cull the weak, and to maximize returns for the strong. As such, it is functioning precisely as intended. What’s best for the people in aggregate is not a concern. That’s society’s problem.

There is no consensus on what the proper or optimal distribution of wealth is. Furthermore, there’s not even any consensus on what, if any, basic resources people within our society are entitled to simply for being alive and what opportunities do and should exist for them to acquire more. Until that consensus is reached, through one means or another, right and left will continue to talk past each other, “debate” will continue to be a vacuous, time-wasting black hole of ad hominem attacks and schadenfreude, and nothing will significantly change, much less improve. Finnegan beginagain.

9 Art Deco July 27, 2015 at 1:39 pm

The purpose of capitalism is not to provide for the people. Its purpose is survival of the fittest, to cull the weak, and to maximize returns for the strong.

Thanks for the parody of Herbert Spencer. We all needed that.

10 FUBAR007 July 27, 2015 at 5:24 pm

@Art Deco:

It’s not extreme enough to be a parody of Spencer. If anything, it’s mild compared to his views.

11 Pshrnk July 27, 2015 at 10:21 am

You can say this about the lottery.

12 Too Late July 28, 2015 at 5:09 pm

The lottery is a zero-sum game. No wealth creation involved.

13 Tyler Fan July 27, 2015 at 1:22 pm

The upshot is that it’s arbitrary, not that it’s easy. One might as well say, “If winning the lottery is so ‘easy,’ go ahead and show us you can do it.”

14 Tyler Fan July 27, 2015 at 1:23 pm

Just saw Pshrnk’s reply….Apologies for the redundancies.

15 HelloKitty July 27, 2015 at 9:21 am

Assertions and random leftist greatest hits

16 nickf July 27, 2015 at 1:14 am

Short-termism isn’t about “management practices” but “financial practices”. No company that focused on the long term would ever buy a hedge or its own stock, or reward managers for doing these things.

17 A July 27, 2015 at 7:03 am

That is a very odd sentence that warrants way more explanation. The most obvious argument for a hedge is to make the future more predictable. And you use “buy” in two different ways. A company is not “buying” stock in the same manner that it buys a hedge. It isn’t stocking an inventory of its own stock. It is releasing capital to shareholders. If you think that is unambiguously for short-term purposes, then you either hold a fanatic’s trust in corporate management, or a fanatic’s distrust in everyone else.

18 nickf July 28, 2015 at 2:08 am

The most obvious argument for a hedge is to smooth quarterly earnings. Short-term fluctuations in commodity prices or exchange rates tend not to matter in the long term. Indeed, if you have a significant long-term FX exposure then a hedge isn’t the right solution at all. That’s why the Japanese carmakers have factories in the US. And hedging oil is generally a mug’s game. That’s why so many airlines are still stiffing us with fuel surcharges. They’re actually hedge surcharges.

The discipline of paying a regular cash dividend is far more indicative of long-termism than sporadic payments designed to benefit corporate insiders. What happened to your affection for making the future more predictable?

19 Green Tea July 28, 2015 at 8:23 am

Strange to view a factory domicile as a currency bet. That ignores labor costs, transportation, supply chain management, taxation, etc…

Even stranger to claim that dividends are more predictable than buybacks. A dividend is a buyback that has been automatically monetized, by management, for shareholders. Taxable shareholders are subject to the whims of market pricing at each payout, and they automatically incur a tax liability, regardless of opportunity. The payouts are arbitrarily linked to calendar dates, rather than any valuation and opportunity cost statement from management. If the act of recieving nominal payouts on calendar dates assures you, then you suffer from a form of money illusion.

20 Kevin Erdmann July 27, 2015 at 1:19 am

nickf, share buybacks are no less reasonable than paying dividends.

Tyler,

Isn’t it funny how so many people hold these two opinions in their heads at the same time:

1) Wall Street is just focused on the next quarter and they push corporations to have short term motives.

2) There was a stock market bubble 15 years ago built around bidding up prices to unprecedented levels for an entire basket of firms which had never been profitable and had no near-term plans for being profitable.

21 Slocum July 27, 2015 at 6:41 am

And, 3) Stock buyers have supported extremely high valuations for Amazon for all the years since then based on the premise that it would ultimately be profitable in the very long term. Which belief finally — only now — seems to be panning out.

22 nickf July 28, 2015 at 1:51 am

What’s wrong with paying a dividend? My point is that share buybacks are right at the very heart of quarterly capitalism because they’re used to hit financial metrics like earnings per share, for the sole benefit of the insiders who get paid on such metrics. They offer no long-term benefits over paying dividends, especially if the company borrows money to do so. If a company has excess cash and doesn’t want to pay a dividend, it should invest that money in the business in ways that earn a long-term return for shareholders. They don’t get paid to liquidate the business.

23 Kevin Erdmann July 28, 2015 at 2:42 am

Buybacks can be better for a lot of reasons. For starters, instead of being spread arbitrarily among all shareholders, the return of capital is targeted to the marginal shareholder who is actually signaling that they want to liquidate their shares by putting them up for sale.
Buybacks do increase earnings per share over time compared to dividends, but compensation committees know the buyback/dividend policy when they set targets. Yours is a common belief, but it is wrong. For instance, in the formula for valuing options, the dividend yield is part of the formula. Maybe options issued during a previous policy would pay off better after a one-time shift to buybacks, but this could only happen once.
A firm’s payout policy and their liability management policy have absolutely nothing to do with one another. And, in any case, firms have been massively deleveraging, so if they did have anything to do with one another, you would still be incorrect to say it is happening now.
They have always gotten paid to liquidate the business. If anything, dividends used to be more of a focus than they are today. Most valuation models are based solely on the present value of future liquidations.

Other than that, I agree with everything in your comment. 🙂

24 nickf July 28, 2015 at 7:21 am

I think you’re assuming that all CEOs in America know what you’re talking about. They don’t. They use buybacks because they see them as more “flexible” than dividends, which is to say that they see them as a way to manage earnings. It doesn’t matter whether this is true or not. The point is that buybacks are a symptom of so-called quarterly capitalism, and that this “flexibility” comes at a cost.

25 Brett July 27, 2015 at 1:31 am

Folks making the whole “far-sighted, not responsible to those grubby investors” argument (like Matt Yglesias) tend to focus on a handful of cases where the founders are visionaries (or think they are) and use their supposed lack of accountability to go wild. Aside from being false – if investors started mass-dumping Google stock over this, you’d bet they’d respond – it’s a selection bias. What we want to know is whether the whole population of firms that aren’t accountable to investors are better run and make more long-term investments, and I’m not convinced that that’s the case unless I see some data supporting it.

In any case, I think this is just a surface rationalization. This is just another way for left-leaning folks to complain that corporations aren’t “investing in their businesses” enough – code for “they’re not raising their employees’ wages and hiring more employees”. It’s kind of like how “structural labor market reform” is code for “making it easier to fire people”, and “reduce class sizes” is code for “hire more teachers, reduce their hours, and implicitly raise their pay”.

26 Adrian Ratnapala July 27, 2015 at 1:41 am

But the handful are significant. Growth happens beacause of unexpected developments (such as steam engines and packet switched networks) except they are only unexpected from the point of view of society as a whole. They were probably entirely expected by the crazy who actually made it happen.

27 A July 27, 2015 at 7:13 am

Matthew Yglesias is generally an interesting writer, but when it comes to buybacks he seems to have found a position and then stopped thinking. I keep waiting for him to explain his framework. Are companies forgoing long-run returns due to shareholder pressure, and then shareholders are creating a deadweight loss through malinvestment? If so, what are the recipients of malinvested capital?

What’s really strange about Yglesias’ work is that he will claim that the market is short-term oriented and discouraging investment through buybacks, and then, in the same article, point to Google and Amazon capital expenditures. Those are public companies! Where is the analysis of why some companies, apparently, receive long-term consideration and others are forced into an excessive payout ratio? Even more sophisticated writers like Mike Konczal fail to clarify their underlying economic intuition. They seemingly adhere to a micro version of the bank reserves to lending fallacy. If you force banks to withhold payouts, investment will increase without Cantillon effects. Or something.

28 Art Deco July 27, 2015 at 1:47 pm

The notion was being peddled when Mr. Yglesias was in diapers by the coterie of journalists which collected around Charles Peters. I think among them Joseph Nocera actually had put in time as a business reporter. Another promoter was the late Michael Harrington. If you rummage around in some back issues to opinion magazines of that era, you can find a piece by Lester Thurow attempting to explain to Michael Harrington that his concerns were misplaced (to no avail).

29 TW Andrews July 27, 2015 at 1:53 am

In well run companies, I don’t think the focus on quarterly returns is much of an issue–good managers balance the need for consistent performance and long-term planning with a combination of actual performance and expectation management to their analysts–Amazon is the gold-standard for this.

It’s really companies which have hit a rough patch where the short-termism is an issue. There you basically end up eating the seed corn in hopes that a miracle occurs and things can get straightened out, whereas if managers were able to sustain a crappy quarter or two without immediate risk to their jobs, I think you’d see better adjustment to changing circumstances. IBM for instance, is a total disaster–they’ve tried to maintain their stock price with financial engineering rather than make the appropriate investments in new product lines. That works for awhile, but the tricks eventually run out, and when they do, the company has been depleted of the human and financial resources to function at a high level.

30 Dzhaughn July 27, 2015 at 3:18 am

But isn’t that just the nature of corporate decline? Eating the seed corn is a lousy bet, but it is a better bet than starving to death.

You are on the cusp of saying that the fact that many dying companies are short-termist does not imply that companies die of short-termism.

31 derek July 27, 2015 at 5:44 am

Essentially the company is being liquidated, and it should be described as such. Investors can do well in a liquidation carried out this way.

32 Dave July 27, 2015 at 11:27 pm

Well said, Derek.

How is it self-evidently true that IBM should spend huge amounts of money trying to compete in areas where other firms (whether Google, or Apple, or Oracle) may have competitive advantages that render such investment a poor risk-return decision? Better to manage the business for cash and return that cash to shareholders. (I am accepting as a given that’s what IBM is doing. I am not up to speed enough on details of their recent performance to know if TW’s statement on that point is true or not.)

Indeed, the natural bias of public company management is normally optimistic and in favor of growth, reflecting confidence in their own abilities, so pressure against that tendency from activist shareholders is a natural counterbalance.

33 TW Andrews July 27, 2015 at 11:22 pm

There’s some truth to that observation. I guess my assertion is that there’s a set of companies which could respond to decline effectively, and in time, if they didn’t waste resources chasing quarterly returns before it became obvious that those returns are ephemeral.

34 TallDave July 28, 2015 at 2:27 am

No one ever knows how long a rough patch will last. A lot of companies face commodity price pressures that may have a lot of variance.

Not many thought oil prices would collapse again. I have some clients who lost billions because they didn’t leverage what was coming. Of course, a lot of people would have called them insane if they had!

That’s the wonder of capitalism, we constantly learn how little we know.

35 David Wright July 27, 2015 at 2:20 am

As Matt Yglesias pointed out, while this is a fine and interesting academic question, politically it’s a side-show. If HRC’s concern was about corporate short-term-ism, she would have proposed a revenue-neutral change in tax law. The fact that she proposed a revenue-positive change indicates that her primary concern is for the government to get more money, and she needs a politically viable narrative that money is coming from those-other-people who are doing-something-bad.

36 Mike W July 27, 2015 at 9:41 am

Of course her proposal is a political side-show but, I don’t remember seeing anything in her proposal that indicated it would be revenue-positive.

37 David Wright July 27, 2015 at 9:39 pm

Every rate in her proposed schedule is equal to or greater than its current value. So either she is purposefully trying to land on the wrong side of the Laffer curve or she is trying to increase revenue.

38 Steve Sailer July 27, 2015 at 3:25 am

I worked for a company that complained that the stock market was overly focused on our quarterly shortcomings rather than on our brilliant long term strategy. But then it turned out that our long term strategy didn’t work.

39 E. Harding July 27, 2015 at 10:03 pm

+1

40 TallDave July 28, 2015 at 2:30 am

Their mistake was relying on a long term strategy that was composed of short term segments of time.

41 Dan W. August 1, 2015 at 9:34 am

The present belongs to those who can tell the best story about the future.

42 BC July 27, 2015 at 3:36 am

The trope that institutional investors cause short-termism never made much sense because institutional investors are the most likely to use NPV analyses, which explicitly account for long-term vs. short-term tradeoffs. There was a link on this blog on Sunday to a White House piece on interest rates. If financial markets were really getting more myopic in recent decades, then long-term interest rates, the exchange rate between long-term and short-term benefits, would have been going up not down.

43 Luis Pedro Coelho July 27, 2015 at 3:43 am

Long-termism is probably as common as a failure mode as short-termism.

Both public and private services suffer from both, but long-termism in the public sector is less self-correcting.

(I’ll define long-termism as the failure mode where actions are taken, over long periods of time, for a benefit whose due date keeps slipping off into the future)

44 rayward July 27, 2015 at 6:29 am

How can it be argued that short-term oriented investment is causing short-term oriented management at a time of very high P/E ratios (not as high as in 2000, but high historically). If anything, investors are signaling enormous patience for companies to deliver earnings commensurate with the P/E ratios. Or not. Volatility can’t be explained by a single cause. For example, Apple’s stock goes up and down like a roller coaster (which might explain why everyone hasn’t become an Apple millionaire), yet Apple consistently delivers huge earnings. Amazon’s stock, on the other hand, is less volatile, yet (except for the recent quarter) Amazon doesn’t produce earnings, or even project earnings, anywhere near a level that would support its stock price. What’s puzzling is that investors are optimistic about future earnings (as reflected in high P/E ratios), yet the rate of return from capital (r) has been falling for over 30 years. Under the circumstance, why would management invest in productive capital when the potential returns from speculation in financial assets are far more inviting. And why would investors be so optimistic about future earnings (as reflected in the high P/E ratios)? Is there hidden growth in r buried somewhere in the financial statements? Or in the minds of irrational investors?

45 Gary Leff July 27, 2015 at 7:13 am

Cowen’s law that there’s research on everything but I haven’t seen any look at the role of GAAP accounting standards on firm performance, e.g that publicly traded firms work to game their accounting results at the expense of long-term performance (such as by ignoring unprofitable operations and allowing them to continue, rather than recognizing – or even identifying – elements of a business that are unprofitable – because the firm would have to write them down if they did).

We do know that firms will game numbers, piling on losses in especially bad quarters in order to show better results in the future. What about the role of compensation tied to stock price, and whether that causes changes in firm strategy such as increased buybacks aligned with the vesting of options?

My intuition is that many firms pursue suboptimal compensation strategies at the micro level, and poor business strategies at the macro level, and that at least the latter is in part driven by requirements for public companies and how standardized information is used by institutional investors. I suspect that elements of these questions are actually underexplored. But as a non-expert unlikely to invest significant time studying the matter I look forward to additional posts on this topic.

46 Mike W July 27, 2015 at 10:49 am

But isn’t the question, are shareholders influenced by these manipulations?

47 Just Saying July 27, 2015 at 8:06 am

Both of those studies are fairly dates – 1996 and 2001. This happened before the massive rise of algorithmic high frequency trading (HFT), which really only became as powerful as it is today in 2009, when trades could regularly be executed in milliseconds, and were designed to take advantage of lower latency to the floor, versus market knowledge. It seems odd one would use a 20-year old study (1996?) to try to prove a fact about today’s marketplace, given how fast technology has changed our world relative to twenty years ago.

48 dirk July 27, 2015 at 8:12 am

I thought the complaint was mainly about financial institutions who pursued high-yield short term strategies such as a carry trade. If I’m a trader trying to get rich in a few years with other people’s money, I’m going to go after high-probability short-term trades regardless of what the expected long-term return on those positions are.

49 dirk July 27, 2015 at 8:16 am

For instance, I might have thought high-yield mortgaged backed securities were a great investment for my annual bonus like those fellows at AIG.

50 Mike July 27, 2015 at 3:25 pm

FX Carry is a long term strategy. Typical holding period is > 1 year.

51 Mike July 27, 2015 at 3:26 pm

Any carry trade involves sitting in a position for a long time to pocket the difference in yields. The longer you sit, the more you make. Who on earth told you that carry was a high-yield, short-term strategy?

52 dirk July 27, 2015 at 8:26 pm

I admit it is not quarterly capitalism, which is why I made the comment.

Playing a carry trade is a bet against the law of large numbers. Sure, you might hold it for two years, but the expectations of profit are zero. It’s like putting your chips on two rows of the roulette table. When you lose, you lose big. That’s not long-term thinking.

53 Paul Zrimsek July 27, 2015 at 12:04 pm

The most remarkable thing about the belief in short-termism is how popular it is with people who also believe in the existence of predatory pricing.

54 Art Deco July 27, 2015 at 1:51 pm

Ya think? I seem to recall the popular literature denouncing people like William Agee as ‘a quarterly reports kinda guy’ post-dated an older discourse on anti-trust and on international trade which concerned itself with things like ‘dumping’. The purveyors I remember were also critics of the trade unions and were more inclined to promote the idea of emulating the Japanese than instituting restrictions on Japanese imports.

55 John July 27, 2015 at 12:28 pm

It’s always struck me that this focus on quarterly results (as much media driven IMO as trading driven) is largely a secondary market issue (secondary market pricing issue) than one of corporate capital investment decision-making. If we’re going to accpt the monetary policy only has a losse linkage to the underlying economic decisions and actions I don’t find it much of a leap to think that the linkage between the behavior in the secondary markets and firms’ behaviors has an even looser linkage.

56 John July 27, 2015 at 12:43 pm

I think the conclusion (from Yan and Zhang) that short-term investors are better informed a bit questionable. Investment horizon no doubt will influence how important specific data, such as expectations (or even inside knowledge) of next quarters results, is in terms of current holding and buy/sell decisions. That doesn’t mean that the short-term insitution is better infromed about the company at all.

It’s probably good to understand what type of firms were driving the earlier results so seems like good research.

57 Mike July 27, 2015 at 3:28 pm

Better informed about the company? Not sure what that means or how it should be measured. I’m sure you can come up with something, but so what? Discussion is about there being better informed about future prices.

58 TallDave July 28, 2015 at 2:23 am

If you ask C-level execs they will always tell you their plan for the company’s next 10-25 years. The plan is probably wrong, but it’s a plan.

I think a lot of this misperception is driven by the government taking on so much basic research that used to be done privately. Companies are reluctant to invest in anything that is already being provided at taxpayer expense.

59 Art Deco July 28, 2015 at 8:34 am

Which government and what industries? Roughly 2/3 of federal research and development expenditure is attributable to the military. Another bloc is devoted to the space program, which had an $18 bn budget when last I checked. About $35 bn went to the National Institutes of Health and $25 bn to the national laboratories. About $7 bn went to the National Science Foundation. How much crowding out is there outside of aerospace and pharmaceuticals?

60 Mike August 3, 2015 at 11:53 am

US Military R&D money is not just aerospace. It’s actually extremely broad as areas like transportation and computing are considered important to national security. It also includes a lot of basic research in areas like game theory, optimization, algorithms, machine learning, etc.

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