How a Short-Term Strategy Can Backfire
Patterns appear in higher stock volatility, increased capital costs, and a drop in return on assets.
Title: Short-Termism, Investor Clientele, and Firm Risk
Author: Francois Brochet, Maria Loumioti, and George Serafeim (all Harvard Business School)
Publisher: Harvard Business School Accounting & Management Unit Working Paper No. 1999484
Date Published: February 2012
Analysis of conference calls with investors has shed new light on firms that explicitly try to maximize near-term earnings and stock prices — an approach known as “short-termism.” According to this paper, these firms face greater risks, including a higher cost of capital and a lower return on assets, than companies that focus on creating long-term value. One reason for that finding, also reported here, is that firms with a short-term approach have a base of like-minded investors, which results in higher stock-price volatility. What’s more, such companies show a higher likelihood of barely beating analyst forecasts, of reporting very small positive earnings, and of being vulnerable to the violation of loan covenants.
All in all, the researchers imply, short-termism can lead to mixed results in the short term as well as risks to long-term performance.
Critics have long complained that short-termism, in stressing nearsighted projects over research and development and other capital investments, misallocates resources and stunts future development. Largely fueled by the pressure from stock analysts and investors to deliver good news in quarterly earnings reports, short-termism has been blamed for playing a role in the recent financial crisis.
But attempts to track its effects on individual firms have faltered in the past, because it is difficult to pinpoint when companies act predominantly in their short-term interest. This paper takes a new approach, creating a proxy for short-termism by analyzing transcripts from quarterly conference calls.
By coding the language used in discussions between senior managers and investors, the researchers could assess the time horizon that firms emphasized in their communications; they then developed a measure of short-termism based on the ratio of key words referring to the near future (a year or less) and those referencing the long run (beyond one year).
The authors analyzed the full text of transcripts from earnings conference calls on the Thomson Reuters StreetEvents database. After they eliminated firms based outside the U.S. and those with missing or incomplete data, the final sample encompassed more than 70,000 calls for 3,613 firms from 2002 through 2008. Financial information was obtained from other databases and matched with the firms.
After controlling for several industry and firm variables, the authors’ analysis showed that on average, firms are more oriented to the short term than the long term, and they disclose more information related to the near future.
Overall, firms that sell apparel, automobiles, beverages, consumer goods, pharmaceutical products, and recreation services are more oriented to the long term, the analysis found, as are such industries as construction, medical equipment, and utilities. On the other hand, companies that sell business services and supplies, computers, and electronic equipment are focused more on the short term, along with the banking, energy, export trading, insurance, and wholesale industries.
“Companies that sell products to individual consumers are more long-term oriented compared to companies that sell products to other businesses,” the authors write, and companies “whose performance is driven by branding and innovation are more long-term oriented compared to companies whose performance is driven by efficiency of execution.”
The results also indicated that companies exhibiting a short-term view had a more tumultuous business model, with higher cash-flow volatility and a longer operating cycle (that is, the time it takes to sell goods or services). Short-termism was also negatively correlated with return on assets, leverage, rank in the S&P 500, and market-to-book ratio.
The authors also found that long-term investors were less likely to hold the stock of a firm focused on the short term, which led to higher stock-price volatility for firms with a short-term focus. “This is consistent,” the authors write, “with firms that have greater short-term emphasis [on] (i) attracting investors that are more sensitive to short-term news and (ii) being more responsive to short-term news in their own planning decisions.”
The authors caution that although executives may bemoan the short-term focus of investors, they reinforce that mind-set. For example, when company leaders deliberately establish expectations for the next quarter’s earnings that they know they can beat by just a penny or two, they are trying to elicit a short-term bump or to duck sharp downturns in the stock price.
The authors also point out that managers may feel they have no choice. “Executive compensation is typically tied to current performance and stock prices,” they note, “incentivizing managers to overweight the short-term.”
Although firms and managers frequently focus on projects designed to deliver in the near future, the immediate results are often mixed and mask greater risk for the long term than other companies face. In addition, these firms attract a base of short-term investors, leading to higher stock-price volatility.