Short and Long Term Investors (and Other Stakeholders Too): Must (and Do) Their Interests Conflict?

Hill & McDonnell

The world of corporate governance is undergoing two intense, inter-related debates. One is a debate as to whether profit-maximization in the short term is really different from profit-maximization in the long term, and if so whether American corporations are currently too short-termist. The second debate is whether shareholder profit maximization is and should be the exclusive goal for corporate managers.   The debates are inter-related because corporations focused on long term rather than short term profits are likely to more fully take into account the interests of other stakeholders, although even a robust focus on the long term will not fully equate the interests of shareholders and other interests.

Traditional economic theory holds that there should be no difference between profit maximization in the short and long term given that a company’s value is the present value of its future cash flows. What investors are paying for is the future cash flows. A project whose payoff is far in the future of course needs to be far better than a project whose payoff is tomorrow, but there is no additional discount beyond the time value of money (and the uncertainty associated with any project).   Yet, the contrary position is frequently taken, mostly in the press, but even among some academics, in characterizing activist investor demands. These investors encourage cost-cutting, notably on future research and development and other investments that might lead to desirable projects, in order to, in effect, ‘take the money and run.’ They would cut off funding for even a desirable project. They would prefer to have a moderate- sized dividend now than a cure for cancer in 8 years.

We argue that there are ways to reconcile traditional economic theory with an overly high discount rate for the future. One way involves agency costs. Activist investors demand immediate results, and managers, wanting to keep their jobs, do what it takes to provide those results to pre-empt the activists. The activists’ funders, concerned about their own returns, demand that the activists show quick results. Why aren’t there ‘quick results’ from projects from long-term payoffs? Markets are not necessarily fundamentally efficient. Rather, they are informationally efficient—the market price represents the consensus view of what the future holds. Because the future is necessarily uncertain – the further in the future, the greater the uncertainty — leaving a margin of error is the best strategy.   Potentially leaving twenty dollars on the floor is a small price to pay to minimize the likelihood of doing worse than one’s peer investors. It is a hard empirical question, though, whether factors such as these really cause corporations to give too little weight to long term profits. The difficulty in answering that question cautions against aggressive policy reforms that assume the answer is that corporations are overly focused on the short term, even though we do think there are some very good arguments that they are.

Moreover, even if there isn’t as much long-term investment as there ‘should’ be, many proposed solutions may be worse than the problem they purport to solve. Insulating the board and company management from activist investors has obvious risks: the board and management can engage in self-serving behavior rather than behavior that benefits the company.   Indeed, the rise first of hostile takeovers, then of stock-based executive compensation, and now of shareholder activism, can quite rightly be seen as a response to the empire-building of corporate conglomerates of decades past, where supine boards allowed managers to fall well short of zealously pursuing shareholder value.

Activist investment is also criticized for limiting a company’s ability (and incentive) to focus on stakeholders other than shareholders, such as employees, beneficiaries of research and development, and the environment.   To what extent companies should try to benefit stakeholders other than shareholders is of course a hugely controversial, complicated, and foundational topic for corporate governance. We do not take on that question here. But we do consider whether a long-term focus could benefit both shareholders and other stakeholders.

Reputational effects can help more closely align the interests of shareholders and others associated with a business. A reputation for fair and generous treatment of employees may attract better and more loyal workers. A reputation for high quality products or service may attract customers willing to pay a higher price. A reputation for ethically responsible behavior towards the community and environment may attract employees and customers who prefer being involved with ethical companies.

Reputation matters for the long run, so companies that place greater weight on the long run are more likely to take actions that may be costly in the short run but benefit their reputations in the long run. And, other kinds of actions that pay off in the long run may also have important benefits for society—research and development spending is an obvious example. Thus, governance reforms that encourage corporations to focus more on long run profitability may in various important ways more closely align the interests of shareholders and other corporate stakeholders.

But one should not be too Pollyannish about this point. Even companies with a heavy emphasis on the long run may find that shareholder profits collide with other values. In some cases, outsourcing workers or replacing them with automation may be best for even long run profits. For some kinds of harms to the community or the environment, employees and customers may either not know or not care enough for reputational effects to make avoiding those harms the profit-maximizing option. Some types of research and development may lead to positive externalities that the company cannot capture, and that the company cannot justify looking at a bottom line focused on profits. Reforms that create a stronger long term profitability focus will reduce the tensions between a shareholder and a stakeholder conception of corporate purpose, but they will not eliminate those tensions.

So where does all this leave us in evaluating competing suggestions for addressing corporate short termism and/or protecting non-shareholder constituencies? There is much darkness, but some points of light. Growing numbers of examples of shareholder investment and activism focus on the long run and on social concerns. Socially responsible investment funds have been around for some time, public fund investors can be a force for good, and plenty of more conventional investors and managers are now at least paying lip service to a long run focus and/or the importance of other corporate stakeholders. Markets may and do move to correct some, if not all, of their own mistakes. They will probably not do as much as one might desire even to address short termism, and more certainly will not do as much as many desire to address the concerns of non-shareholder groups. But at least there is some movement in the markets. And given the enormous conceptual and empirical challenges in identifying the extent to which corporations are overly short termist in orientation, or what is the appropriate balance between shareholders and other stakeholders, and also given the dangers of weakening managerial accountability, the various forms of experimentation going on in the markets may be the best we can do.

The preceding post comes to us from Claire A. Hill, the James L. Krusemark Chair in Law at the University of Minnesota Law School, and Brett McDonnell, the Dorsey & Whitney Chair in Law at the University of Minnesota Law School.  The post is based on their book chapter, which is entitled “Short and Long Term Investors (and Other Stakeholders Too): Must (and Do) Their Interests Conflict?” and available here.

2 Comments

  1. A. Jallai

    “Reputational effects can help more closely align the interests of shareholders and others associated with a business. A reputation for fair and generous treatment of employees may attract better and more loyal workers. A reputation for high quality products or service may attract customers willing to pay a higher price. A reputation for ethically responsible behavior towards the community and environment may attract employees and customers who prefer being involved with ethical companies.

    Reputation matters for the long run, so companies that place greater weight on the long run are more likely to take actions that may be costly in the short run but benefit their reputations in the long run. And, other kinds of actions that pay off in the long run may also have important benefits for society—research and development spending is an obvious example. Thus, governance reforms that encourage corporations to focus more on long run profitability may in various important ways more closely align the interests of shareholders and other corporate stakeholders.”

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