Corporate short-termism has been much discussed over the past few decades, but has recently become a growing concern for the U.S. economy. Executives and politicians warn of increased market pressure on corporations to meet short-term performance metrics at the expense of long-term value creation and sustainable growth. Sheila C. Bair, former chair of the FDIC, lamented in an op-ed piece that efforts to prevent the financial crisis “were impeded by the culture of short-termism” in both the financial and political arena.
Some empirical evidence is consistent with these concerns; surveys of executives, analyses of firm investments, and various anecdotes point to rising short-termism. This behavior may take several forms within firms, but typically is thought to reflect preferences for short over long term returns, even at the expense of the size of returns, and efforts to align investment with such preferences. However, other evidence, such as historically high levels of firm R&D investment and price earnings ratios, reveals a more equivocal picture. We lack broader, market-wide evidence of whether markets are shortening their time horizons and influencing firm behavior as a result.
Investor time horizons are critical for the pricing of assets, as Richard Thaler, winner of the 2017 Nobel Prize in Economics, demonstrates in his work. He found that investors with a long-term outlook who evaluate their portfolios relatively less frequently may be willing to tolerate higher risk than myopic investors. As myopia in investing is an inseparable part of corporate short-termism, a systematic empirical study of investor time horizons may help us understand the scale and scope of short-termism.
In our recent paper, “Are US markets becoming more short-term oriented? Evidence and implications of market discounting of firms, 1980-2013,” we seek to evaluate whether investor time horizons are shifting by first estimating a proxy of investor time horizons at the firm level. Specifically, we modify a standard capital asset pricing model to estimate how much markets are discounting firms beyond the standard cost of capital implied in stock price. We then evaluate this measure as a proxy for time horizons by estimating correlations with firm characteristics and market pressures, identified by previous research as signals of short-term focused behavior by firms or pressures on firms to emphasize short-term returns.
Our firm-level estimates reveal that markets are increasingly discounting expected future returns from stocks, in both the NYSE and NASDAQ as well as across all major industry sectors. While the trend is persistent over time, important shifts in discounting accompany significant market-wide events. Markets discounted firms more after the dot-com bubble of 1999-2000 and the financial crisis of 2007-08. These upward shifts in discounting likely reflect the broad market uncertainty around how future firm performance is affected by these events. Alternative measures of market discounting confirm this trend, including one based on analyst earnings forecasts.
These patterns are revealed not only on average across firms, but within firms; the majority of U.S. listed firms show an increase in market discounting over time. The upward trend in market discounting also appears to coincide with declining firm R&D productivity and relatively stagnant total factor productivity growth. This suggests that market beliefs correlate with factors that imply declining expectations of firm growth.
To better reveal whether market discounting is capturing time horizons, we then examine the relationship of market discounting with firm investment behavior, institutional investor behavior, and other measures capturing external market pressures on firms – all factors found by earlier work to correlate with short-term firm behavior. Investments that often have a long-term payoff horizon, such as R&D and capital expenditure, are negatively correlated with how much markets discount those firms. Using random coefficient models, we also estimate the differences between firms in the magnitudes of these relationships. We find significant variations in how markets appear to view different firms’ investments. Some firms, such as Microsoft, seem to be rewarded for additional R&D spending, while others, such as Ericsson, are more heavily discounted for similar spending. This difference may well be attributable to historical track records of the firms as well as varying degrees of information asymmetry around R&D investments. This variance in effect between firms exists not only for R&D investment, but other investment types as well, including capital expenditure. These results imply both that markets view investment types differently (e.g., capital versus R&D) and also that the identity of the firm matters within investment type (e.g., R&D).
We find similarly consistent relationships of market discounting with institutional investor behavior and other external market pressures on firms. Firms held by institutional investors that own investments for shorter periods are more heavily discounted by the markets. This is consistent with earlier research showing that firms cut R&D spending to meet earnings expectations when held by such owners. We also find that firms are more heavily discounted when they face more significant external pressures that increase the responsiveness of share price to news, including the extent of analyst coverage and earnings response coefficients, or when they are subject to the threat of shareholder activism. Since we expect that these factors influence firm strategy and investment behavior through a variety of mechanisms, but particularly stock based executive compensation, we also examine long term executive compensation and find a negative relationship with market discounting.
On the basis of strong observed trends and consistent correlations with measures capturing market and firm behaviors that have direct implications for time horizons, we provide strong evidence not only of shrinking investment horizons in the capital market, but also argue that such a trend may reflect public firms shifting their focus towards the short term. This shortening of time horizons may well be rational for investors. Uncertainty over technology change, globalization exposure, and other market-wide shifts point to less optimism for long-term returns and shortened investment cycles at the market level. We conjecture that this signals rising impatience around firm level returns.
While a shortening of investor time horizons may be a rational (and perhaps even optimal) response, it is unclear that the same is true for the effect of market impatience on firms. Given the link between share prices and executive compensation in many firms, markets can exert significant pressure on firm behavior. If, as a result of shifting market preferences, firms alter their investment strategy to favor short-term payoffs at the expense of potentially larger, but longer term and more uncertain payoffs, long-term growth and performance may suffer. Ultimately, whether this is true depends on the match between investor time horizons and the ideal time horizons for a particular firm. The ideal time horizon for investments varies among firms, but given market trends and within-firm increases in discounting, at least some firms are clearly being pressured to change their investment horizons and strategy in sub-optimal ways. Unless the optimal investment time horizon has shortened for all firms across all industries, there will be a mismatch between investor preferences and optimal strategy for some and possibly many firms in our sample.
It’s difficult to overstate what this implies for longer-term firm productivity. If firms change their investment strategies to favor projects with more certain, short-term yields over long-term projects with higher payoffs, then changing market preferences can profoundly alter long-term productivity and growth. For example, while firm R&D investment has increased significantly in recent decades, pressures to focus on the near term may lead firms to invest in different types of R&D projects, such as customizing existing products to new customers rather than developing new materials or products that would fuel long-term growth. The impact of these investment decisions spills over to the broader economy, affecting economy-wide productivity and growth.
Taken together, our findings have broad implications for policy makers, managers, and academics. By demonstrating that discounting of firm long-term value has intensified throughout the economy in the last 30 years, we hope to advance the debate over short-termism towards a productive dialogue of potential implications and responses.
This post comes to us from Professor Rachelle Sampson at the University of Maryland’s Robert H. Smith School of Business and Yuan Shi, a PhD candidate at the school. Sampson is currently a visiting professor at Georgetown University’s McDonough School of Business. The post is based on their recent article, “Are US Markets Becoming More Short-Term Oriented? Evidence and Implications of Market Discounting of Firms, 1980-2013,” available here.