Short-term corporate behavior is a major problem in the 21st century firm. Too many companies prioritize quarterly earnings over long-term innovation, human capital investment, and brand development, and many people believe short-term shareholders are to blame. The popular argument goes as follows: Short-term investors – those who hold onto a stock for less than, say, a year – aren’t interested in the company’s prospects beyond that year. So, if the company misses its quarterly earnings target, they sell their shares. The fear of such selling forces the firm to fixate on meeting the target, cutting investment to do so. Moreover, since shareholders can sell at the drop of a hat, the firm has no stable source of long-term capital, and so cannot make long-term plans.
Loi Florange doubles investors’ voting rights after two years. Hillary Clinton proposed a sharply higher capital gains tax on shares held for fewer than two years. Some companies take matters into their own hands. Toyota has a class of shares that gives investors “loyalty dividends” if they hold onto them for five years. Other proposals go further. Arguing that shareholders are irremediably short-term, they advocate abandoning shareholder primacy altogether by putting other stakeholders on boards, or giving stakeholders equal priority with shareholders in terms of directors’ fiduciary duties.
We must indeed ensure that companies act in the long-term interest of all stakeholders, not just shareholders. And there are many reforms that can facilitate this, such as increasing the horizon of executive pay, as I have argued before. However, laying the blame on short-term shareholders is shooting at the wrong target, and may actually make things worse.
The error in the popular argument is that it confuses the holding period of a shareholder with her orientation. Short-term selling need not be based on short-term information.
Take a company that is thinking about cutting investment to boost earnings, hoping to inflate its stock price. An informed shareholder, who looks beyond earnings numbers and analyzes the company’s intangible assets, would notice that the firm has mortgaged its future. She would sell her shares, pushing the stock price down. Anticipating this, the company will decide not to cut investment in the first place.
Critically, short-term selling by shareholders need not entail short-term behavior by managers. Instead, it disciplines it, a mechanism known as “governance by exit”. In fact, the evidence shows that much-maligned short-sellers actually discipline earnings management, the practice of making a company’s performance look better than it is in order to meet an earnings target.
Thus, what matters is not whether shareholders hold for the long-term, but whether they trade on long-term information. So how can we ensure the latter? By encouraging them to take large stakes. Gathering information on a firm’s intangible assets is costly, and so not worth doing if you own only a tiny bit of stock in a company. Small shareholders have little “skin in the game” and so will not bother to bear this cost, and so will base their trading decisions on freely available short-term information. Large shareholders – blockholders – do have incentives to gather intangible information. Doing so not only deters manipulation, but also actively encourages long-term investment. If earnings are low, “the market sells first and asks questions later” as the adage goes. But blockholders, due to their large stakes, have the incentive to ask questions first. If they find out that low earnings are due to investment, rather than inefficiency, they will not sell – and may even buy more. Blockholders thus shield firms from the vagaries of uninformed investors.
For these reasons, the focus should be on creating large shareholders, not long-term shareholders. And this highlights the problems with one of the common proposals for dealing with short-termism: lock-in schemes. First, they discourage shareholders from building large stakes in the first place. If investors know that they will be locked up for several years, they will be less willing to buy a stake – just like the requirement to sign a five-year lease would deter many renters. Proponents of lock-ups argue that, all else equal, it’s best to stick with a company’s current shareholder base. But, all else is not equal – if shareholders knew they had to wait several years to have full voting power or avoid excessive taxes, many might not be there to begin with – the current shareholder base would be different in the first place.
Second, lock-in hinders shareholders from building large stakes by making it less likely that other, smaller shareholders are willing to sell. Shareholders can only buy if other shareholders sell. Trades of large blocks between investors lead to a significant increase in firm value, consistent with the block being reallocated to a more effective monitor.
Third, even taking the existence of a large shareholder as given, loyalty dividends encourage only holding for the long-term, rather than stewardship. An investor can outperform the market by simply waiting to collect the dividend. She will be less willing to gather long-term information if she knows that she will be unlikely to use this information by selling. And if the investor has to wait two years before she has full voting power, she has limited “voice” – ability to engage directly with the company. Moreover, engaged investors are in short supply. Once an investor has successfully turned around a company, she should be able to take her capital and reform another company, rather than having to stick around afterwards.
Finally, the criticism of liquidity and short-term trading is not new, and the evidence does not support it. An influential 1992 HBR article by Michael Porter advocated the Japanese model of long-term illiquid stakes. But the intervening 25 years suggests that Japan is not the model economy previously thought. While Japan’s underperformance has many causes other than illiquidity, there is direct evidence on the benefits of liquidity. These studies use the decimalization of the major U.S. stock exchanges in 2002 to identify causation rather than mere correlation. Decimalization made trading cheaper and improved firm value — particularly in firms with large shareholders — suggesting that governance through exit was a key driver of the improvement. It also encouraged more blockholders to form in the first place.
Turning from evidence on liquidity to evidence on short-term investors, activist hedge funds are seen as the epitome of the latter – allegedly stripping assets and piling on debt to make a quick buck. However, a decade of research finds that hedge fund activism raises firm value by 7%, with no long-term reversal. This increase in value is not through piling on debt but improving labor productivity. Productivity also improves in plants sold by hedge funds. This suggests that such sales are not asset stripping, but reallocating assets to buyers who can make better use of them.
What about innovation? Hedge funds do cut R&D, which might seem to be the “smoking gun” proving short-termism. But the number and quality of future patents improves – hedge funds get more with less. This illustrates a broader point for the short-termism debate. Commentators often use investment expenditure to measure short-termism, but it takes no skill to simply spend money. Responsible companies don’t invest willy-nilly, but judiciously. What matters is the output of an investment, not the input.
Additionally, the very idea of “patient capital” is misleading in a critical respect. Some commentators compare short-term equity to short-term debt. Short-term debt only provides a firm with short-term capital; at maturity, the investor gets back her money. The analogy implies that short-term equity sales similarly deprive a firm of capital – that shareholders “take it back”, according to a recent HBR article. But when an investor sells her shares, she sells them to another investor, not back to the company. The company still has its capital. In this sense, all equity is patient capital. The firm is guaranteed the capital regardless of whether the investor subsequently sells it on the secondary market.
In sum, we do want shareholders to be loyal. But, unconditional loyalty – staying with a firm, regardless of whether it is destroying long-run value – does not provide good governance and simply entrenches management. This was the case with Volkswagen’s long-term shareholders, and has been an unintended consequence of the Loi Florange.
The best form of loyalty is conditional loyalty: staying with a firm, even if short-term earnings are low, but only if the firm is pursuing long-run value. It is the combination of loyalty if the firm continuously innovates for the long-term, plus the threat of exit if it coasts or pursues the short-term, that will help build the great companies of the future.
In business, stakeholders should have the right to walk away. Banks, workers, customers, and suppliers can all quit, depriving a firm of credit, labour, customs, or supplies. The “Delete Uber” exodus is heralded as an example of customer governance, not short-termism. The same should be true of shareholders.