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Source: The Harvard Law School Forum on Corporate Governance and Financial Regulation, October 12, 2015 posting

Observations on Short-Termism and Long-Termism

Posted by Charles Nathan, RLM Finsbury, on Monday, October 12, 2015

Editor’s Note: Charles Nathan is partner and head of the Corporate Governance Practice at RLM Finsbury. This post responds to a post by Robert C. Pozen, titled Institutional Investors and Corporate Short-Termism. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here), and The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here).

The debate about whether U.S. public companies are afflicted by short-termism rather than more beneficial longer-term behavior and, if so, its effect on our economy is ubiquitous. It occupies increasing attention in corporate board rooms, executive suites and investment management businesses from the smallest to the largest. The debate is a commonplace topic in the legal and academic worlds as well as the financial press, and it is rapidly spreading to more general news outlets and the political scene—to the point where at least one Presidential candidate has made the debate a focal point of her tax reform platform.

A complicating factor in the debate is that there is no consensus about what short-term and long-term refer to. Is or should the debate be about:

  • investor behavior (e.g., short-term traders versus long-term holders),

  • investor objectives (e.g., increases in portfolio value in the short-term at the cost of foregoing better long-term fund performance),

  • corporate behavior (e.g., focusing on short-term profitability to meet or better quarterly performance goals to the detriment of greater long-term profitability), or

  • corporate objectives and strategy (e.g., engaging in financial engineering to generate short-term value creation, thereby precluding long-term investment in building the business through research and development, improved plants and production methods or product and market expansion)?

In this post we offer some observations on the debate, as well as its rhetoric and assumptions, in an effort to bring some clarity to the topic, identify the important issues and resolve at least some of them.

Four Critical Fallacies

The duration of any investor’s holding period in a company’s stock is simply not relevant to issues involving corporate value creation. In today’s equity markets there is virtually no end of investment styles and goals which vary greatly on many levels, including projected or actual duration of discrete portfolio positions.

  • Index funds and their EFT equivalents, by hypothesis, must remain invested (directly or synthetically) in every equity within their index, adding a new stock to portfolio only when its issuer is added to the index, and eliminating a stock from portfolio only when the company is dropped from the index. These types of quantitative funds are the epitome of long-term investors—they always own the index. But the fact that they are long-term investors says little about their behavior as voting shareholders. In fact, index investors are often among the most avid supporters of short-term corporate initiatives.

  • Other quantitative investors, such as high frequency and other program traders, may trade in and out of a specific security multiple times in one day or even in an hour or minutes, creating a new epitome of short-term trading. But it is hard to see how such avowedly short-term traders have a meaningful effect on corporate behavior and strategy. They are involved in corporate governance only by the accident of holding a stock at the close of business on a record date for a shareholder meeting. Whether in that case they do vote and, if so, for or against management is an idiosyncratic response. The extremely short duration of their holding periods seems relevant only to trading volumes and portfolio turn-over statistics (as well, of course, their asserted potential to distort market pricing).

  • Actively managed portfolios, unlike index funds, partake of both long-term investing behavior (e.g., establishing and maintaining a position in a desired stock often for years) and short-term buying and selling (e.g., to adjust the size of a portfolio position in reaction to one or more macro and micro factors affecting the portfolio company). Their apparently short-term trading decisions may be based on the long-term fundamentals of the issuer or on shorter-term considerations, such as a weak quarterly performance. But their short-term portfolio “balancing” rarely affects the long-term inclusion of a company’s stock in the investor’s portfolio. Moreover, while their voting on matters affecting corporate governance and strategy may be more informed than that of quantitative investors, it hardly falls into a specific pattern of supporting or opposing management initiatives and strategies based on the projected duration of the program.

  • Activist investors are often characterized as short-term investors. However, it is quite clear that their holding period for any given portfolio equity may range from days to years, thus belying a facile characterization of their trading behavior.

  • Another problem with characterizing investor holding periods as short or long-term is deciding at what point in time a holding period is to be measured, as well as differentiating between entrances and exits from a stock position and adjustments to a portfolio position in light of the investor’s investment style and objectives. For example, if a hedge fund has a large position in a company’s stock for three years and decides to liquidate the position in its entirety based on a discrete event, is the fund’s behavior short-term (the time between the event and the sale of the position) or long-term (the time between creation and elimination of the position)? Similarly if an investor buys into a stock for the first time and its behavior is viewed 30 days later, is it acting in the short or long-term? What if it intends to maintain the position indefinitely but changes its mind three months later?

  • Finally, and most telling, there is simply no connection between an investor’s holding period for a given stock and the behavior of the issuer. Of course, issuers may wish to build a base of long-term holders to reduce volatility in their stock price and to facilitate investor relations and relationships. But their underlying concern is to create more buyers and fewer sellers of their stock. Companies are concerned principally with buying and selling imbalances in the market which cause increases or decreases in the price of their stock. It is not the duration of the buyers’ and sellers’ holding periods that matters to the issuer—it is the act of buying or selling that matters, without regard to the holding period objectives or practices of the investor.

A second fallacy is that the duration of a prototypical investment implied by a particular investment style or objective of a shareholder is relevant to the corporate value creation discussion. It is clear that some investors, albeit for different reasons (contrast an index investor when a new stock is added to an index and a fundamental value investor, like Warren Buffet, who decides to make an investment in a new portfolio company), establish positions in a stock as part of a consciously long-term investment strategy. In contrast, of course, are consciously short-term traders (think day traders and high frequency traders, whose investment strategy in the extreme case may be to buy and sell on the basis of mere basis point changes in the price of a stock). The reality is that some investors are or want to be long-term holders, some are wholly short-term in their investment style and are more than willing to own a stock for minutes or seconds, and many are simply agnostic about the duration of their holding period for a particular equity. Projected and actual holding periods under the multitude of investment strategies being practiced vary all over the short-term/long-term continuum. But that fact says nothing about corporate behavior. As noted above, companies are insensitive to investment styles, but highly sensitive to the balance of buyers and sellers in the market.

A third fallacy is that the duration of a company’s business initiative (whether involving capital allocation, entrance or departure from a line of business, investment or dis-investment in R&D, plants or products, diversification, concentration or any other strategic or tactical program) has an implicit connection to value creation. Too often, the term “short-term” is applied to a business tactic or strategy as a pejorative, as if a long-term initiative inherently creates more value than a short-term program. This is patently not true. The correct question in every case is not how short or long the duration of the initiative, but rather whether it will generate more net present value than the available alternatives. The answer to this question will obviously vary from initiative to initiative—it will not be the same for every company, even those deemed most comparable—nor will it be the same for a company when addressed at different points in time when circumstances differ.

The fourth fallacy in the short-term—long-term debate is that, given every company’s finite resources, choosing a corporate strategy that can be implemented in a relatively short-time period (often a type of so-called “financial engineering”, such as a major stock buyback, a divestiture or spin-off of a business or a sale of the entire company) prejudices, if it does not preclude, longer-term more beneficial strategies (such as greater investment in R&D, upgrading productivity of plants and equipment or acquisitions). This formulation of the debate associates activist investors with short-term strategies at the cost to the company and its other shareholders of greater long-term value creation. But this formulation of the debate simply does not make sense. Activist funds are in business to maximize value creation for their investors (and for their principals who get rich on their carry and their investment in their own funds). Why would any rational activist investor consciously forgo the higher net present value of a long-term company business initiative in favor of the investor’s lower short-term value creating idea? Activist fund managers don’t get paid for ego trips; they get paid for maximizing returns. The same, of course, is true for all actively managed institutional investors. Even index and other quantitative investors should opt for the highest net present value creator if they have the capability of understanding and evaluating the competing proposals. In theory, only short sellers should oppose the highest net present value added program regardless of its duration.

Properly Framed the Debate Should Be about Game Plans Not Time Duration

So then, what is the long-term, short-term debate all about? Stripped of the rhetoric and emotional biases of managements and boards, on the one hand, and investors, on the other hand, the debate is not about duration of implementation, but rather about evaluating competing agendas that frequently have different time horizons. While in theory net present value should be the arbiter of the debate, in practice it obviously is challenging to determine the net present value of a given corporate business initiative, and reasonable people can and will disagree about its calculation. Hence, activist campaigns are typically characterized by competing investor presentations, through which management and the activist each tries to demonstrate the value creation superiority of its business plan.

But if the debate does boil down to nothing more than investors’ choosing between two competing strategies for a company, why all of the heat and passion? Our view is that the source of much of the emotion is that boards, managements and their proponents believe that the shareholder vote (actual or projected) that ultimately resolves the conflict between an activist’s game plan and the board’s is unfairly stacked against the board.

Because most activist investor business plans focus on shorter-term solutions than those of management, it is convenient to characterize them as “short-term”, and there is no doubt that today “short-term” does have pejorative connotations. Viewed in this light, one would think that many institutional investors would be emotionally biased against activist investors and in favor of management’s typically longer-term program, not the contrary as believed by most managements and boards.

Are Institutional Investors Biased in Favor of Activists and Against Boards?

There is at least one objective reason why investors might, in general, favor activist campaigns focusing on shorter-term initiatives. After all, the longer the duration of implementation of a business strategy, the greater the risk of miscalculation of its net present value creation. While projections are inherently uncertain, it is clear that the uncertainty factor increases over their duration. Moreover, execution risk also rises as the time frame for implementation lengthens. To this extent, being biased in favor of a shorter-term program instead of a longer-term one makes sense. Passage of time is not a friend to confidence in projected outcomes. But this consideration, standing alone, does not seem sufficient to explain the concerns of management and boards with the impartiality of investors.

Why Many Institutional Investors Favor Activists

Over the past thirty years, institutional investors’ relationship with portfolio companies has changed drastically. Until the mid-1980s, the paradigm was simple. At actively managed funds portfolio managers and buy-side analysts were the sole point of contact with management; directors were simply not involved in the dialog. And, of course, quantitative investors had no reason to, and did not, have dialogs with management.

Beginning in the mid-1980s, this paradigm began to change as institutions increasingly felt compelled to vote, independently of management’s recommendations, on every ballot proposal for every shareholder meeting for every portfolio company. This represented a major change in policy from what many characterized as the “Wall Street Walk”—a policy of institutional investors to vote with management on all matters, and at least for all actively managed funds to sell a company’s stock when the institution lost faith in management. The demise of the Wall Street Walk resulted in a sea change in the way institutional investors dealt with the multitude of proxy votes they faced each year.

In response to the pressure to vote thousands of times each proxy season, institutional investors resorted to two or three complementary strategies.

  • First, almost all institutions created an internal team (separate from the portfolio management function at actively managed funds) specifically to manage the portfolio company share voting process. These teams, while initially small, have grown over the years as shareholder voting decisions and fund complexes have grown in number and complexity. This is particularly the case at quantitative firms where the voting decisions cannot be informed, let alone made, by the portfolio management function which simply does not exist.

  • Second, many institutional investors outsourced voting recommendations, and quite often voting decisions, to proxy advisory firms, today principally ISS and Glass Lewis.

  • Finally, the sheer number of voting decisions effectively demanded adoption of comprehensive voting policies by both investors and proxy advisory firms. The benefit of one-size-fits-all proxy voting policies, of course, is their ability to cope with thousands of voting decisions while requiring only a relatively small group of employees for implementation. In contrast, a far larger staff would be needed for a proxy advisor or institutional investor to deal with each ballot proposal on an individual case-by-case basis in the context of the particular circumstances at each portfolio company. The institutional investment community was simply not willing to commit the financial resources that would be required to support a case-by-case approach to share voting.

More important to the issue of bias against management and boards, the dominant philosophy driving the creation and implementation of ISS’ and institutional investors’ voting policies has consistently been aligned with a populist/progressive skepticism about the motivations and behavior of corporations and their managements. This was true in the late 1980s when ISS and some pioneering public pension funds began to push back against the Wall Street Walk, and it remains true today, well after the Walk vanished into the pages of financial history as the prevailing voting paradigm. The negative populist/progressive view of corporate management, moreover, has gained additional credibility from a number of events and the popular narrative surrounding them.

  • First, the resistance of boards and management to the takeover wave of the 1980s (in particular, the widespread adoption of Poison Pills throughout corporate America) was quickly labeled as systemic “entrenchment” by many investors and not-infrequently by courts. The opposition to takeover defense and management entrenchment further benefitted from the wide-spread support of academics, both Chicago School free market enthusiasts and shareholder empowerment advocates. Thought leaders at ISS and a number of investors (principally state and local pension funds and union pension funds) soon converted their philosophical distrust of corporate management into a campaign to critically examine and improve corporate governance at U.S. companies, often starting with redemption of Poison Pills. By the early 1990s the die was cast. Corporate governance reform became the dominant policy not only of the proxy advisors but also of the managers of the proxy voting process at state, local and union pension funds and an ever increasing number of for-profit institutional investors.

  • The negative view of corporate management and boards gained additional credence during the wave of corporate scandals in the early years of this Century which preceded and was responsible for the enactment of the Sarbanes-Oxley Act. Rightly or wrongly, the sins of the relatively few were attributed far more broadly to corporate America as a whole by a large swath of the public, the press and the political establishment, making it even more important in the eyes of the corporate governance community to rein in bad managerial behavior by major reforms in corporate governance.

  • The suspicion and, too often distrust, of corporate management was yet again reinforced by the virtually universal attribution of the financial crisis of 2007 -2009 to bad (if not venal) managements and boards. The fact that, at most, only a portion of the financial services industry (principally, money center banks and major investment banks) were connected to the events that gave rise to the crisis seemed not to matter to most of America. The prevailing narrative quickly became that the crisis was the fault of bad governance at public U.S. companies.

The end result, fairly or not, is that the corporate governance movement is not a natural friend of management and boards. It was born and bred from a philosophy of distrust and opposition to them. Given its provenance and history, it is hardly surprising that the corporate governance community seems (and probably is) biased against management and in favor of activist investors, particularly when the activists embrace corporate governance reform as part of their campaigns against management.

Can the Bias of Corporate Governance Activists Be Overcome?

This, of course, is the question du jour for management and boards today, whether or not their company is faced with an actual or imminent activist campaign. It is the ultimate rationale for the growing importance of the concept of “engagement” that is now offered as a universal component of every activist defense playbook. Engagement, quite simply, is the idea that senior management and, more importantly, directors must get to know the corporate governance staffs at their major investors in order to establish bonds of confidence and trust in the strategy of company and its senior leadership.

Whether a successful engagement campaign will prove sufficient to overcome the negative bias of the corporate governance community in the context of an activist campaign is the sixty-four dollar question. But there do not seem to be any other remedies available to a company in today’s world.

  • A variety of defenders of corporate America against activist investing have and continue to campaign against activism and the institutional investor bias in favor of activists through a variety of media utilizing a number of arguments—for example, asserting that activists don’t create lasting corporate value enhancements. However, this type of argumentation has not worked to date, and there is nothing on the horizon to suggest that it will be more successful in the future.

  • It is not plausible to think that the corporate governance community’s strangle hold on proxy voting at the vast majority of institutional investors will go away. While it is possible that some portfolio managers may gain a greater voice in voting decisions on activist campaigns, this will only be true for actively managed funds in a world where assets seem to be flowing toward quantitative investment strategies.

  • Nor is it any more realistic to think that the corporate governance world, the academic community or the press will soon alter their generally negative views of corporate management’s motives and behavior, which is a critical underlying component of the prevailing pro-activist bias on the part of the “owners” of the proxy machinery.

  • Another possible solution could be a relative implosion in the credibility of activist investor game plans brought about by a regression to the mean as the growing size of the activist investor asset class overwhelms the number of available deserving corporate targets. Even if this were to occur, it will not happen quickly, and in any event some number of the more competent activists will continue to post out-sized returns, even though more mundane members of the pack falter or even fail.

  • Another answer, in theory, could be some form of government intervention. For example, some advocate imposing fiduciary standards on the world of public pension fund administrators, as well as on the proxy advisory industry. This, however, is an unlikely antidote. After all, all the other participants in the institutional investor community have long been subject to strict fiduciary standards under both ERISA and the 1940 Investment Company and Investment Advisors Acts. Others have suggested deterring or foreclosing so-called short-termism through changes in capital gains taxation and/or capital gains treatment for carried interest. However, adoption of these proposals are unlikely to bring activism to a halt. They might alter activist investor holding periods or the economics for the principals at activist investors, but such changes in the tax law are unlikely to end the appeal of activist investing so long as activists continue to produce above-market equity returns for their investors.

What About Actively Managed Institutional Funds?

But, one might ask, what about actively managed funds. Surely, portfolio managers and buy-side analysts should understand the concept that net present value creation does not demand selection of shorter-term corporate strategies at the cost of greater value creating long-term programs. While fund complexes housing actively managed funds may have corporate governance specialists manning the proxy voting function, don’t (or shouldn’t) portfolio managers have significant influence, or better yet control, of proxy votes on economic matters, such as an activist investor campaign.

Indeed, portfolio managers usually do count in proxy voting decisions at least on economic matters. However, the expectation that portfolio will automatically support greater net value creation, even if it requires more time for realization, does not take into account the reality of asset-gathering by institutional investors—which, after all, is the lifeblood of the asset management industry. For better or worse, asset gathering today is irrevocably tethered to quarterly performance. The vast majority of investors in actively managed portfolios (be they individuals with IRAs or 401K accounts or fiduciaries for public and private pension funds, foundations and charities) base their asset allocations on their funds’ quarterly performance measured against the relevant benchmark indices. Put simply, an active investment manager to be successful in the current environment must pay heed to its performance on a quarterly basis. This, in turn, explains why portfolio managers may be biased in favor shorter-term initiatives than longer-term ones, even if the latter are likely to produce higher net value in the long-term. The search for “alpha” by active asset managers is not just constant, but because of the pressure of being measured quarterly, immediate.

Ironically, as a result, actively managed funds are often more likely to support short-term value creation programs than quantitative investors, many of whom do have a longer-term perspective. It was not simply a coincidence that DuPont won its recent proxy contest with Trian by virtue of the support of a number of the largest quantitative investors in the country. A company has few weapons to combat the bias of active portfolio managers favoring shorter-term value creation programs simply on a durational basis. Best among them is engagement with the portfolio management function, as well as the corporate governance function, in order to establish sufficient trust and confidence in management and the board to overcome that bias.

Conclusion

For better or worse, engagement is management’s and directors’ best, and perhaps only, hope to obtain a relatively unbiased hearing from the proxy voting decision makers in the context of an activist campaign. At the very least, it is something all companies should be seriously examining today, if they have not already embraced the policy.

The difficulty, however, is that for all but the larger-cap companies getting a hearing at their key institutional investors is easier said than done because institutional investors rarely have the bandwidth to meaningfully engage with all of their portfolio companies. Ironically, this problem is most apparent at the larger institutions whose portfolios encompass thousands of companies. Smaller investors which focus on relatively concentrated portfolios may prove easier targets for productive engagement.

The bottom line, unfortunately, is that for the foreseeable future corporate America will have to continue to live with an investor community that is inherently biased in favor of activism. At best, the larger companies and some of the more fortunate mid-cap and smaller companies may be able to ameliorate this bias by engaging productively with their key investors. The vast majority may just have to accept their potential victimhood.

 

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