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Source: The Harvard Law School Forum on Corporate Governance and Financial Regulation, June 22, 2016 posting

How Economic Attention Deficit Disorder Infected the Corporate Boardroom

Posted by Jon Lukomnik, Investor Responsibility Research Center Institute, on Wednesday, June 22, 2016

Editor’s Note: Jon Lukomnik is the Executive Director of the Investor Responsibility Research Center Institute. The ideas in this post related to his new book, What They Do With Your Money: How the Financial System Fails Us and How to Fix It (Yale University Press), co-authored with Stephen Davis and David Pitt-Watson.

According to one widely reported study, three quarters of senior American corporate officials would not make an investment that would benefit a company over the long run if it would derail even one quarterly earnings report. [1] Combine that with the fact that corporate officials and institutional investors commonly over-discount the future, meaning that they don’t fully appreciate returns on investments that are more than a few months away. For instance, the Bank of England has found that cash flows five years away are actually valued in the marketplace as if they were eight years away and cash flows 30 years in the future are not valued at all. [2] “This is a market failure. It would tend to result in … long-duration projects suffering disproportionately… including infrastructure and high-tech investments… often felt to yield the highest long-term (private and social) returns and hence offer the biggest bang to future growth,” explained Andrew Haldane, the Bank’s Chief Economist. [3]

Simply put, we are suffering from an epidemic of Economic Attention Deficit Hyperactivity Disorder. But if short-term thinking at today’s companies is commonplace, the implications are profound. Economic ADHD silently robs us of wealth and decreases our standard of living.

If Economic ADHD is the disease, and underinvestment in our economy the symptom, what is the cause? Absent discovering how and why Economic ADHD infects the board room, the odds of reversing it are slim.

Let’s start our forensic search in the capital markets. In theory, at least, we invest for the long term; for retirement, home ownership, education. Indeed, that used to be the case. In the 1930s, when the modern regulatory framework of our markets was established, the average holding period of a New York Stock Exchange traded stock was 10 years. By 2010 it was down to six months. While high-frequency traders certainly have some effect on that number, the truth is that even traditional mutual funds tend to turn over the value of their entire portfolios every year. [4]

What has changed? Almost everything, from computerization to a change in national market regulation. But let’s focus on three underlying contextual issues: the legal underpinning of our capital markets regulation, and the business model and culture of the investment management industry. These three factors often escape attention exactly because they are chronic and omnipresent rather than acute and sporadic. As a result, we tend to accept them as the background against which short-termism plays out, rather than examine them as causes which contribute to Economic ADHD.

Indeed, while we may call it “investing”, our capital markets and the investment industry are really organized around trading, at least insofar as public securities are concerned. Let’s begin with the legal architecture of our capital markets, which is built on disclosure to help trading markets, not on corporate law to help owners steward their investments.

There is a simple reason for this. Corporate law is largely a state matter. Indeed, sales of securities was, until the 1930s, largely a state matter, governed by the various states’ blue sky laws. Following the Great Depression, a consensus for national regulation bumped up against a constitutional issues: How can we grant Washington authority over companies, when there are Delaware companies, Nevada Companies, Massachusetts companies, but virtually no nationally-chartered companies? The solution was to focus on interstate commerce. Is it any wonder that the resultant national regulatory regime centers on disclosure so as to facilitate a market for securities sales and trading, not corporate stewardship.

Twenty years later, Nobel prize-winning economist Harry Markowitz invented modern portfolio theory (MPT). [5] MPT was a great step forward in that it popularized diversification, allowing investors/traders to hold “riskier” individual assets. But MPT also accelerate the trend towards trading by focusing on securities, rather than on the companies which issued them. For example, MPT judges the relative return and risk of an individual securities against that of the market overall. From there it was a minor step to investment managers judging how well they did by comparing their performance to that of the market, rather than against the long-term liabilities (e.g. the need for retirement income or offsetting mortgage payments). So, for example, an investment manager with a large-capitalization US stock portfolio will judge its performance against the S&P 500, or some other “market” index. Since the price movements of both the market and the managers’ portfolios can be measured continuously, they were. Pretty soon the excess or lesser performance was being measured quarterly or monthly or even daily (and, particularly on trading desks, in real time). An entire industry of performance measurement sprang up to compare investment managers’ performance month-to-month or quarter-to-quarter. As the amount of money those managers attract is materially affected by those short-term, market-relative returns, and as investment managers are paid based on how much they have in assets under management, the pressure to “beat the market” on a quarterly basis is intense.

In fact, most active traders trail the overall market. But that doesn’t stop them from turning over their portfolios in rapid fire bursts. One study found that two thirds of all institutional money managers trade more than they anticipate doing even though they know that doing so is likely to be disadvantageous. They advance various reasons for that, including both market and macroeconomic conditions, but, notably, they also mention behavioral biases such as herding and recency bias. Faced with ever changing situations and pressed for outperformance on a real-time basis, investment management houses have a hard time sitting still. [6]

The combination of a legal/regulatory structure based on disclosure for trading/price discovery purposes, plus the domination of MPT with its focus on securities rather than companies, has also shaped the dominant interpretation of fiduciary duty in the United States. For decades, it has been interpreted as encouraging investment managers, acting on behalf of beneficial owners, to maximize short-term financial results. Longer term sustainability issues were regarded as either irrelevant to fiduciary obligation or even, at times, as antithetical to it. [7]

To that you can add a dominant investing culture that focuses on short-term trading. We may say we admire Warren Buffet, whose “favorite holding period is forever,” [8] but more people watch those hyperactive television shows promoting trades for that day than read his annual letters. Do a Google search for “buy and hold is dead” and you will get more than 4 million hits. [9] You can buy videos, download podcasts, or enroll in training sessions all designed to get you to trade securities, rather than to own companies.

So the capital markets have become more short term. That begs a key question: How did Economic ADHD jump from the trading floor to the board room? Via the transmission mechanism of executive compensation. In trying to tie executive compensation to performance, we accepted that performance meant short-term stock market (price) performance, rather than anything more fundamental to the company. So, for instance, we cheered when the President Bill Clinton signed into law a tax law which made executive compensation of more than $1 million deductible only if it were performance related [10], and then said stock options and other types of compensation payable in currencies linked to the equity market’s price-setting mechanism—a mechanism designed to establish trading prices, not to run companies—would automatically qualify as performance related and therefore deductible. [11] As former Merck CEO Ray Gilmartin notes, how can you not expect short-termism when you pay senior management in a currency that fluctuates with every with every market up and down? [12]

Some might say, so what? Long-term performance is just a compilation of shorter periods. But it’s not quite that simple. By reducing the incentive to invest in NPV positive projects so as to reduce market price volatility, we have unintentionally contributed to the hollowing out of American productive capacity.

So how do we solve the problem. Solutions abound, from the Aspen Institute’s suggestion that companies end quarterly guidance [13] to changing the measurement period for executive compensation to be at least five years and changing the performance measures to better focus on drivers of a company’s future growth rather than stock market price. [14]

Those are all logical suggestions, in that they seek to divorce motivations in the boardroom from the short-term pressures of the capital markets. But perhaps instead of accepting the trading-oriented, short-termist legal, business and cultural underpinnings of the capital markets as givens, we should focus on changing them. There are innumerable efforts to do just that.

  • James Hawley, Keith Johnson and Ed Waitzer have written a succession of articles arguing that fiduciary duty is, and should evolve to consider longer-term sustainability issues. [15]

  • Generation Management and others claim the mantle of long-term investors, and Generation even published a white paper seeking to change how investment managers are paid. “Most compensation schemes emphasize short-term actions disproportionately …. Instead financial rewards should be paid out over the period during which these rewards are realized,” they wrote. [16]

  • Even international investor organizations are taking notice and trying to change the culture of the investment management industry. The United States is one of the few developed markets in the world which does not have a stewardship code for investors. But that gap may be plugged, at least partially, when the International Corporate Governance Network, representing asset owners and asset managers in 47 countries with $26 trillion under management, unveils its stewardship principles late this month at its annual general meeting in San Francisco. [17]

There are dozens of other initiatives focused on re-orienting public capital markets to investing and long-termism, rather than short-term trading. They are gaining traction—the number of signatories to the Principles for Responsible Investment (PRI) has grown to more than 1500 in its ten years of existence, but it seems to be a race against time, as an increasing amount of capital simply flees markets which the investors regard as short-term and goes to where a long-term focus is expected. The number of private equity firms in North America has more than doubled, growing from 936 in 2004 to 1956 in 2014. [18]

It’s time to recognize that Economic ADHD is an epidemic that is draining our economic future. Yes, the symptoms manifest themselves in corporate board rooms. And we have to combat them there. But we also must minimize the factors which gave birth to it: the legal, business and cultural short-termism which infest the capital markets.

Endnotes:

[1] John R. Graham, Campbell R. Harvey and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting,” Journal of Accounting and Economics 40, nos 1-3 (December 2005); 3-73.
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[2] Andrew Haldane, “The Short Long,” speech, May 2011.
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[3] Ibid.
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[4] James Saft, “The Wisdom of Exercising Patience in Investing” (Reuters, March 2, 2012).
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[5] Harry Markowitz “Portfolio Selection,” Journal of Finance 7, (March 1952): 77-91.
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[6] Danyelle Guyatt and Jon Lukomnik “Does Portfolio Turnover Exceed Expectation?”, Rotman International Journal of Pension Management 3, no 3 (Fall 2010): 40
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[7] James Hawley, Keith Johnson and Ed Waitzer, “Reclaiming Fiduciary Balance,” Rotman International Journal of Pension Management 4, no 2 (Fall 2011): 4-16
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[8] Warren Buffet, 1988 Annual Report of Berkshire Hathaway.
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[9] Google search performed May 27, 2016
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[10] Section 162(m) of the United States tax code.
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[11] Christopher Cox, “Testimony Concerning Backdating,” US Senate Committee on Banking, Housing and Urban Affairs, September 6, 2006.
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[12] Raymond Gilmartin, Comments to the 2013 Board Leadership Conference of the National Association of Corporate Directors, National Landing, Md.
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[13] See, for instance, The Aspen Institute, “In Focus: Earnings Guidance.” November 2007. Accessed May 29, 2016.
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[14] IRRC Institute and Organizational Capital Partners, “The Alignment Gap between Creating Value, Performance Measurement and Long-term Incentive Design,” 2014.
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[15] See, for example, Hawley, Johnson and Waitzer, above, as well as articles in the Cambridge Handbook of Institutional Investment and Fiduciary Duty (2014).
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[16] Generation Investment Management, “Sustainable Capitalism,” February 15, 2012.
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[17] www.icgn.org. Accessed May 30, 2016
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[18] http://pitchbook.com/news/articles/number-of-active-pe-firms-up-143-since-2000-a-global-breakdown. Accessed May 30, 2016.
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