03
April
2018
|
16:40
Europe/Amsterdam

The Price of Corporate Short-termism, and the influence of Investor-Horizons

Summary

How much impact does a short-horizon investor base have on the behaviour of corporate executives – and what is the follow-on effect on long-term firm value?

In his master thesis, Tobias Ouwerkerk [MSc Finance Tilburg University 2017], one of the talented interns taken on by Kempen, focused on the causes and consequences of corporate short-termism. His research has yielded some interesting findings:

1. Executives knowingly shift the balance between the short- and long-term to accommodate a short-horizon investor base

2. Actions to inflate near-term earnings have a negative effect on long-term firm value

“This study represents another step towards understanding the sources and consequences of corporate short-termism. The advancements made provide essential knowledge for investors, leaders in business and governments, and can be used to design interventions to restore the balance between short-term accountability and long-term value creation,” says Ouwerkerk.

This study aims to address the questions of whether short-horizon investor ownership induces corporate short-termism, and whether this comes at the cost of long-term value. The research provides evidence that executives knowingly shift the balance between short- and long-term to accommodate a short-horizon investor base, as the presence of short-horizon investors is associated with greater use of earnings management, higher probabilities of marginally beating targets, R&D investment cuts, and lower ESG scores. With regards to the price of short-termism, this study provides evidence that corporate short-termism does indeed have a detrimental effect on long-term firm value, as firms that display short-termism exhibit financial underperformance relative to firms that do not.

Introduction

The questions of whether short-horizon investors induce corporate short-termism, and whether this comes at the cost of long-term value, have been the subject of debate among leaders in business, government, and academia for decades. First-hand evidence is provided by Graham et al. (2005), who surveyed executives and discovered that 78% were willing to forgo positive NPV projects to meet short-term earnings targets.

This research focusses on the assertion that there is a positive relation between short-horizon investors and executives’ decisions to inflate near-term earnings, at the cost of long-term value. The assumption is that executives, incentivized by short-horizon investors through short-term payment, take actions to temporarily inflate valuations. Short-horizon investors are able to benefit from these temporarily inflated stock prices by selling shortly afterwards to other, overly optimistic shareholders. In turn, investors that remain in the company suffer from a reduction in firm-value caused by the negative effects of earnings manipulation and investment cuts.

 

 

 

 

 

 

 
Figure 1: Methodology used to identify short-termism, both indirectly through investor horizons, and directly by computing a corporate horizon index.

Measuring short-termism is a far-reaching challenge in the advancement of the debate. Extant literature has taken the approach of using investor horizons as an indirect proxy to assess the firm value consequences of short-termism. In an effort to capture corporate short-termism and its effect on financial performance more directly, this research constructs an index by aggregating different measures associated with corporate short-termism. Most empirical research on short-termism is conducted for US samples, whereas surveys show that the issue of short-termism is not confined to the US. The research in this study contributes to the current literature by investigating whether the association between investor-horizons, corporate short-termism and financial performance holds for the EU.

Analysis and findings

1. Executives knowingly shift the balance between the long- and short-term towards the short-term to accommodate a short-horizon investor base

We measure corporate short-termism through a set of actions/symptoms that indicate an overemphasis on the short-term: earnings management, target beating, investment cuts and lower environmental, social and governance (ESG) scores. In turn, the presence of short-horizon investors is determined on the basis of institutional investor portfolio turnover.

 

 

 

 

 

 

 
Figure 2: Positive relationships exist between short-horizon ownership, and corporate actions associated with short-termism.

We find that firms with more short-horizon investors are more likely to engage in actions that inflate near-term earnings, and less likely to engage in actions whose benefits occur several years into the future. Firms with more short-term investors exhibit greater use of earnings management, which translates into avoidance of small losses and a tendency to beat targets by marginal amounts. With regards to capital allocation, the research finds that the arrival of short-term investors leads to a reduction in research and development (R&D) expenditures. Lastly, the study finds that short-horizon ownership predicts lower ESG scores in the subsequent year.

2. Actions to inflate near-term earnings have a negative effect on long-term firm value

To answer the fundamental question of whether short-term actions have a detrimental effect on long-term firm value, shareholder value is used as arbiter. Portfolios are sorted on the principle component index of corporate short-termism.

 

 

 

 

 

 

 

 
Figure 3: Alpha across quintile portfolio’s sorted on the corporate horizon index. Quintile 1 contains companies marked as ‘long-term’ whereas quintile 5 contains those considered ‘short-term’.

The results show that firms that exhibit less of the actions/symptoms associated with short-termism outperform firms associated with short-termism, and that they generate returns above and beyond what is explained by common risk factors.

Implications and recommendations

This study represents another step towards understanding the sources and consequences of corporate short-termism. The advancements made provide essential knowledge for investors, leaders in business and governments, and can be used to design interventions to restore the balance between short-term accountability and long-term value creation. Academics should continue to unravel the inner-workings of short-termism, its costs and potential solutions.

Read the full thesis here