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Author: chris dillow   |   Latest post: Mon, 19 Feb 2018, 02:09 PM

 

In defence of short-termism

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Rick says that UK companies are too short-termist, and that Carillion - which paid big dividends until soon before collapsing - is a manifestation of this. I'm not so sure.

Of course, some firms, like Carillion, have short-termist bosses and subsequently collapse. But is the collapse because of the short-termism? Or might it be instead that short-termism is a response to the prospect of collapse, and that rational managers, sensing their business is destined to fail, take money out of it?

And very many businesses do fail. The ONS shows that around 10% of firms cease trading each year, and less than half of them survive five years. Granted, failure rates are much smaller for larger or older firms. But in the long-term they are still considerable. For example, only three of the UK's largest employers in 1907 are independent stock market-listed firms today. And a list (pdf) of the original constituents of the FTSE 100 when it was formed in 1984 contains plenty of firms that subsequently declined. A failure rate of only 3% a year means that firms have a less than 50-50 chance of making it to their 25th birthday.

If you're not going to survive into the long-term, why not be short-termist?

And in a healthy dynamic economy, we should see lots of failures as competition and creative destruction eliminate profits. It's only monopolies or near-monopolies that can fight off competition for many years and afford to be long-termist. Do we really want that?*

What's more, creative destructive means there's uncertainty even for firms that do (with hindsight) survive. This uncertainty compounds over time. On a two or three year horizon, most decent firms have a reasonable idea of where the threats from rivals or new technology come from. On a two or three decade view, however, they have no clue. Faced with that uncertainty, why not focus upon managing the company well in the short-run?

In this context, long-termism isn't necessarily a virtue. It might instead reflect merely irrational overconfidence. Yes, short-termism might well be one cause of low capital spending. But high investment doesn't guarantee success. As Charles Lee and Salman Arif show, it often leads instead to lower profits. This is consistent with high investment being a sign not of rational long-termism but of irrational over-optimism. Hyly

We have some more empirical evidence here. Let's say that stock markets were too short-termist. In such a world, we'd expect them to under-price growth stocks and pay too much for stocks that pay high dividends. Generally speaking, though, the opposite has been the case. For most of the last 30 years, high-yielding shares in the FTSE 350 have out-performed lower-yielding ones: the main exception came between 2003 (when tech stocks were under-priced) and 2010**. And the FTSE Aim index - which contains many "growth" stocks" has horribly under-performed the All-share index since its inception in the mid-90s. This tells us that stock markets have generally paid too much for growth and too little for dividends. They have been too long-termist, not too short-termist.

Of course, managers can be as irrational as the rest of us. But it's possible to be too long-termist as well as too short-termist.

The biggest problem with corporate governance - as highlighted by Carillion - is not that bosses are too short-termist, but that they have too much power to plunder firms for their own private gain.

* There's a big difference here between the UK and US: the rise of monopoly power is more pronounced in the US than UK.

** In fact, given the big decline in long-term interest rates we should have seen growth stocks boom in the 00s as investors discounted future cashflows less heavily. That this didn't happen is yet more evidence that growth stocks have been over-priced.

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