Managers of public companies are under constant pressure to meet quarterly guidance and maximize profits, often at the expense of future profitability. Those pressures, driven by a number of factors, are likely to increase in the next 10 to 15 years as corporate profits decline and labor costs rise. Public companies are dying faster than ever, and these contracting corporate life spans are, on average, diminishing long-term value creation, making it more important than ever that business leaders act to ensure that the drivefor short-term performance doesn’t come at the expense of sustainable value creation. Along with board members and investors, business leaders should review their companies’ governance structures and consider whether any changes could better serve their long-term prospects.

What is driving short-term behavior?

Activist hedge funds Activist investors are gaining ground in the governance of public companies. In 2014, activists gained board seats at 107 companies, an all-time record that is likely to be broken this year. And, when companies resisted putting activists on their boards, the activists won proxy contests 73 percent of the time last year.

Increasing payouts to shareholders is one of the most frequent demands of activist hedge funds, after obtaining board seats and M&A campaigns such as sale of the company or a spin-off, and these demands drive some short-term behavior. From October 2008 through August 15, 2015, hedge fund activists led more than 220 public campaigns against US companies to increase payouts to shareholders.

Short-Term Behavior

Short-Term Behavior

Executive compensation design The design of stock compensation, the main component of executive pay, may exacerbate that focus on short-term results. Performance triggers for stock compensation that are tied to near-term indicators, such as earnings per share or one-year share price increases, encourage executives to focus more on short-term share price and accounting measures than on long-term performance. Stock compensation is also linked to increasing stock buyback programs at companies that seek to offset dilution to shareholders when options are exercised or share grants vest. Whether buybacks add or destroy value depends upon the price paid relative to intrinsic value. If a company pays less than intrinsic value (i.e., shares are cheap), a buyback will add value. If the company pays more than intrinsic value (i.e., shares are expensive) a buyback will destroy value, since wealth is transferred from those who hold to those who sold.

Quarterly capitalism Pressure on managers of public companies to meet quarterly earnings is one of the most often-cited drivers of corporate behavior focused on short-term value extraction, which often comes at the expense of long-term value creation-reduced investing to meet earnings targets. When asked how much of their companies’ quarterly earnings or revenue targets could be put at risk to pursue an investment with a positive net present value that would boost profits by 10 percent over the next three years, a majority of more than 1,000 C-level executives and directors surveyed by McKinsey & Company and Canada Pension Plan Investment Board responded that their companies would not be willing to accept significantly lower quarterly earnings for this kind of investment, and nearly half said short-term pressures reduce their companies’ willingness to pursue investments with less certain returns. The vast majority felt the most pressure to deliver financial results in two years or less, despite the fact that 86 percent said using a longer time horizon to make business decisions would positively affect financial returns and innovation.

Changes in capital markets: from investing to trading Changes in the stock market itself contribute to short-termism. Technological and regulatory changes have reduced the costs of trading stocks, giving rise to high-frequency traders and more frequent trading by many other market participants.5 Trading does not provide capital for investment in the business; it simply flows capital between shareholders. Stock markets have largely become trading platforms in which capital is directed not to business but to traders.

What Can Be Done?

Leaders and stakeholders should discuss these recommendations in the context of their company’s particular circumstances as they determine how best to move forward to achieve their long-term strategy.

Governance changes public companies, with support of their investors, can make

Abandon quarterly bottom-line earnings guidance and replace it with longer-term guidance and information that is material to the company’s longer-term prospects. Investors can encourage the companies they own to shift away from issuing quarterly guidance to focus on communicating metrics that are material to long-term value creation-for example, 10-year economic value added, R&D efficiency, patent pipelines, multiyear return on capital investments, and energy intensity of production. A balanced scorecard approach can help boards communicate non-financial metrics to help guide strategy when income statements don’t capture the emerging story.

Revamp executive compensation to reward longer-term thinking.

Companies should review the design of their executive pay to ensure that it effectively incentivizes thinking beyond the current stock price movements. In particular, companies should consider stock ownership guidelines or retention policies and should ensure that their long-term incentive plan design measures performance in a way that is consistent with company strategy.

Stock ownership guidelines obligate executives to act as “buy and hold” investors by requiring them to purchase and hold a substantial number of shares according to policies tailored to the company’s circumstances.6 Another variation on this theme is to require executives to retain most of their shares awarded under compensation plans for several years or until they retire (with an allowance to sell a limited number of shares to cover taxes due on vesting of stock awards or exercise of options).

Incentive plan metrics should measure performance consistent with company strategy. Long-term incentive plan design can be improved by applying value-based performance metrics such as return on invested capital relative to their weighted average cost ofcapital and/or economic profit in performance measurement design and a move away from a dominant use of total shareholder return or earnings per share. Future value improvement drivers (i.e., innovation, customer loyalty) can be added to the performance metrics mix, and the long-term investment plan design and the performance period for named executive officers can be extended beyond three years.

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