Curbing Short-termism in Corporate America: Executive Compensation

Curbing Short-termism in Corporate America: Executive Compensation

Curbing Short-Termism in Corporate America:  Focus on Executive Compensation Robert C. Pozen – Harvard Goverence Studies  – May Issue

Short-termism – defined as judging company performance over a brief time period – has recently come under a barrage of criticisms from multiple sources – business groups, think tanks, academics and lawyers. The emphasis on short-termism is said to be destructive to American businesses – discouraging corporate executives from investing in long-term projects and sustainable growth, while encouraging them to inflate reports of quarterly earnings.

Arguments from the critics of short-termism

The critics of short-termism argue that rapid trading by shareholders of public companies is heavily pressuring company executives to focus on current earnings rather than long-term performance. According to these critics, such a short-term focus of corporate executives is exacerbated by the expanding rights of shareholders relative to directors and by the compensation rewards for brief increases in stock prices.

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Yet, long-termism seems alive and well in important aspects of corporate America. Investors have gobbled up initial public offerings of fledgling companies with growing revenues and no profits – presumably on the belief that those revenues will translate into profits over the next decade. Similarly, public shareholders have highly valued shares of biotech companies, like Amgen, Inc. (NASDAQ:AMGN) and Genentech, which have been investing large sums in long-term drug development.

To better understand the arguments on these topics, it is necessary to move away from looking at the “average” institutional investor and move toward looking at three subsets of investors: dedicated, transient and quasi-indexers. Most of the damaging effects of short-termism derive from the behavior of “transient” institutional ownership. Thus, the first section of this paper will dissect the composition of trading by different types of public shareholders. It will then go on to evaluate the three most popular proposals to curb short-termism:

  • Altering the compensation arrangements of asset managers and corporate executives,
  • Constraining the rapid trading of stocks by public investors, and
  • Limiting the influence of institutional shareholders on corporate governance.

This paper will conclude that:

  • The most effective way to curb short-termism would be to lengthen the time horizons in the compensation packages of asset managers and corporate executives,
  • Other effective measures to curb short-termism would be to limit “empty voting” by investors not owning shares and to discourage companies from publicly projecting their quarterly earnings,
  • The proposals to constrain rapid trading, even if they reduced trading volume, would not significantly change the business plans of most corporations, and
  • The benefits from most proposals to reduce the governance influence of institutional investors would be outweighed by the costs of undermining corporate accountability.

Trading Patterns of Equity Investor’s

The criticisms of short-termism are based on several trends over the last few decades: the expanded volume of equity trading, the increase in stock turnover and the shorter holding period of investors. During the last few years, however, the trading volume and turnover rate for US stocks has decreased significantly.

In any event, these data reflect average investor behavior. US institutional investors should be divided into three distinct categories on the basis of continuity of share ownership within a portfolio and size of stakes in portfolio companies. According to Professor Bushee, 61 percent of institutional shareholders were “quasi-indexers”, percent were “dedicated” investors and 31 percent were “transient investors.”

  • “Transient” institutional investors hold well-diversified portfolios of publicly traded securities: they pursue short-term profits through high turnover of their portfolios and heavy use of momentum trading.
  • “Dedicated” institutional investors have substantial investments in a relatively small number of portfolio companies; they hold a high percentage (often over 75 percent) of their portfolio shares for two years or more.
  • “Quasi-indexers” fall between the two other categories of institutional investors; they have highly diversified portfolios of publicly traded securities, and also a high degree of ownership continuity since they seldom trade.

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