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E-MailRichard T. Thakor is Assistant Professor of Finance at the University of Minnesota Carlson School of Management. This post is based on his recent paper. Related research from the Program on Corporate Governance includes The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here), and Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang.
In the area of corporate investment policy and governance, one of the most widely-studied topics is corporate “short-termism” or “investment myopia”, which is the practice of preferring lower-valued short-term projects over higher-valued long-term projects. It is widely asserted that short-termism is responsible for numerous ills, including excessive risk-taking and underinvestment in R&D, and that it may even represent a danger to capitalism itself. Yet, short-termism continues to be widely practiced, exhibits little correlation with firm performance, and does not appear to be used only by incompetent or unsophisticated managers (e.g. Graham and Harvey (2001)). In A Theory of Efficient Short-termism, I challenge the notion that short-termism is inherently a misguided practice that is pursued only by self-serving managers or is the outcome of a desire to cater to short-horizon investors, and theoretically ask whether there are circumstances in which it is economically efficient.
I highlight two main findings related to this question. First, there are circumstances in which the owners of the firm prefer short-term projects, even though long-term projects may have higher values. There are other circumstances in which the firm’s owners prefer long-term projects. Moreover, this is independent of any stock market inefficiencies or pressures. Second, it is the managers with career concerns who dislike short-term projects, even when the firm’s owners prefer them.
These results are derived in the context of a model of internal governance and project choice, with a CEO who must approve projects that are proposed by a manager. The projects are of variable quality—they can be good (positive NPV) projects or bad (negative NPV) projects. The manager knows project quality, but the CEO does not. Regardless of quality, the project can be (observably) chosen to be short-term or long-term, and a long-term project has higher intrinsic value. The probability of success for any good project depends on managerial ability, which is ex ante unknown to everybody.
In this setting, the manager has an incentive to propose only long-term projects, because shorter projects carry with them a risk of revealing negative information about the manager’s ability in the interim. Put differently, by investing in a short-term project that reveals early information about managerial ability, the manager gives the firm (top management) the option of whether to give him a second-period project with managerial private benefits linked to it, whereas with the long-term project the manager keeps this option for himself. The option has value to the firm and to the manager. Thus, the manager prefers to retain the option rather than surrendering it to the firm.
The CEO recognizes the manager’s incentive, and may thus impose a requirement that any project that is funded in the first period must be a short-term project. This makes investing in a bad project in the first period more costly for the manager because adverse information is more likely to be revealed early about the project and hence about managerial ability. The manager’s response may be to not request first-period funding if he has only a bad project. Such short-termism generates another benefit to the firm in that it speeds up learning about the manager’s a priori unknown ability, permitting the firm to condition its second-period investment on this learning.
There are a number of implications of the analysis. First, not all firms will practice short-termism. For example, firms for which the value of long-term projects is much higher than that of short-term projects—such as some R&D-intensive firms—will prefer long-term projects, so not all firms will display short-termism. Second, since short-termism is intended to prevent lower-level managers from investing in bad projects, its use should be greater for managers who typically propose “routine” projects and less for top managers (like the CEO) who would typically be involved in more strategic projects. Related to this, since it is more difficult to ascertain an individual employee’s impact on a project’s payoffs at lower levels of the hierarchy, this suggests that the firm is more likely to impose a short-termism constraint on lower-level managers. Third, the analysis may be particularly germane for managers who care about how their ability is perceived prior to the realization of project payoffs. As an example of this, it is not uncommon for a manager to enter a job with the intention or expectation of finding a new job within a few years. The analysis then suggests that the manager would rather not jeopardize future employment opportunities by allowing (potentially risky) project outcomes to be revealed in the short-term, instead preferring that those outcomes be revealed at a time when the manager need not be concerned about the result (i.e. in a different job).
Overall, the most robust result from this analysis is that informational frictions may bias the investment horizons of firms, and that the bias towards short-termism may, in fact, be value-maximizing in the presence of such frictions. This means that castigating short-termism as well as the rush to regulate CEO compensation to reduce its emphasis on the short term may be worth re-examining. Indeed, not engaging in short-termism may signal an inability or unwillingness on the CEO’s part to resolve intrafirm agency problems and thus adversely affect the firm’s stock price. This is not to suggest that short-termism is necessarily always a value-maximizing practice, since some of it may be undertaken only to boost the firm’s stock price. The point of this paper is simply that some short-termism reduces agency costs and benefits the shareholders.
For example, the project horizon for a beer brewery is typically 15-20 years. Similarly, R&D investments by drug companies have payoff horizons typically exceeding 10 years.
The paper is available for download here.
References
Graham, John R., and Campbell R. Harvey, 2001, “The Theory and Practice of Corporate Finance: Evidence from the Field”. Journal of Financial Economics, 60 (2-3), 187-243.
This is in line with Roe (2015), who states: “Critics need to acknowledge that short-term thinking often makes sense for U.S. businesses, the economy and long-term employment … it makes no sense for brick-and-mortar retailers, say, to invest in long-term in new stores if their sector is likely to have no future because it will soon become a channel for Internet selling.”
One can think about the long-term and short-term projects concretely through examples. Within each firm, there are typically both short-term and long-term projects. For example, for an appliance manufacturer, investing in modifying some feature of an existing appliance, say the size of the freezer section in a refrigerator, would be a short-term project. By contrast, building a plant to make an entirely new product—say a high-technology blender that does not exist in the company’s existing product portfolio—would be a long-term project. The long-term project will have a longer gestation period, with not only a longer time to recover the initial investment through project cash flows, but also a longer time to resolve the uncertainty about whether the project has positive NPV in an ex post sense. There may also be industry differences that determine project duration. For example, long-distance telecom companies (e.g. AT&T) will typically have long-duration projects, whereas consumer electronics firms will have short-duration projects.
