Trajectory #7: Short-Termism in Capitalism
Public Markets, Myopia and Incentives
|Mikal Khoso||Oct 23, 2019||1|
This week’s key issue is the question of the alleged short-termism of capitalism and in particular public markets. Politicians and the public lambast public markets and public market investors as being overly short-termist and putting tremendous pressure on companies to maximise short-term returns. Often, maximising short-term returns is said to come at the expense of long-term company sustainability and environmental / public health. But in many ways I believe the idea that public markets are short-termist is a narrative mirage. This week we’ll delve into the history of shareholder value theory and explore alternatives to the public market including the Long-Term Stock Exchange and alternative stock structures.
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Have a great week,
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Key Issue: Short-Termism in Capitalism and A New Social Contract for Shareholders
“Modern capitalism is plagued by short-termism and myopia.”
“Shareholders are king and everyone else gets left behind.”
“The public markets hurt companies more than help them.”
This is the popular narrative today and to some extent it is true. It is true that modern capitalism does present numerous challenges for public companies. Quarterly reporting cycles provide a consistent drumbeat of investor pressure, executives prioritize short-term earnings to protect their positions and companies fail to invest in innovation and lose their competitive edge. Today, a growing number of people point to the drive to promote shareholder value as the root cause of these challenges. Perhaps it is.
The Rise of Shareholder Value Theory
In the 1980s, Shareholder Value Theory (SVT) rapidly emerged, in large part thanks to General Electric CEO Jack Welch, and quickly became the dominant viewpoint on the purpose and goals of a company. Under this theory, the purpose of a company and therefore the goals of its executives is maximising shareholder value — that is, increasing the price of the company’s stock consistently over time. Thus, the ultimate measure of a company’s success is the extent to which it enriches its shareholders.
Intellectually this seems right. Shareholders are the most “bought in” stakeholders of a business aside from employees (who often are shareholders as well). Similarly, some of the largest shareholders are pension funds and other asset managers that protect and grow people’s savings and retirement funds. Fiduciary duty is the foundation of corporate governance and it is a duty to serve the shareholders and requires company executives to put personal interests aside. Intuitively however, measuring a company’s success purely by how much it enriches its shareholders seems to gloss over other measures of success and other parties that are affected by corporations — customers, current or future competitors and the public at large (thanks to environmental effects for example).
Over time, Shareholder Value Theory has resulted in several negative and unintended consequences. For example, the theory advocates tieing executive compensation to stock performance in the short-term. While at first glance this seems like a good idea, it has resulted in executives engaging in behaviours that bump short-term stock prices at the expense of long-term investments in the company — such as share repurchases. Indeed, in the fourth quarter of 2018 US companies repurchased a record $223 billion worth of shares.
Other tactics executives have pursued in recent years include slashing costs like R&D spending to boost short-term profits. Clearly, slashing R&D spending or artificially boosting stock prices with techniques like repurchases are a direct threat to the long-term viability and sustabinability of a company. Companies could instead by investing this money in R&D, human capital development and capital expenditures to continue to scale, innovate and thrive. Another way to think about the effect of these short-term stock-boosting choices is the opportunity cost of that capital. While repurchasing shares might have a near-term financial benefit, the opportunity cost of not investing it in R&D over the long-term could be significantly higher.
The Shrinking and Changing Public Market
These concerns are not theoretical, they don’t just affect a select few. They are a practical reality that seems to be radically affecting the public markets. Only a measly 10.4% of US public companies that were part of the Fortune 500 in 1955 are still part of it today. Only 52 of these 500 companies maintained their position over this 62 year period. Similarly, the average tenure of companies on the S&P 500 dropped from 33 years in 1964 to 24 years by 2016. This is expected to drop to just 12 years by 2027, a precipitous drop. Finally, the number of public companies has also undergone a steep decline. In 1976, the United States had 4,943 firms listed on exchanges. By 2016, it had only 3,627 firms.
Today, the US public markets have fewer publicly-traded companies and are experiencing greater turnover than ever, especially at the top. While there are structural changes driving part of this trend, including technological advancement and the increasing scale of the country’s largest corporations, these changes are still substantial and abnormally large.
In an age of high velocity information flows, rapidly advancing technology and industries that are reconstituting and reshaping themselves from the ground up, perhaps it is time to measure company success with more broad-based measures than just shareholder value. Mabye it is time for a new contract between shareholders and executives. While the Shareholder Value Theory was put in place to drive investor returns and protect their interests, in some cases it seems to have turned out to be quite counterproductive in practice. By using stock performance as the yardstick to measure executive and company success, shareholders seem to be slapping each other on the back in the short-term and shooting themselves in the foot in the long-term.
Bill Gates famously remarked that people overestimate the change that happens in two years and dramatically underestimate the change that happens in ten years. Today, long-term thinking needs to be a strategic priority for all public companies, especially those where technology is only just beginning to radically reshape their industries — manufacturing, healthcare, logistics and more.
The LTSE and Tenured-share Voting
One of the successes of the Shareholder Value Theory is its simplicity, clarity and universality. Measuring all companies using a common standard provides the foundation for comparative analysis. How can we maintain this clarity and simplicity while exploring more broad-based measures of company success? How can we incentivize long-term thinking instead of short-term financial engineering? How might we adapt SVT for a modern age?
The Long-Term Stock Exchange (LTSE) is one possible version of an answer. This year, the LTSE was approved by the SEC as the 14th stock exchange of the United States. The LTSE was founded with the explicit goal of pushing back against the short-termism of US public markets in order to make it easier for technology startups in the US to go public earlier while continuing to build towards a long-term vision. Companies that list on the LTSE commit themselves to a set of long-term priorities that are supposed to serve as the basis for the company’s long-term vision and provide clarity to shareholders. While these commitments are not contractual, the idea has been floated that failing to deliver on these priorities could serve as the basis for securities fraud cases. These commitments embody the goal of the LTSE in general, creating a struture for companies and investor to think in the long-term.
Among several innovations the LTSE proposes to achieve this, one that has gained increasing attention in recent years is tenured-share voting (also called time-phased voting). Under tenured-share voting, shares gain voting power the longer they are held. It’s designed to reward long-term investors with increased ability to influence corporate governance and decision-making and protect against short-sellers and other short-term investors. Some models of tenured-share voting propose a cap on the voting power of shares held for long-period of time at four or five times the voting power of newly bought shares.
In capitalist economies entrepreneurs play a special role in the economy. They are the engines and instruments of innovation that power the dynamism of capitalist economies and markets. For entrepreneurs, tenured-share voting promises to maintain founder/CEO control in the post-IPO years and enable them to continue to execute on the long-term vision they set for themselves and the company. Over time the LTSE envisions public market investors gaining equilibrium in voting power with the founders as they sell their shares, especially if there are caps in place on how much voting power each share can accrue.
The incredible success of Amazon and Jeff Bezos’ exceptional vision and leadership has helped create an ideal of entrepreneurship that lionizes a founder’s ability to see and execute on a long-term, sometimes multidecade, vision. Bezos has famously remarked that it is always Day 1 at Amazon:
“Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death,” he said. “And that is why it is always Day 1.”
The Day 1 philosophy permeates Amazon’s culture. Amazon has a building named Day 1 and the official blog of the company is called Day One. In many ways tenured-share voting is designed around this ideal of the visionary entrepreneur in order to protect them from activist pressure from the public markets and enable them to execute on that vision at the expense of short-term financial performances.
Tenured-Share Voting: Does it Work?
Intellectually, tenured-share voting is a elegant and appealing solution to the problem of the short-termism of public markets and executives. Multi-class stock structures have become increasingly prevalent in the last decade thanks in part to Google and Facebook’s choice to pursue dual-class stock structures when listing. Between 2011 and 2017 about 15% of U.S. IPOs had a dual-class structure.
However, there is one small problem. Both the mechanism and narrative around tenured-share voting and multi-class stock structures have no supporting evidence. In fact the opposite seems to be true — tenured-share voting is generally a net negative for companies that adopt it.
Indeed, a 2017 paper analyzed US public markets from 1980 to 2017 looking specifically at firms with single versus dual-class stock structures found that dual-class stock structures seem to be counterproductive in the long-term. In the short-term, companies with the dual-class stock structure have about a 13% valuation premium versus single-class companies by one measure of company value. However, the paper finds that this valuation premium dissipates over time and that companies with dual-class stock end up trading at a discount relative to their single-class counterparts. This is a sobering conclusion and strong evidence against the projected benefits of tenured-share voting.
Tenured-share voting also creates an additional problem around governance. Since voting power accrues to those who hold shares the longest, index funds and money managers will end up holding a disproportionate amount of voting power because they typically are the longest of long-term investors. These firms typically avoid taking activist roles in companies and the industry is centered around passive investing. This would require a whole segment of the financial industry to restructure how they operate. Given how broad and large their holdings are across numerous companies, effectively exercising voting power and ensuring governance across these companies is a monumental task to achieve.
Are Public Markets Really Short-termist?
But the narrative around the public markets being short-term and not supporting long-term thinking is also hollow. The case of Amazon is case in point. Amazon famously lost money every quarter for the first six years of its life as a public company. Despite this, Bezos didn’t face tremendous pressure from investors, he wasn’t nearly removed as CEO and Amazon wasn’t forced to prioritize short-term profitability over its long-term vision.
From this Quartz article
Instead, Bezos consistently messaged to his shareholders and employees that Amazon was a company thinking for the long-term. In Amazon’s 1997 shareholder letter — its first shareholder letter as a public company — Bezos wrote:
“We believe that a fundamental measure of our success will be the shareholder value we create over the long term.”
“We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.”
“We will balance our focus on growth with emphasis on long-term profitability and capital management. At this stage, we choose to prioritize growth because we believe that scale is central to achieving the potential of our business model.”
Since then Amazon has become one of the most valuable and impactful companies in history, crossing a valuation of $1 trillion on September 4th 2018. Clearly long-term thinking was good for Amazon and its customers but even more so for it shareholders. What the story of Amazon proves is that public markets can and do support companies and CEOs who are looking to think in the long-term. Maybe it is not public markets that make CEOs and companies optimize for the short-term, perhaps it is simply short-term thinking CEOs and executive teams that are the cause of the problem in the first place. The case of Amazon certainly points to this.
What’s clear is that tenured-share voting — while elegant in design — will be challenging to implement and the value of doing so seems to erode for companies within 6 to 9 years. Similarly, the narrative around the pressure from public markets to optimize for the short-term seems to be exaggerated. In fact, Amazon shows that the public markets are willing to support long-term thinking if the company leadership communicates a clear and measurable vision and goals.
Capitalism and short-term markets aren’t as short-termist and myopic as everyone says. but rather we are as people. Fixing that problem can’t be done just by restructuring a stock exchange or changing tax laws, although both could certainly help. Instead, short-termism seems to arise from business culture today and human instinct. Changing business culture will be key to enshrining long-term thinking and ensuring it has a durable impact.