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MYOPIC MANAGEMENT
Relevant to ACCA Qualification Papers F9 and P4 For many years, managers of large businesses have been accused of focusing on short-term rather than long-term performance. Managers, so it is argued, often prefer projects that generate quick returns rather than those with slower, but ultimately higher, returns. Such myopic behaviour can create a host of problems for the business, for the broader economy and for society as a whole. These problems include reduced investment returns, the destruction of shareholder value, business collapses and the undermining of corporate governance. Furthermore, it can lead to a loss of public trust in large businesses and a growing sense of unfairness in the way in which society is organised. In this article we explore the causes of management short termism and the remedies available.

WHY FOCUS ON THE SHORT TERM?

Modern finance theory is founded on the notion that the purpose of a business is to maximise the wealth of its shareholders. This means that the role of managers, who are employed to act on behalf of shareholders, is to maximise the value of ordinary shares over the long term. In practice, however, managers may not seek to do this. This may be because they have a different time horizon to that of shareholders. There may be powerful incentives for managers to adopt a short-term focus in order to maximise their own welfare. These incentives are often linked to the ways in which their remuneration is structured. Where managers are in line for bonuses based on short-term share performance, or where share options are about to mature, they may be encouraged to make short-term decisions that boost the share price. Incentives may also be linked to management tenure and contracts. Where managers are unlikely to stay with the business for a long period and there are bonuses linked to current performance, they may prefer to invest in projects with lower net present values, but with higher returns in the early years, than projects with higher net present values, but with higher returns in later years. Although the latter projects will ultimately bring greater benefits to the business, the managers will not be around to reap the benefits of their actions. For similar reasons, managers may try to cut back on discretionary expenditure such as research and development, staff training or marketing campaigns that would lead to a reduction in current profits even though it would enhance long-term value. Even where managers do not intend to leave, they may feel under pressure to produce quick results, particularly if their employment contracts are short term and have to be renewed frequently. We have seen that the interests of managers and shareholders may conflict because of the difference in time horizons between the two groups. However, shareholders may also adopt a short time horizon. Where this occurs, it can reinforce myopic managerial behaviour. By aligning their behaviour to the same

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time horizon, managers may feel that they are responding to shareholder needs and will expect to be rewarded accordingly. Thus, where they judge that shareholders are focused on the forthcoming quarterly, or half yearly, profit announcements, they may strive to produce results that meet expectations. Frequent reporting of profits can intensify the pressure on managers to achieve quick results. This is because it can lead to the premature evaluation of performance (1). (For this reason, the European Union Parliament rejected a proposal in 2004 to make quarterly reporting mandatory for large companies (2)). Frequent financial reporting may be particularly damaging where there is no accompanying management commentary that would help shareholders to see the results in context. The misuse of financial metrics may also promote myopic management behaviour. It has been argued that accounting ratios like ROCE and ROI, which focus on the efficiency of capital investment, encourage managers to avoid investment in long-term innovation. They may lead managers to minimise the investment in assets appearing in the financial statements in order to boost the percentage rate of return. Even DCF methods are not immune from encouraging short-term thinking. According to Salter: ..when the internal rate of return (IRR) metric is used, the return naturally goes up as the time horizon comes down. So, when companies plan investments and keep score according to efficiency measures, they inevitably invite investment decisions; where uncertain, empowering innovations requiring long lead times for development are sacrificed for more certain, efficiency innovations requiring much shorter time horizons for profitable results. (3)

THE EVIDENCE
There is evidence to support the existence of management short termism. A survey of US chief financial officers, for example, found that they placed great emphasis on meeting or exceeding two key benchmarks: profits for the same quarter of the previous year and the consensus of analysts estimates for the current quarter. The survey also found that in order to meet the desired level of quarterly profits nearly 80% would be prepared to cut discretionary spending (such as investment in research and development and advertising expenditure) and more than 55% would be prepared to delay a new investment project even though it resulted in some sacrifice in value. (4) A more recent survey of FTSE100 and 250 executives by PwC also provides evidence of short-term thinking among managers. When given a choice between 250,000 tomorrow and 450,000 in three years time, the majority of respondents chose the former (5). By doing so, however, they were applying an annual discount rate of more than 20% to the future benefits, which is likely to be much higher than the cost of capital of their business. Excessive discounting of future cash flows by managers has important implications for the allocation of resources within a business. It can lead to the rejection of investment projects that would otherwise be profitable and to favouring projects with a short time horizon. This evidence concerning short-term thinking is accompanied by a trend towards shorter management tenures. The tenure of CEOs of large US businesses, for example, has fallen significantly over time. For the period 20002007, the average tenure was less than six years. (6)

THE ROLE OF SHAREHOLDERS

We saw earlier that shareholders may be the driving force behind the short-term focus of managers. Some believe that institutional and private shareholders are preoccupied with movements in quarterly and half yearly profit figures and make share investment decisions on this basis. This, in turn, leads managers to run their business in a way that meets shareholder expectations concerning short-term

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profits. It may also lead managers to provide earnings guidance to shareholders to help manage their expectations concerning the future share price. Shareholder concern for the short term, however, suggests a clear gap between theory and practice. theory, the value of a share is represented by the future discounted cash flows that it generates. As a result, shareholders should be concerned with the ability of a business to generate long-term cash flows rather than on its ability to meet short-term profit targets. To explain this gap it has been argued that using discounted cash flows can be a time-consuming, costly and speculative process (7). Shareholders do not have access to inside information that could help them to predict cash flows with reasonable accuracy. They, therefore, rely on short-term profit performance instead. In other words, shareholders engage in short termism because of a lack of good quality information concerning long-term prospects. While this may provide a partial explanation, other, more powerful, reasons are likely to exist. One such reason is that shares are held by shareholders for increasing short periods. In the UK, shares of listed businesses are now held for around six months compared with eight years in 1960 (8). It seems that shareholders are acting increasingly like share traders and less like owners. This means that shareholders are likely to become less concerned with the future stream of dividends over time and more with concerned short-term share price movements (which, in turn, are likely to be influenced by short-term profit performance). It also means that shareholders are less likely to be interested in the future direction of the business. There is less incentive to monitor the behaviour of managers because the benefits of doing so are often long term. There is also less incentive to engage with the business and, if a business gets into difficulty, its shares are more likely to be sold. The end result is that corporate governance is weakened and managers become less accountable. Furthermore, the stock market is reduced to little more than a casino. Various reasons have been cited for the rise of short-term investing behaviour. One important reason may be the short-term focus of institutional shareholders. It has been argued that there is often quarterly evaluation of fund managers performance, which increases pressure to produce short-term returns. This short-term focus, however, may be at odds with the longer term requirements of those investing in the funds. The speculative activities of hedge funds have also been cited as a further reason for the rise short-term investing. One widely-used practice of hedge funds is short selling. This involves selling shares that have been borrowed from a broker, or other third party, with the intention of buying back the shares at a later date to return to the broker. During the period between selling and buying back the shares, the hedge funds hopes to benefit from a decline in the share price. Where this activity is simply a response to market inefficiencies, however, it should not provoke short-term behaviour among managers.

THEORY AND EVIDENCE

The claim that shareholders adopt a short-term focus is difficult to square with the efficient market hypothesis (EMH). In an efficient market, the value of a share should reflect the long-term future cash flows arising from holding that share. If we accept that stock markets are efficient, this implies that a critical mass of shareholders do not adopt a short-term view when making share investment decisions. The fact that some shareholders do is, therefore, not really important. Indeed, some argue that shortterm shareholders have a positive role to play by bringing liquidity and stability to stock markets. There is increasing evidence, however, that the stock market is not always efficient and that share prices do deviate from fundamental economic values. There is a growing body of literature on behavioural finance, for example, which suggests that shareholders are not always rational when making investment

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decisions. This can result, among other things, in speculative share price bubbles and extended bull runs in share prices. Although short termism in financial markets is widely discussed, there has not been much evidence to support its existence. One recent study, however, examined 624 businesses listed on the UK FTSE and US S&P indices over the period 19802009 to see whether the pricing of shares was affected by short termism. If so, it should be evident by the excessive discounting of future cash flows from shares over and above the risk-free rate. The findings of the study suggest that short termism does exist and that it is prevalent across all industry sectors. According to the study: In the UK and US, cash flows five years ahead are discounted at rates more appropriate eight or more years hence; 10-year ahead cash-flows are valued as if 16 or more years ahead; and cash-flows more than 30 years ahead are scarcely valued at all . (9) Interestingly, there was much greater evidence of short termism among the sample businesses in the final decade of the study. It seems, therefore, that short termism is on the rise. If shareholders have a short-term perspective it would, of course, be entirely rational for them to construct managerial reward systems that encourage managers to take a short-term view. Hence, bonuses may be heavily weighted towards current profits and share options may be given short vesting periods.

WHAT ARE THE REMEDIES?

It is clear from the above that management myopia does not stem from a single cause and that a variety of measures may be needed to address this phenomenon. These measures should deal with the incentives that drive the behaviour of both managers and shareholders and also deal with the interaction between the two groups. The following are some of the measures that have been proposed: Management rewards and contracts It is frequently argued that management rewards should be linked more closely to long-term performance and to the strategic aims of the business. Various suggestions have been made to achieve this link such as share options having longer vesting periods, less weight being given to bonuses based on annual profits and the use of non-financial targets as the basis for rewards. (Non-financial measures, such as investment in staff training, can often be lead indicators of long-term financial performance.) It has also been suggested that managers should be given long-term contracts to help them forge a closer bond with the business. The behaviour of shareholders To encourage shareholders to invest for the long term, a loyalty dividend has been proposed for those who hold shares for a certain period of time. This dividend would be over and above the dividend normally paid to shareholders. It has also been suggested that rewards for fund managers should be linked to long-term investment performance and that details of the reward structure for fund managers should be published so that those investing in the funds can make more informed decisions. To help counteract the importance attached to quarterly or half yearly financial reports, various remedies have been suggested. For example, it has been suggested that additional reporting of the long-term prospects of the business should be included in the annual financial reports. It has also been suggested that closer interaction with shareholders will help enhance their relations with senior managers and encourage them to take a long-term view. (10)

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Corporate governance Weak corporate governance procedures allow short termism to thrive. A cornerstone of the Combined Code is the role of independent non-executive directors in promoting the interests of shareholders. It is concerning, therefore, that surveys have revealed that these directors often confess to having a poor grasp of their companies strategy and that their understanding of the business is not held in high regard by many CEOs. (11) Institutional shareholders can play an important role combating managerial short termism. In recent years there have been frequent calls for them to actively engage in the corporate governance of an investee business and to become more accountable to their principal shareholders as well as to society as a whole. The UK Stewardship Code was introduced in 2010 to address the accountability issue. The Code requires that institutional shareholders disclose how they discharge their stewardship responsibilities, how they monitor investee companies, what their voting policies are and so on. To help the board of directors retain a long-term focus, various changes to voting procedures and to the composition of the board of directors have been suggested. These include additional voting rights for long-term shareholders, to enable them to have greater board representation and greater influence at shareholder meetings, and for employee representation on the board. Taxation policy Changes to taxation policy have been proposed that aim to make short-term investing less attractive. They include introducing a tax (or increasing an existing tax) on the transfer of shares. This is designed to make it more expensive to buy and sell shares on a frequent basis. In addition, higher rates of tax on gains from the sale of shares held for a short term than those held for a long term have been proposed. (12) While many of the proposals mentioned may be intuitively appealing, there are often problems and unintended consequences associated with their implementation. The proposal to introduce (or increase) tax on the transfer of shares, for example, has been criticised as follows: (it) is not limited to trades that take place when stock (share) prices change rapidly. Instead, it would tax every trade, including trades that occur when there is minimal or zero volatility, and thus is likely to inflict enormous costs on society. Generally, it ensnares and imposes hardship on investors that have virtually no contribution to the speculation problem that it is designed to curb. (13) Similarly, higher rates of capital gains tax to deter shareholders from selling their shares after only a short period may have undesirable side effects. It has been argued that it may damage market liquidity, punish those who are forced to sell their shares (because, for example, a takeover has occurred) and make it more difficult to issue new shares offering better returns.

SUMMARY AND CONCLUSIONS

In this article we have examined the arguments and evidence concerning management myopia. We have seen that there may be powerful incentives for managers to favour pay offs arising in the short term rather than larger pay offs arising in the longer term. These incentives may reflect a difference in time horizons between managers and shareholders or may reflect a shifting focus by shareholders towards the short term. To avoid the damage that short termism can inflict on businesses and to the economy as a whole, various remedies have been suggested. These are aimed at changing the behaviour of both managers and shareholders. Many of these remedies, however, need careful consideration as they may well have unintended consequences.

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Written by a member of the Paper F9 examining team

References 1. Gigler F, Kanodia C, Sapra H and Venugopalan R, How frequent financial reporting produces managerial myopia, Working Paper February 2009 2. Gigler F, Kanodia C, Sapra H, and Venugopaian R, How Frequent Financial Reporting Causes Managerial Short-Termism: An Analysis of the Costs and Benefits of Reporting Frequency, Chicago Booth Research Paper No 13-01, papers.ssrn.com, 1 December 2012 3. Salter M, Short-termism at its worst: How short-termism invites corruption and what to do about it. Edmond J. Safra Working Papers, No 5, http://www.ethics.harvard.edu/lab April 11, 2013, p38 4. Graham J, Harvey C and Rajgopal S, The economic implications of corporate financial reporting, Working Paper 11, January 2005 5. PriceWaterhouseCoopers 2011 reported in Haldane A and Davies R, The short long Speech given at 29th Socit Universitaire Europene de Recherches Financires Colloquium: New Paradigms in Money and Finance?, Brussels May 2011, p21 6. Kaplan S and Minton B, 'How Has CEO Turnover Changed?' International Review of Finance 12(1) (2012):5787, available at http://dx.doi.org/10.1111/j.1468-2443.2011.01135.x. 7. A Rappaport, The economics of short-term performance obsession, Financial Analysts Journal Volume 61 No. 3 May/June 2005, pp65-79 8. Wighton D, We must end short termism. And it wont wait, The Times, 17 May 2011, www.thetimes.co.uk 9. Haldane A and Davies R, The short long Speech given at 29th Socit Universitaire Europene de Recherches Financires Colloquium: New Paradigms in Money and Finance?, Brussels May 2011, p1 10. Jackson K, Rowe S, and Zimbelman A, Can companies reduce current investor short-termism by 'relationship reporting?' papers ssrn.com March 2013 11. See reference (3), pp48-49 12. Jackson G and Petraki A, Understanding short-termism: the role of corporate governance, report to the Glasshouse Forum 2011 13. Duruigbo E, A critical appraisal of proposals for overcoming shareholder short-termism, Working Paper January 2011, p21

Last updated: 25 Oct 2013

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