Short-termism Meets a New Frontier

Matt Orsagh, CFA, CIPM
Senior director, Capital Markets Policy, Americas, CFA Institute

A company’s focus on short-term results can corrode shareholder wealth. Our analysis of short-termism for the CFA Institute has proved that, and yielded recommendations for how to fix the problem. And now, short-termism is taking on a new meaning as investment management and corporate leaders focus on sustainability and ESG (environmental, social, governance) goals.

Companies that failed to invest in research and development; selling, general and administrative expenses; and capital expenditures tended to underperform in the medium term (three to five years), when the numbers were crunched over a 22-year period. The results? Short-termism over that period resulted in estimated agency costs (i.e., foregone earnings) of $1.7 trillion, or about $79.1 billion annually.

Clearly, this is a problem that merits attention.

Progress on Recommendations Since 2006

Since 2006, we have recommended the following to corporate leaders, asset managers, investors, and analysts:

• • Reform earnings guidance practices: All groups should reconsider the benefits and consequences of providing and relying on focused, quarterly earnings guidance and their involvement in the “earnings guidance game.”
  • Develop long-term incentives across the board: Compensation for corporate executives and asset managers should be restructured to achieve long-term strategic and value-creation goals.
  • Demonstrate leadership: Leaders should shift their focus to long-term value creation.
  • Improve communications and transparency: More meaningful, and potentially more frequent, communications about company strategy and long-term value drivers can lessen the financial community’s dependence on earnings guidance.
  • Promote broad education of all market participants: All parties should understand the benefits of long-term thinking and the costs of short-term thinking.

Since 2006, progress has been made on several of these fronts. S&P 500 companies issuing quarterly guidance fell from 36.0% in 2010 to 27.8% in 2016, according to Moving Beyond Quarterly Guidance: A Relic of the Past, published by FCLTGlobal.

Executive compensation practices have improved as well. Developments such as shareowner say-on-pay voting and majority voting for boards of directors have increased engagement between investors and issuers on compensation. Some of the worst practices—including tax gross-ups and the repricing of stock options—have mostly gone away. Now executive compensation is more often linked to long-term strategic interests. Also, transparency around executive compensation has improved.

New Recommendations

After revisiting the topic of short-termism with another set of distinguished panelists, CFA Institute adopted four new recommendations for market participants in Short-Termism Revisited: Improvements Made and Challenges in Investing for the Long-Term (2020):

1. 1. Issuers and investors should focus their engagement on long-term strategy and agreed-upon metrics that drive that strategic success as a substitution for stepping away from earnings guidance.
   2. Issuers and investors should simplify executive compensation plans so that incentives better align with those of shareowners and are more easily understood.
   3. Issuers and investors both should make meaningful investments in engagement to foster increased discussion around the long-term issues most important to a company’s strategy.
   4. Issuers and investors should establish better standards around ESG data, so the data are consistent, comparable, and audited, as well as material.

Although executive compensation practices have improved, the panel we assembled had a common complaint: Executive compensation programs have become too complicated and simpler pay structures would benefit both issuers and investors.

Engagement has improved communications between issuers and investors, helping to better educate each side. This development has required leadership; all actors in this market development should be commended.

The Next Frontier: Sustainability and ESG

Sustainability and ESG were not part of our 2006 study, but in 2020 they represent the next frontier of short-termism.

Much work needs to be done for ESG to constructively contribute to overcoming short-termism. We need agreement on the following:

• • Who are the principals? When addressing short-termism, the principal is the shareholder. When addressing ESG, we usually consider multiple stakeholders whose interests need to be considered.
  • How do you define agency costs? For short-termism, agency costs are the reduction in shareholder value. For ESG, each element of the triad has multiple potential agency costs, some of which—but not others—can be easily defined as a monetary value. Environmental agency costs might include the remediation costs of cleaning up after a polluter. They might also measure the number of polar bears lost because of rising seas.
  • How do you measure agency costs? With short-termism, the loss in shareholder value can be computed as shown in the appendix of Short-termism Revisited. With ESG, one can quantify some environmental and remediation costs, but that doesn’t answer questions such as how to measure the value of stopping the trade in conflict diamonds or how do you measure the value of a diverse board of directors or of workers having representatives to the board?
  • What about trade-offs? With short-termism, there is a clear goal (maximizing shareholder value) and no intrinsic trade-offs to reach that goal. ESG necessarily involves trade-offs among the E, S, and G goals themselves, as well as between ESG goals and earnings. There are also trade-offs among different shareholders. For example, a proposal could benefit employees at the expense of shareholders, or customers at the expense of employees.
  • How big is the prize? CFA Institute estimates that addressing short-termism could increase shareholder value by some $200 billion. This is a large figure, but it is dwarfed by the potential costs of making poor ESG decisions. The Economist Intelligence Unit estimated the global cost of climate change by 2050 to be approximately $8 trillion (some 40 times the impact of short-termism), according to Phys.org. And this is just one subset of one part of the ESG triad. So, although the challenge of addressing ESG is vastly greater than that of short-termism, it offers a vastly greater prize.

Big numbers and tough choices are not just short-term problems.

References

CFA Centre for Market Integrity, Business Roundtable Institute for Corporate Ethics (2006), Breaking the Short-Term Cycle. https:// www.cfainstitute.org/en/advocacy/policy-positions/breaking-the-short-term-cycle

CFA Institute (2020), Short-Termism Revisited: Improvements Made and Challenges in Investing for the Long-Term. https://www. cfainstitute.org/-/media/documents/article/position-paper/Short-termism-revisted.ashx.

FCLTGlobal (2017), Moving Beyond Quarterly Guidance: A Relic of the Past https://www.fcltglobal.org/wp-content/uploads/Moving-Beyond-Quarterly-Guidance-A-Relic-of-the-Past.pdf.

Galey, Patrick, “Climate impacts ‘to cost world $7.9 trillion’ by 2050,” Phys.org (Nov. 20, 2019), https://phys.org/news/2019-11-climate-impacts-world-trillion.html.