Long-term capitalism is currently one of the most discussed topics in the circles of lawmakers, company boards, academics, innovators, and public investors. Many have commented on the age of the “quarterly capitalism”, in which leaders of public companies are under tremendous pressure to keep up their quarterly earnings to satisfy shareholders and avoid a drop in their stock price. The companies whose quarterly earnings do not keep up to the expected mark often face attacks by activist investors, who try to get board seats, dictate the policies of the company, and often try to get top management changed.
Whether activist investors add value to the company or just make quick profits for themselves is the subject of debate and research. However, to avoid the instability associated with disappointing earnings figures, public companies have to often skip investing in long-term projects like R&D, which could have created long-term value for the firm. This is because these long-term investments require heavy investments, take years to bear fruit, and in the short term, they only result in large investments, which obviously subtract from the quarterly profit figures. Plus, the results of these investments are seen several quarters later, by which time the company might suffer attacks by activist investors, see its stock price fall, and the top management might be replaced as well. Thus there is very low incentive for managers to undertake these long-term investments.
However, these investments, like R&D for example, are what drive the company, and ultimately the whole economy forward, by means of innovation in products and business processes. If enough investments are not made in these areas, not only will the company lose out on its competitive advantage in a few years, but a culture of not investing in such projects will stall the progress of the economy itself. Thus, this is an area which requires reforms at the government level, the company level, as well as the investor level.
1. Reforming the tax code (covered in Our Gambling Culture, by Lawrence Fink, in McKinsey Quarterly): This article focusses on the features in the US tax code that have encouraged short-term behaviour among investors. Under the tax code, capital gains are taxed at a much lower level than ordinary income. However, capital gains over a one-year period onwards are considered for this tax treatment. Fink says that a one year holding period encourages short-termism. Also, companies are encouraged to pay out extra cash as dividends because dividends are also treated for preferential tax treatment. This extra money could have gone towards investing in long-term growth projects. This leads to “quarterly capitalism”, where shareholders are happy to receive extra cash from companies, while eroding the future competitiveness of the companies. The article recommends the following steps to lawmakers to deal with the situation:
i. Increasing the holding period to three years from one year to get tax benefit from capital gains. Holding a position for three years is much better than the short-term one-year outlook.
ii. For capital gains with holding periods below six months, the tax rate should be higher than even that for ordinary income. This would discourage very short term thinking.
2. Building a forward-looking board (McKinsey Quarterly) : The board of governors should play a leading role in the company’s policies. While the management has to contend with day-to-day issues, the board should steer the long-term vision, and thus a significant responsibility to ensure long-term outlook fall on the board. The article recommends a set of steps for the board to facilitate sustainable development practices:
i. Having a view of external developments, by calling in external experts on different topics for board discussions.
ii. Focussing the board on strategy-making: The article argues against the prevalent model in many companies in which the CEO presents the strategy to the board, which meets once or twice a year, and the board largely accepts it with minor modifications. It argues that the board should have an active advisory role throughout the year for the top management on strategy issues, as they can bring in a broader vision.
iii. Bring in long term perspective on talent management: The article argues that boards can bring in company-wide interests into talent management. For example, a high performer in a particular division would be highly values within the division, the the managers of the division would want to hold on to him/her even if the employee’s talents could be better utilised in another division, which would lead to more benefit for the company. The board can bring in a company-wide perspective.
iv. Deal with existential risks: The article argues that boards are much more qualified and equipped to deal with risks like possible insider trading, corruption etc. that might be eating into the long term interests of the firm.
3. Dealing with activist investors (Bain & Co) : This article deals with how a firm can effectively deal with activist investors, so as to ensure continuity in company leadership and long-term vision. They recommend the following steps to the management-
i. Looking at your firm from activists’ perspective: Activist investors look for predictable patterns: will a business be worth more broken up into its constituent parts? Will a change in management unlock more value? If a firm looks at itself and asks these questions, and thus strengthens its strategy, it can prevent surprise activist attacks.
ii. Having a fair internal valuation of the company, measuring for any gaps from the market valuation and understanding the reasons for the same, communicating the reasons to sizeable investors with the power to move the stock price, and delivering investor objectives with adequate milestones will help guard against activism.
iii. Having an emergency plan in place: If an activist attack does occur, have teams fully trained and prepared for their roles to assess the threat, develop adequate plans of how to execute strategy and how to communicate with activists and other investors.
Long-Term Capitalism is still being debated and discussed, and as such, a lot of questions remain unanswered. Reforming accounting measures remains one, while the growing activity of activist investors calls for stronger measures to align their interests with the long-term interests of the company.
Question 1: How do we reform accounting measures to encourage long-term investments by firms? (As long as we follow the current accounting practices, even in the absence of threats from activists, the bottom line will be diminished due to large scale investments in R&D. Thus, how to encourage the firms to do so without them losing out on reported earnings?)
Opinion: Eric Ries in “The Lean Startup” points out that Intuit, to promote innovation, reports revenue from sources that did not exist a period of time ago. He also calls out for the creation of a “Long Term Exchange”, where the companies listed would be free from the plague of quarterly.
This train of thought looks interesting: There can be an accounting measure that measures “revenue from those sources which did not exist a fixed period ago”, where the fixed period can be set to any time period that is suitable to measure progress in long-term projects, for example, three years. Thus, this measure will contain only the progress due to new long-term investments. If there are no investments for the future, and the company focuses solely on meeting its quarterly targets, then this measure will show zero revenue. If this measure is also included in the earnings for a company, then the company will have an incentive to overcome extreme short-term behaviour and invest in long-term projects to get good earnings number for this measure.
Question 2: How can the activist investors be made more aligned to long-term objectives? (As long as we allow for free markets, we cannot bar activists from trying to shake up companies.)
Opinion: An activist investor who attempts to change management policies should be locked out of selling his shares for a fixed period, say three years. This is to prevent the activist investors from making a “quick buck” at the expense of the company. Often, activist investors are accused of changing policies at the company that boost the share price of the company, and then sell off their shares which are now worth more than when bought, thus making profits. However, this type of activist is a “renter” and not a “buyer”, because he/she is just interested In making quick profits and then selling off the shares. Such investors are not worried about whether the company suffers after they sell their own shares, and so they may press for changes in the company that are harmful in the long run for the company itself. If we lock in an investor from selling his shares for three years, he will have no incentive to press for such harmful changes. He will press for changes that are helpful to the company in the long run, so that the share price is higher after three years.