The macro impact of short-termism

Stephen Terry 17 January 2015

a

A

For over a century economists and business leaders have expressed concerns with short-termism. As far back as 1890 Alfred Marshall colourfully wrote that people act “like the children who pick the plums out of their pudding to eat them at once”. The concern has carried through to the present, as market analysts currently widely publicise short-term firm profit projections or earnings targets for large public firms. As the managing director of McKinsey & Company wrote in 2011, “the mania over quarterly earnings consumes extraordinary amounts of senior-executive time and attention.”1 In a recent series of surveys of executives at large US firms, around 90% of managers reported pressure to meet earnings targets. Perhaps troublingly, almost half of executives reported that they would reject a profitable project if taking the project meant missing short-term profit targets.2

In my job market paper (Terry 2014), I study the consequences of short-termism through the lens of analyst earnings targets. Executives and commentators have suggested that short-termism might also manifest itself in high project hurdle rates or short capital budgeting horizons.3 However, the prevalence of earnings targets in manager decision-making apparent in executive surveys suggests that analyst profit projections provide a natural place to start with a systematic analysis of short-termism.

In the US, long-term R&D investments are almost fully drawn or expensed from current profits.4 Therefore, managers subject to incentives to meet short-term targets may sometimes cut their R&D to do so, an implication I empirically verify using detailed firm-level data. After building a theoretical macroeconomic model and estimating the parameters of this model, I find that the resulting distortion to R&D from short-termism leads to a loss in firm value of around 1% on average, lower long-term growth rates for the macroeconomy by about 0.1% each year, and lower welfare for consumers by almost half a percent, or $50 billion each year in lost consumption.

Short-termism in the data

My analysis starts empirically. I first document bunching of firm earnings just above analyst forecasts. Figure 1 drawn from Terry (2014) displays the histogram of earnings forecast errors for large US public firms from 1982-2010. The horizontal axis is realised profits in a given firm fiscal year minus consensus analyst expectations from the middle of the same period, as a percentage of firm assets. A disproportionately high number of firm profit realisations just meet or beat analyst expectations, while the distribution is hollowed out just below zero with relatively few firms reporting profits failing to meet earnings targets.

Figure 1. Earnings forecast errors for large US firms and realised profits (1982-2010)

Systematic actions taken by managers to meet profit expectations would naturally lead to the bunching of firm profit realisations seen in Figure 1. I investigate this possibility further, finding that firm-years in which managers just meet earnings targets have on average discontinuously lower R&D growth, about 2.5% lower growth per year. Since R&D is expensed from profits, one might expect relatively more shifting of this type of long-term investment rather than traditional tangible investment which is depreciated or drawn from firm profits over a longer period. Consistent with this logic, I find no discontinuity or change in tangible investment behaviour for firms just meeting targets.5

Why would firms and managers distort their long-term investments in this manner? My empirical analysis reveals that when just failing to meet earnings targets managers have around 7% lower total compensation, and that stock returns are around two-thirds of a percent lower when firms just fail to meet analyst expectations. My results are consistent with systematic manager incentives and market pressure for firms to deliver profits above short-term targets.

The consequences of short-termism

Motivated by this evidence consistent with R&D distortions and short-term incentives, I extend a standard macroeconomic model of long-term growth to include a rich microeconomic problem for managers. Managers solve an infinite horizon dynamic optimisation problem, making both R&D and paper manipulation choices in the face of firm-level profit shocks as well as short-term incentives to meet analyst forecasts of their earnings.

After building the theoretical model, I take my framework to the data, estimating both the fundamental micro-level shock processes at work as well as the magnitude of short-term incentives for managers.

  • By comparing my estimated economy to a world without short-term incentives, I find that the primary consequence of short-termism is higher R&D volatility as managers cut and expand their R&D budgets to meet short-term targets. Inefficient R&D investment leads to a 1% average loss in firm value at the micro level.
  • Aggregating the microeconomic effects within my theoretical structure, I find that short-term incentives lead to approximately 0.1% lower long-term growth for the entire economy each year.

Consumers as a whole lose from the compounding effects of lower growth by approximately 0.4% of consumption, or $50 billion dollars per year in the US.

When comparing these losses from short-termism to recent estimates of the welfare costs of business cycles or the welfare gains from trade of around 0.1-2.5% in consumption, the sizeable losses from short-termism validate traditional concerns on the part of economists and commentators.6

The sources of short-termism

Even in light of the distortions induced by short-term pressure, firm investors and owners still may not want to remove short-term incentives. The existence of short-term discipline and pressure through profit targets can serve to guarantee high effort from executives or constrain overinvestment and ‘empire building’ tendencies on the part of managers. In my analysis I show within the theoretical model that in the presence of such manager incentive problems, investors may actually gain from short-term incentives even if society as a whole loses from the resulting lower long-term growth and consumption levels in the economy. Short-termism is therefore likely a problem intricately embedded within the conflicting incentives of agents within firms.

References

Barton, D (2011), “Capitalism for the Long Term”, Harvard Business Review, 89, 84-91.

Dichev, I D, J R Graham, C R Harvey, and S Rajgopal (2013), “Earnings Quality: Evidence from the Field”, Journal of Accounting and Economics, 56, 1-33.

Financial Accounting Standards Board (2014), Accounting Standards Codification, 730-10-25-1.

Graham, J R, C R Harvey, and S Rajgopal (2005), “The Economic Implications of Corporate Financial Reporting”, Journal of Accounting and Economics, 40, 3-73.

Krusell, P, T Mukoyama, A Sahin, and A A Smith Jr. (2009), “Revisiting the Welfare Effects of Eliminating Business Cycles”, Review of Economic Dynamics, 12, 393-404.

Marshall, A (1890), Principles of Economics.

Melitz, M J, and S J Redding (2013), “Firm Heterogeneity and Aggregate Welfare”, Working paper.

Poterba, J M, and L H Summers (1995), “A CEO Survey of US Companies’ Time Horizons and Hurdle Rates”, Sloan Management Review, 37, 43-43.

Roychowdhury, S (2006), “Earnings Management through Real Activities Manipulation”, Journal of Accounting and Economics, 42, 335-370.

Terry, S J (2014), “The Macro Impact of Short-Termism”, Working paper.

Footnotes

1 See Marshall (1890) for the 19th-century quote. See Barton (2011) for the quote on a quarterly focus for executives

2 See Dichev et al. (2013) for discussion of the executive survey including 90% prevalence of earnings pressure. See Graham et al. (2005) for discussion of the executive survey including the prevalence of rejection of profitable projects.

3 See Poterba and Summers (1995) for discussion of firm hurdle rates and executive horizons from a CEO survey.

4 For a statement of this rule in the latest version of the US Generally Accepted Accounting Principles, see rule 730-10-25-1 in Financial Accounting Standards Board (2014).

5 For related work on changes in firm activities when just avoiding losses, see Roychowdhury (2006).

6 See Krusell et al. (2009) and Melitz and Redding (2013) for estimates of the welfare loss from business cycles or the gains from trade, respectively.

a

A

Topics:  Industrial organisation

Tags:  short-term incentives, R&D investment, growth

PhD Candidate in Economics, Stanford University

Events