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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
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
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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 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. In
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 in
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 short-term
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)
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
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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.
Written by a member of the Paper F9 examining team

References
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papers.ssrn.com, 1 December 2012
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J anuary 2005
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Financires Colloquium: New Paradigms in Money and Finance?, Brussels May 2011, p1
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J ackson K, Rowe S, and Zimbelman A, Can companies reduce current investor short-termism by 'relationship
reporting?' papers ssrn.comMarch 2013
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Last updated: 25 Oct 2013
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