What is “short-termism?”
The tendency to invest in proposals with quicker benefits (net of costs) while sacrificing initiatives with greater net benefits received over a longer time – even after adjusting those proposals for differences in strategic options created,
As with any decision process, there are several causes of poor decisions:
- Dynamic environment, capabilities and “what if?” insufficiently understood
- Estimates poorly made of cost and benefit cash flows over time, strategic options, risk and interest rate; including a tendency to “over-discount” the future
- Process poorly designed so the right information doesn’t flow to the right people at the right time, in the right frame, with the right questions
- Prior decisions foreclosed options
- Pressure from external stakeholders with shorter-term horizons than the organization overall
- Pressure from internal organizational bargaining and personal incentives such as compensation programs not aligned throughout an organization and especially those that do not reward calculated risk-taking to create growth
Errors arise from structural blindness and/or bias to assumptions that are thought to be too small to matter but later are damaging.
How old is this problem?
"Penny wise, pound foolish" goes back at least to Robert Burton (1577–1640) of Oxford University. Strategically, the concern is millennia old with roots in military and commercial logistics (think Alexander the Great or the Great Silk Road trade). Financially, risk, discounted cash flows and options have been standard textbook material for decades.
From U.S. data, the problem became more pronounced with: 1) the rise of beta/quant/index funds shifting investor attention toward market data and away from company fundamentals and 2) financial markets double dip in 1999 and 2001 that shifted investment decisions by companies.
Are there solid approaches to overcome short-term decision-making?
Yes, from multiple professional disciplines:
- Competitive analysis and strategy (authors such as C.K. Prahalad and Gary Hamel)
- Product
Management (C. Merle Crawford and C. Anthony Di Benedetto) - Finance methods for net present value (with thoughts brought together by Joel Dean in 1951)
- More from decision science (such as Graham Allison and Philip Zelikow), organizational behavior and engineering disciplines (especially W. Edwards Deming)
Why have past attempts at issuer-investor engagement to overcome short-termism not been successful?
Reasons vary by company, industry and country, including:
- Board members with insufficient business domain knowledge, discipline knowledge in strategy, product management, quality and/or finance; hiring CEOs who are more “CFOs in CEO clothing” rather than growth/visionary leaders; or approving compensation systems that emphasize measures other than risk-adjusted growth rates that reflect strategic objectives and sustained profitable revenue growth.
- Management with insufficient business domain knowledge, discipline knowledge in strategy, product management, quality and/or finance. Of special concern are knowledge gaps that result in managers using “payback” rather than “real options” or “net present value” methods for evaluating investments.
- Lack of knowledge of and appreciation for “future value” as a major component of firm value; lack of competitive foresight and plans to create future value and the metrics need to measure those plans.
In some ways, this could be summarized as “talk is cheap.” After years of admonitions to “be more long-term,” talk doesn’t matter much compared to board strategy and individual capital allocation decisions.
How can CFOs act to foster a longer-term outlook (even 3-5 years)?
Reform the company financial planning and capital budgeting process around risk-adjusted growth rates, net present value and valuing options. Stop using payback; avoid focus on earnings per share.
Team with head of investor relationships to revise annual meeting, investor presentation and quarterly calls to emphasize risk-return-aware value creation. Fully understand how shares trade and establish regular communications flow with designated market maker (including crisis communications process – BEFORE the crisis).
Team with corporate secretary to shape board decision packages rich with competitive foresight, a robust “what if?” understanding of risk, and clear math of options with net present value. Make clear that “strategic” is not a code-word for “squishy benefits.”
Learn – build personal depth in art and science of selecting investments in the context of options with net present value. Depth includes sufficient knowledge of customer and competitive analysis, strategy and product management to fully appreciate the source and nature of inputs to decisions. Thoroughly learn how fundamental investors view your company (most on this in the course of the same name).
Intentionally design, don’t just document process. Ensure strategic and investment processes are rigorous, with built-in filters for bias. A “defined” or “documented” process does not mean it is able to produce good outcomes. Recall, bid rigging is a highly defined process intended for malicious results, and frauds are enabled when a process is well-documented but incorrect.
Team with
In considering “long term” this could imply decades to match the outlook of an individual investor’s retirement outlook. However, often this is just improving to 3-5 years from a 1-2 year payback.
How can CFOs improve the investor conversation?
Enable CEO and board members to bridge between investor portfolio needs and company capabilities through a measure shared by both – risk-adjusted growth rate in revenue and operating free cash flow. Discuss:
- Why the strategy and capital allocation process is reliable because it is risk-aware and tuned to growth, not just well-documented.
- Why the environment and business capability analysis, and “what if?” risk scenario analysis is competitively superior and thus able to achieve higher risk-adjusted growth rates from capital allocation.
- How cost of capital by business line was determined (including the investor’s funds)
- Why investments were selected and rejected in view of strategy and available capital
- What has been learned about risks and how this led to oversight and management improvements
- How management of risk is performance-based and built into all financial reporting – NOT a audit-like bolt-on.
- How value creation process improvement is measured and why those measures are most appropriate.
CFOs and big ideas…
The big idea is that if Finance leaders shifted their companies to a longer term approach through more risk-return enlightened capital allocation, then business sales would grow and with it country GDP (U.S. business sales are about 75% of GDP).
Consider the S&P 500 member companies. If together they increased sales by 2%, then the total would be the combined GDP of the 130 smallest country economies, home to over 1 billion people. Those tangible, “ring the register” sales could do far more for global growth than government monetary and fiscal stimulus has struggled to deliver for the past seven years.
Are you ready to make a difference?
Learn more:
Best Practices for CFOs to Improve Investor-Company Communications
Driving Effective Earnings Calls and Ongoing Investor Communications