Observations on the Short-Term/Long-Term Debate, Part 1

The debate about whether U.S. public companies are afflicted by short-termism rather than more beneficial longer-term behavior and, if so, its effect on our economy is ubiquitous. It occupies increasing attention in corporate boardrooms, executive suites and investment management businesses from the smallest to the largest. The debate is a commonplace topic in the legal and academic worlds as well as the financial press, and it is rapidly spreading to more general news outlets and the political scene — to the point where at least one Presidential candidate has made the debate a focal point of her tax reform platform.

A complicating factor in the debate is that there is no consensus about what short-term and long-term refer to. Is or should the debate be about:

• investor behavior (e.g., short-term traders versus long-term holders),
• investor objectives (e.g., increases in portfolio value in the short term at the cost of foregoing better long-term fund performance),
• corporate behavior (e.g., focusing on short-term profitability to meet or better quarterly performance goals to the detriment of greater long-term profitability) or
• corporate objectives and strategy (e.g., engaging in financial engineering to generate short-term value creation, thereby precluding long-term investment in building the business through research and development, improved plants and production methods or product and market expansion)?

This paper offers some observations on the debate, as well as its rhetoric and assumptions, in an effort to bring some clarity to the topic, identify the important issues and ultimately resolve at least some of them.

Four Critical Fallacies

The duration of any investor’s holding period in a company’s stock is simply not relevant to issues involving corporate value creation. In today’s equity markets there is virtually no end to investment styles and goals, which vary greatly on many levels, including projected or actual duration of discrete portfolio positions.

• Index funds and their EFT equivalents, by hypothesis, must remain invested (directly or synthetically) in every equity within their index, adding a new stock to portfolio only when its issuer is added to the index, and eliminating a stock from portfolio only when the company is dropped from the index. These types of quantitative funds are the epitome of long-term investors—they always own the index. But the fact that they are long-term investors says little about their behavior as voting shareholders. In fact, index investors are often among the most avid supporters of short-term corporate initiatives.
• Other quantitative investors, such as high-frequency and other program traders, may trade in and out of a specific security multiple times in one day or even one hour or less, creating a new epitome of short-term trading. But it is hard to see how such avowedly short-term traders have a meaningful effect on corporate behavior and strategy. They are involved in corporate governance only by the accident of holding a stock at the close of business on a record date for a shareholder meeting. Whether in that case they do vote and, if so, for or against management is an idiosyncratic response. The extremely short duration of their holding periods seems relevant only to trading volumes and portfolio turnover statistics (as well as, of course, their asserted potential to distort market pricing).
• Actively managed portfolios, unlike index funds, partake of both long-term investing behavior (e.g., establishing and maintaining a position in a desired stock often for years) and short-term buying and selling (e.g., to adjust the size of a portfolio position in reaction to one or more macro and micro factors affecting the portfolio company). Their apparently short-term trading decisions may be based on the long-term fundamentals of the issuer or on shorter-term considerations, such as a weak quarterly performance. But their short-term portfolio “balancing” rarely affects the long-term inclusion of a company’s stock in the investor’s portfolio. Moreover, while their voting on matters affecting corporate governance and strategy may be more informed than that of quantitative investors, it hardly falls into a specific pattern of supporting or opposing management initiatives and strategies.
• Activist investors are often characterized as short-term investors. However, it is quite clear that their holding period for any given portfolio equity may range from days to years, thus belying a facile characterization of their trading behavior.
• Another problem with characterizing investor holding periods as short- or long-term is deciding at what point in time a holding period is to be measured, as well as differentiating between entrances and exits from a stock position and adjustments to a portfolio position in light of the investor’s investment style and objectives. For example, if a hedge fund has a large position in a company’s stock for three years and decides to liquidate the position in its entirety based on a discrete event, is the fund’s behavior short-term (the time between the event and the sale of the position) or long-term (the time between creation and elimination of the position)? Similarly, if an investor buys into a stock for the first time and its behavior is viewed 30 days later, is it acting in the short or long term? What if it intends to maintain the position indefinitely but changes its mind three months later?
• Finally, and most telling, there is simply no logical connection between an investor’s holding period for a given stock and the behavior of the issuer. Of course, issuers may wish to build a base of long-term holders to reduce volatility in their stock price and to facilitate investor relations and relationships. But their underlying concern is to create more buyers and fewer sellers of their stock. Companies in the final analysis are concerned principally with buying and selling imbalances in the market, which cause increases or decreases in the price of their stock. It is not the duration of the buyers’ and sellers’ holding periods that ultimately matters to the issuer—it is the act of buying or selling that matters, without regard to the holding period objectives or practices of the investor.

A second fallacy is that the duration of a prototypical investment implied by a particular investment style or objective of a shareholder is relevant to the corporate value creation discussion. It is clear that some investors, albeit for different reasons (contrast an index investor when a new stock is added to an index and a fundamental value investor, like Warren Buffet, who decides to make an investment in a new portfolio company), establish positions in a stock as part of a consciously long-term investment strategy. In contrast, of course, are consciously short-term traders (think day traders and high-frequency traders, whose investment strategy in the extreme case may be to buy and sell on the basis of mere basis point changes in the price of a stock). The reality is that some investors are or want to be long-term holders, some are wholly short-term in their investment style and are more than willing to own a stock for minutes or less and many are simply agnostic about the duration of their holding period for a particular equity. Projected and actual holding periods under the multitude of investment strategies being practiced vary all over the short-term/long-term continuum. But that fact says nothing about corporate behavior. As noted above, companies are insensitive to investment styles, but highly sensitive to the balance of buyers and sellers in the market.

A third fallacy is that the duration of a company’s business initiative (whether involving capital allocation; entrance or departure from a line of business; investment or disinvestment in R&D, plants or products; diversification; concentration; or any other strategic or tactical program) has an implicit connection to value creation. Too often, the term “short-term” is applied to a business tactic or strategy as a pejorative, as if a long-term initiative inherently creates more value than a short-term program.

This is patently untrue.

The correct question in every case is not how short or long the duration of the initiative, but rather whether it will generate more net present value than the available alternatives. The answer to this question will obviously vary from initiative to initiative—it will not be the same for every company, even those deemed most comparable, nor will it be the same for a company when addressed at different points in time when circumstances differ.

The fourth fallacy in the short-term/long-term debate is that, given every company’s finite resources, choosing a corporate strategy that can be implemented in a relatively short-time period (often a type of so-called “financial engineering,” such as a major stock buyback, a divestiture or spin-off of a business or a sale of the entire company) almost certainly prejudices, if it does not preclude, longer-term, more beneficial strategies (such as greater investment in R&D, upgrading productivity of plants and equipment or acquisitions). This formulation of the debate associates activist investors with short-term strategies at the cost to the company and its other shareholders of greater long-term value creation. But this formulation of the debate simply does not make sense.

Activist funds are in business to maximize value creation for their investors (and for their principals, who get rich on their carry and their investment in their own funds). Why would any rational activist investor consciously forgo the higher-net present value of a long-term company business initiative in favor of the investor’s lower, short-term value creating idea? Activist fund managers don’t get paid for ego trips; they get paid for maximizing returns. The same, of course, is true for all actively managed institutional investors. Even index and other quantitative investors should opt for the highest net present value creator if they have the capability of understanding and evaluating the competing proposals. In theory, only short sellers should oppose the highest-net present value-added program, regardless of its duration.

Properly Framed, the Debate Should be About Game Plans, Not Time Duration

So then, what is the long-term/short-term debate all about? Stripped of the rhetoric and emotional biases of managements and Boards on the one hand, and investors on the other hand, the debate is not about duration, but rather about evaluating competing agendas that frequently have different time horizons. While in theory, net present value should be the arbiter of the debate, in practice, it obviously is challenging to determine the net present value of a given corporate business initiative, and reasonable people can and will disagree about its calculation. Hence, activist campaigns are typically characterized by competing investor presentations, through which management and the activist each tries to demonstrate the value creation superiority of its business plan.

But if the debate does boil down to nothing more than investors choosing between two competing strategies for a company, why all the heat and passion? Perhaps the source of much of the emotion is that Boards, management and the proponents of these strategies believe that the shareholder vote (actual or projected) that ultimately resolves the conflict between an activist’s game plan and the Board’s is unfairly stacked against the Board.

Because most activist investor business plans focus on shorter-term solutions than those of management, it is convenient to characterize them as “short-term,” and there is no doubt that today “short-term” does have pejorative connotations. Viewed in this light, one would think that many institutional investors would be emotionally biased against activist investors and in favor of management’s typically longer-term program, not the contrary as believed by most managements and Boards.