Blinded by the Short Term: How to Frustrate Sustainable Value Creation

Blinded by the Short Term: How to Frustrate Sustainable Value Creation

by Vincent Tophoff, Senior Technical Manager, IFAC | June 18, 2014 | 1

In an interview with IFAC, South African Governance icon Mervyn King talked about the “extraordinary socio-economic development” that has occurred over the last hundred years, in which “the greatest shareholder today is no longer the wealthy family, but the individual via his or her financial institution and pension fund.” This is reflected in the growth of the assets owned by these financial institutions, on behalf of the participating individuals, and their large market shares across the globe.

Arguably, as most participants in life insurance plans, pension schemes, mutual funds, etc., are signed up for the longer term, they’d rather have their institutional investor pursue sustainable value creation on their behalf than chase a quick profit. Additionally, as these institutions have a longer-term relationship with their clients and have sufficient capital to diversify, you would expect them to take a longer-term investment approach that would yield the most sustainable value.

Following the financial crises in 2008, there has been a renewed, loud, and widespread clamor for both companies and their institutional investors to take a longer term view.

  • In the same interview, Mervyn King said that “there is absolutely no doubt that institutional investors have an onerous duty. They are making decisions which will impact people’s lives 30 to 40 years hence, and they must assess the quality of governance, of management, and all these so‐called non‐financial aspects which make up the economic value of a company, before investing your and my money in a company.”
  • Institutional investors and their business organizations echo this call. For example, the Association of British Insurers (ABI), notes on its website that it “engage[s] with the government, regulators, and policymakers to ensure legislation and regulation encourages investment for the long term.” It also says that “when investing on behalf of their customers, ABI member companies have an important responsibility to protect and enhance their long-term interests.”
  • A large majority of board members and C-suite executives from around the world declared that using a longer time horizon to make business decisions would positively affect corporate performance in a number of ways, including strengthening financial returns and increasing innovation (86%, according to a 2013 McKinsey and the Canada Pension Plan Investment Board survey).
  • IFAC and the accountancy profession also believe that the creation and optimization of sustainable stakeholder value should be the objective of governance, as argued in IFAC’s International Good Practice Guidance, Evaluating and Improving Governance in Organizations. The guidance argues that governing bodies in all types of organization have the responsibility to use their resources responsibly in order to create and optimize sustainable value for their stakeholders.

In this light, it is rather shocking to learn that short-termism even has gained ground after the latest financial crisis! Even though they believed the opposite, the majority of board members and C-suite executives said that “the pressure to generate strong short-term results had increased over the previous five years” (63%, as per McKinsey). An even larger percentage (79%) felt especially pressured to demonstrate strong financial performance over a period of just two years or less, and almost half (44%) said they use a time horizon of less than three years in setting strategy.

Here is the issue: we all believe that taking a longer term perspective is in the interest of all stakeholders as it enhances the creation of sustainable value. Nevertheless, corporate executives continue to resort to short-termism, according to the survey, because their boards demand they do so and, in turn, these board members continue to resort to short-termism because of the increased short-term pressures of their investors.

So, everybody is blaming another link in the stakeholder supply chain, and the situation deteriorates rather than improves. How do we break this cycle? More regulation? Wider use and perhaps even enforcement of responsible investor codes, such as the UK Stewardship Code, the Code for Responsible Investing by Institutional Investors in South Africa, or the many other responsible investment codes as published at the International Corporate Governance Network? Engaging the ultimate beneficiary, the individuals, to transfer their money to better governed, more sustainable funds? What do you think would work to finally shift the focus?

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Rajesh Mudholkar
August 5, 2014

'Short-termism' gaining ground despite the experience of the latest financial crisis - even though board members believe the opposite - and boards blaming short-term pressures from investors, succintly highlighted by Vincent Tophoff here, is a classic case of 'everyone knows where the shoe pinches, but no one knows the remedy'. It is pertinent to note that Paul Polman, the CEO of Unilever minced no words in an interview with McKinsey Quarterly, saying "Any company-certainly a company of our size-has thousands if not millions of shareholders, and they can have different objectives. Some want you to spin off businesses and get a quick return. Some want share buybacks, some want dividend increases, some want you to grow faster. It’s very difficult to run a company if you try to meet the needs of all your shareholders. So we spent time identifying those we thought would feel comfortable with our longer-term growth model instead of catering to shorter-term interests" (http://www.mckinsey.com/insights/sustainability/business_society_and_the_future_of_capitalism). Even the World Economic Forum has highlighted this issue. (http://www.weforum.org/issues/long-term-investing). One important question every public company must answer is-who is the relevant shareholder as far as supply of equity capital is concerned? Clearly, it must the equity market as a whole and not any of its sub-group which may have disparate return-risk expectations. Further, it has been amply proven through various studies spread over more than five decades, that equity markets are rational in the long term (even if behavioural anomalies cause short term swings), and end up aligning with the economic reality that short-term competitive advantages of the underlying companies vanish in the long term. Classical economic theories, Michael Porter, and more recently a study by Accenture Institute for High Performance, all point to this reality. The Accenture study in particular also showed that short term premiums in equity prices disappered in the long term, proving economic theory and long term rationality of equity markets. If this is true, the only way all public companies would incorporate the long term value creation goal in their Plan-Do-Check-Act cycle, is to provide them with scientific tools to do it. As of now financial management remains a highly subjective art. It must move towards an objective science - rightly pointed out by the Association for Financial Professionals while commenting on its Cost of Capital Survey in 2011 - so that long term shareholder interests are protected and sustained value creation takes place. Here comes the next question. Is financial practice willing to shed traditional models which have been proven to have failed, and seriously review their economic logic? One such model is the Capital Asset Pricing Model (CAPM). In my article titled 'Decoding the CAPM Mystery' which is posted under 'Performance and Financial Management' here, I have analysed the issue and have proposed a well researched scientific solution. Serious discussion on the ideas proposed, can clear the way forward, so that long-term shareholder interests are protected with appropriate and objective regulatory guidelines.


 

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