Paying for short term performance is doing what the investors want, but not what most investors need
19/10/2011
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A confluence of factors is reinforcing the focus on short-term performance.  The growing emphasis on short-term incentives in executive remuneration is entirely in keeping with the expectations of a significant part of the institutional investment community. 

We have researched this in the past (for example – see HEREand HERE).  Now, a recent paper on The Economic Costs of Excessive Short-termism by Hyperion Asset Management explains why the financial markets demand short-term performance over long-term performance from the executives of the companies they invest in.

The findings included:

·          Corporate chief executives are being turned over more quickly. A study of the world’s 2,500 largest companies found the average CEO lasted 10 years in 1995 but only six years in 2009. In Australia, their lifespan is even shorter, with the average CEO lasting just 4.4 years in the job versus 8.6 years globally. The average tenure of chief executives who leave due to underperformance is just 3.6 years, indicating a chief executive’s job is on the line if they don’t produce results in the first couple of years.

·          The need to produce fast results leads chief executives to take on more debt to buy overpriced assets when markets are booming. Debt-to-equity levels peaked at 95 per cent in 2008 when the pre-GFC boom was at its silliest, then many companies were forced to raise capital to satisfy their lenders when prices crashed, further diluting returns to investors. The correlation between executive remuneration and company size may serve to increase the incentive for managers to expand at all costs.

·          A 2006 survey of senior financial executives in the US found 80 per cent would cut discretionary spending on things such as research and development and advertising to meet a short-term earnings target, 55 per cent would delay starting a new project and 97 per cent believed the market rewarded short-term predictability rather than long-term value creation.

·          While fund managers are fond of telling retail investors to hang in for the long haul, few of them practice what they preach. In 1955 the average fund in the US held its portfolio for seven years; in 2005 this was down to 11 months. The average holding period for Australian shares has fallen from more than six years in 1986 to less than 12 months.

·          While it takes 25 years to 40 years for a fund manager’s track record to be statistically significant, managers are frequently sacked following short periods of underperformance. Studies have shown managers are frequently fired just before their performance improves and hired just before performance declines. This has led to fund managers focusing on the risk of losing business due to short-term underperformance at the expense of strategies that could deliver better returns over the longer term.

·          The average tenure of the head of an Australian equities team is less than three years – well below that five- to 10-year investment horizon needed to deliver significant added value.

·          A study of returns achieved by mutual funds in the US found that while the S&P 500 index returned 13 per cent a year between 1983 and 2003, the average equity fund returned 10.3 per cent and the average fund investor just 7.9 per cent. The average fund underperformed because of added costs while the average investor did badly largely due to ”counterproductive market timing and fund selection”.The end result is a market where the next quarter’s results are viewed as being much more important than having a long-term strategy – even if getting those short-term results comes at the expense of growth.

Hyperion’s paper indicates that while taking shortcuts will generally destroy value over the longer term, the trend to short-termism has been increasing. Instead of focusing on the long-term, fund managers in particular become desperate to avoid the inevitable periods of underperformance that come with any long-term strategy.

Some may argue that modern markets have become systemically locked into short-term thinking because it is too dangerous to do otherwise. Where’s the incentive for a chief executive to launch a bold new venture if it will mean a short-term hit to earnings and, inevitably, to their pay packet?What’s the point of a fund manager basing their investments on a five- to 10-year strategy if they will lose business by underperforming over the next 12 months? That’s assuming the actual managers will still be in the job in another five years.

The paper concludes that we need a rethink of how both corporate executives and fund managers are measured and paid. It recommends eliminating remuneration based on short-term earnings, requiring fund managers to make meaningful investments in their funds and requiring company management to set long-term strategic goals and its own list of metrics that the market can assess.

The paper can be found HERE

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