Short-Termism Poses Long-Term Drag on Growth

(Bloomberg View) -- Eric Ries, an entrepreneur and the author of “The Lean Startup” and other business books, has started a company to create a new stock exchange. The Long-Term Stock Exchange will lock up investors' money for a long time, forcing them to think beyond next quarter's earnings. Obviously this lack of liquidity will cause stock sold on the new exchange to go for a discount, since investors will want to be compensated for the inability to get their money out any time they like. But companies might be willing to accept lower stock prices, if they come bundled with a promise that investors won't hound them to focus on the short-term at the expense of their companies' future.

Ries's financial innovation is the latest attempt to address the issue of short-termism in corporate America. That subject has gotten little attention in the halls of policy-making, perhaps because it's not a hot-button political item. On the left, many are skeptical of the notion that more corporate investment is the medicine the economy needs, choosing instead to focus on redistributive taxation and nationalization of the health-care system; on the right, the focus is on cutting taxes and slashing regulation. Although the notion of tweaking capitalism to make it work better may be out of fashion, it could still be an important piece of the puzzle of how to boost growth. And whether you're on the right or the left, faster growth is something everyone should want.

Short-termism might be slowing growth by holding back corporate investment. When businesses invest, the economy grows. But big investments reduce near-term earnings, and incur considerable uncertainty as to whether they'll pay off. If executives of public companies are compensated based on quarterly earnings, there's just very little incentive to make big expensive risky forward-looking investments -- and that means little incentive to grow. That's why it's troubling that many companies are sitting on such big piles of cash instead of investing it:

Is short-termism a major factor here? Back in June, I reported on a research paper by Steven Kaplan of the University of Chicago's Booth School of Business, saying that the threat of short-termism was either nonexistent or exaggerated. But I also argued that the reasons Kaplan gives have major caveats or are of questionable relevance.

Other research has shown important evidence on the negatives of short-termism. A 2010 paper by economists John Asker, Joan Farre-Mensa and Alexander Ljungqvist found that closely held companies tend to invest more than similar publicly listed companies, and also tend to be quicker to respond to new investment opportunities. And a 2007 paper by Rudiger Fahlenbrach found that companies run by founder-chief executive officers tend to invest more in both capital goods, and research and development -- investments that are rewarded with higher stock prices over the long term.

The evidence that short-termism might be harmful continues to pile up. A 2014 paper by Stanford University's Shai Bernstein finds that when companies go public and face pressure for quick results from investors, their best inventors tend to leave, and the ones who remain produce fewer patents. Though patenting is a poor measure of innovation at the industry-wide level (since one company's patents can hinder innovation by other companies), it's a good indicator of the effort a company is putting into research. Bernstein's paper also shows that once companies go public, they plow less of their resources into far-sighted R&D investments.

Meanwhile, economists German Gutierrez and Thomas Philippon have a recent paper investigating the causes of low business investment. They find that the more public companies are owned by institutional investors, the less they tend to invest.

That could be because institutional investor diversification acts as a form of monopoly power, as other researchers have claimed. In addition to low investment, monopoly power in theory should lead to bigger profits and higher stock prices. And since Asker at al. and other researchers have shown that private companies -- which passive investors don't own nearly as much of -- outperform publicly listed ones, it seems unlikely that monopoly power is the sole explanation here. Gutierrez and Phillipon claim that although institutional investment does decrease competition, it also makes companies more vulnerable to short-termist pressures, as they focus more on quarterly earnings.

So although more research needs to be done, evidence is piling up that short-termism is hurting public companies in the U.S. That in turn may be driving more companies to de-list and return to being private or to avoid going public in the first place, which shrinks the number of Americans who are able to share in the wealth those companies create. And it may be holding back those companies that remain public, pushing them to hold cash instead of expanding and hiring more workers.

That's why experiments like Ries's are important and useful. If patient ownership really does confer benefits beyond what the current public markets offer, the Long-Term Stock Exchange or something like it should flourish … at least, in the long term.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

To contact the author of this story: Noah Smith at nsmith150@bloomberg.net.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.

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