A growing number of prominent business leaders have been pushing regulators to address what they believe to be one of the most significant detriments to U.S. economic growth — “short-termism,” or the heightened importance that public companies and their shareholders place on near-term profits.
Warren Buffett and Jamie Dimon co-authored an op-ed piece last June in The Wall Street Journal, arguing that far too many public companies are holding back on investing for the future because they feel pressure to increase the bottom line to meet the next quarter’s forecasts.
At the same time, a movement has gained ground to make it easier for individual investors to access the private company market, where many businesses take a longer-term approach to creating value.
Last month, SEC Chairman Jay Clayton announced that the SEC would weigh the possibility of a major regulatory overhaul that would broaden the definition of “accredited” investor. This would allow more retail clients to take part in private placements, giving them greater opportunity to tap into a rapidly growing segment of the economy.
The fact that these two developing stories are unfolding at the same time is no coincidence.
Rise of Short-Termism
McKinsey & Co. has spent years analyzing the extent to which public companies have shifted their focus away from long-term strategic planning and toward maximizing short-term profits.
Using a data set of 615 domestic large- and mid-cap companies that were publicly listed from 2001-2015, McKinsey developed the Corporate Horizon Index (CHI), which measures the aggregate amount of short-termism in the market.
Their findings show that the median CHI score has become increasingly short-term over the last 20 years. McKinsey also conducted a series of surveys that showed that 87% of public company executives reported feeling the most pressure to generate strong financial results in under two years.
The rise in short-termism could have a meaningful impact on your clients who hold a significant percentage of their wealth in public companies, including via 401(k) plans and IRAs.
There are two primary reasons that stock market returns are expected to decline. First is the logical assumption that public businesses focused on short-term profits are less likely to deliver sustainable growth over the long-term.
To this point, McKinsey’s research shows that from 2007 to 2014, companies classified as having a long-term focus invested more in R&D and showed revenue 47% higher and earnings growth 36% higher than that experienced by short-term oriented businesses. Additionally, the long-term focused firms were 50% more likely to rank in the top decile for total shareholder returns within their given industry.
In contrast, experienced private equity managers are almost obsessively focused on creating value in their portfolio companies over a three- to six-year period, which is the typical length of PE ownership.
These managers spend a tremendous amount of time with the senior executives running their portfolio companies, focusing on long-term value creation plans such as expanding into new markets, making add-on acquisitions and/or improving operations by streamlining costs and selling noncore assets.