Asking The Right Questions On Short-Termism

The Fed released a study this week that presents an important finding: companies that go public tend to invest more than similarly situated private companies. Firms listed on the stock exchange invest nearly 50 percentage points more than privately held ones, relative to tangible assets. Selling shares — or in the Fed’s words, “the financing of large, risky investments by distributing risks among many smaller investors” — means more spending by companies on research and development and other investment spending.

To illustrate, here’s what investment looks like when a company does an IPO. The public offering happens at 0; R&D as a share of total investment is on the vertical axis.

Screen Shot 2018-10-05 at 4.48.15 PM
Feldman et al (2018)

To some, the study is a blow against the market myopia hypothesis, i.e., that the incentive structure of the stock market rewards ultimately harmful short-term behavior (buybacks, underinvestment, etc). In Barron’s the headline is “The “Short-Termism” Critique of Public Companies Is Nonsense.” FT Alphaville: “’Short-termism’ isn’t a thing, say Fed economists.” This interpretation seems to have been intended by the Fed economists, who explicitly set up short-termism as a myth to be busted.

This would indeed undercut the short-termism hypothesis if that position boiled down to “private companies invest more than public ones.” But I don’t think that statement captures the most cogent criticisms of the current workings of the publicly traded sector.

It is true that evidence of a public-private financing gap plays a part in criticisms of how public companies operate. Noah Smith gestured to it (among other data points) in a recent interview on EconTalk. The most relevant empirical evidence is Asker, et al (2015), which looked at public-private investment dynamics and found that:

compared with private firms, public firms invest substantially less and are less responsive to changes in investment opportunities, especially in industries in which stock prices are most sensitive to earnings news. These findings are consistent with the notion that short-termist pressures distort investment decisions.

According to the Fed study, the Asker results can be chalked up to inadequate data, particularly with regards to R&D spending, which Asker et al left out. The Fed’s better data suggest that “Public firms outinvest private firms in R&D by nearly 200% on average.” 

That’s a remarkable number, but I don’t think it says as much about the short-termism hypothesis as people think. The compelling critique isn’t that public companies underinvest relative to private ones, but that present public companies underinvest compared to past ones. I don’t think there are a lot of people arguing that publicly traded equity is a bad way to raise money for productive investment, full stop. Matthew Klein of Barron’s writes, “The public company is one of the greatest financial innovations of all time,” and I think many of those who worry about short-termism would agree.

What people do argue is that publicly traded equity markets, and the institutions that undergird them, have changed over the last few decades in ways that skew how public firms operate. A sampling of investigations that take the above approach would include:

  • Gutierrez and Philippon (2016): “Private fixed investment in the United States has been lower than expected since the early 2000’s. The trend started before 2008, but the Great Recession made it more striking. Investment is low despite high levels of profitability and Tobin’s Q [an equity valuation metric interpreted here as a measure of investment potential] … We test 8 alternative theories that can explain the investment gap … Among these, the only ones that find consistent support in our industry and firm level datasets are decreased competition, tightened governance and, potentially, increased short-termist pressures.”
  • Mason (2015): “In the 1960s and 1970s, an additional dollar of earnings or borrowing was associated with about a 40-cent increase in investment. Since the 1980s, less than 10 cents of each borrowed dollar is invested. Since the 1980s, shareholder payouts have nearly doubled; in the second half of 2007, aggregate payouts actually exceeded aggregate investment. Today, there is a strong correlation between shareholder payouts and borrowing that did not exist before the mid-1980s.”
  • Lee et al (2016):  “We show that capital no longer flows more to the industries with the best growth opportunities because, since the middle of the 1990s, firms in high [Tobin’s] Q industries increasingly repurchase shares rather than raise more funding from the capital markets.”

The comparisons here aren’t private-vs-public but then-vs-now. Theories of stock market short-termism aren’t intended to explain some eternal problem with public equity financing. They’re interested instead in a set of potentially related phenomena that emerged around the time of the shareholder revolution in the 1980s. The private-vs-public question might be of interest, but it’s largely orthogonal to the short-termism one. (It would be interesting, however, to use a longer data set and examine the stability of the private-public investment gap over time, according to the Fed’s methodology.)

Incidentally, the Fed study gives some credence to the idea that short-term pressures have a measurable effect on the behavior of public companies. Measuring the investment patterns of companies whose stock prices are jolted more by earnings surprises — that is, those that “feel the strongest short-termist pressure” — the Fed finds:

The [data] suggest that short-term pressures are important … As industries become more responsive to earnings announcements, long-term investments and R&D expenditures fall. These findings suggest that short-term performance pressures reduce investments in these assets that depreciate slowly or may take time to generate returns.

This is consistent with studies in the short-termism camp. Almeida et al found that public firms put off investments and do share buybacks to meet earnings figures. According to a 2005 survey, more than 40 percent of corporate financial officers would reject a promising investment project if it meant missing quarterly expectations

Whatever you think about short-termism (personally I don’t love the framing), comparing private to public companies in the present doesn’t answer the really pertinent question, i.e., why things have changed so much in the last 30 years. The answer to that question could have to do with issues related to market myopia — executive compensation, buybacks, hedge fund bad guys, etc — or it could be largely unrelated. Suffice to say that short-termism has not yet been debunked.

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