Short-termism and manipulation of financial results: causes, problems, ways to overcome

The global financial crisis that started in 2007 drew attention to the concept of value creation and long-term investments as opposed to improvement of shortterm earnings. This article describes the phenomenon and seeks for ways to overcome it.

Short-termism can be defined as the inclination of corporate managers to orient corporate strategies towards maximization of short-term earnings at the cost of long-term objectives [3].

But what makes managers behave in such a way? The main reason is the pressure of investors who require improvement of financial indicators in the short- term. Nowadays, in the world of new technologies and globalization, the issue becomes an emerging problem. Individual investors prefer to entrust their savings to investment funds, since today there is a huge load of information that can be properly and timely analyzed only by special means. which are possessed by financial institutions. But in return, individual investors require a visible growth of their wealth. They have an opportunity to compare the results of investment funds in the near future and change the allocation of their money transferring them to another fund with minimal transactional costs. That implies a rough competition between the financial institutions and influences their investment policy. Therefore, investment funds tend to finance not the companies with promising sustainable future growth, but the companies that are likely to improve their financial results in the near future. The next level of short-termism pressure is the influence exerted by shareholders on top-managers. There are three factors. The first one is the reelection period of an executive director which, for example, in the UK equals to one year that motivates managers not to work towards maximizing shareholders’ value in a long-run, but towards attaining the results that would satisfy shareholders expectations in the short-term. Secondly, since hostile takeovers and managerial dismissals are common, executives try to avoid low current stock valuations and respond to investors’ explicit demands in order to prevent them. The third factor is a remuneration scheme that is a driver for actions and decisions of executives. If executives’ bonuses depend on achieving some short-term goals, such as an increase in the market capitalization or annual revenue growth, they have incentives to pay more attention to these performance indicators at the cost of longer-term value creation [5]. Moreover, if an executive owns stock options with short vesting periods, he/she is more likely stimulate actions to accelerate the growth of the company in the short-run to benefit from selling their holdings before the long-term costs of their decisions materialize.

One of the illustrations of short-termism would be that management of companies uses high discount rates while evaluating investment projects. In 2011, Andrew Haldane and Richard Davies found out that among UK and US listed firms, “cash-flows 5 years ahead are discounted at rates more appropriate 8 or more years hence; 10 year ahead cash-flows are valued as if 16 or more years ahead; and cash-flows more than 30 years ahead are scarcely valued at all.”[2] That is why short-term investments are made more often regardless the fact that long-term ones could be more benefit for companies.

The ROI requirements now placed on both private and public companies are inconsistent with the long intervals usually needed to develop value-adding innovations in industries such as electronics and pharmaceuticals. While it could still be argued that stock-market valuations are more accurate than any alternatives, these markets are primarily a device for valuing existing assets and re-trading entitlements to their returns. Capital for new investment is raised only when companies make initial public offerings or issue new bonds or shares. Even in this instance, some of the funds raised, represent a value transfer from new (public) to existing (private) investors, which may be followed by value extraction as earlier loans are repaid and shareholdings cashed-in[4].

Underinvestment is also considered with human capital. Short-termism is an obstacle for a company to train its employees and attract new specialists. To reduce short-term costs and increase stock price, companies announce significant layoffs, which affect long-term performance detrimentally.

In my opinion, it is impossible to overcome short-termism problem completely. But there is a number of ways to minimize its pressure on executives. The first one is communication of the long-term goals and strategies and the ways of their implementation. Since executive appointment is limited to a short-time period, it is necessary to be able to provide the results of the work not only through profit, capitalization, and positive trend in CF criteria, but also by undertaking well-evaluated investment projects and development of sustainable growth in a company. These topics can be communicated via annual reports and different meetings. Annual reports should be formed in a way to establish a focus on the achievement of long-term value increase. Also, stakeholders should work on improvement of incentive plans for executives, so that they would be motivated to make decisions that would influence the future of a company in the best way, for example, the vesting periods should be long.

Taking into consideration individual investors, restrictions should be imposed to improve effectiveness of investment funds, especially those ones that have to provide a return in long-term (pension schemes). The retention can also be raised by increasing transactions costs. The same measures can be applied to institutional investors, which might be supplemented by implementing a rule by which long-term investor may have more voting rights, etc.

Short-termism not only influences some individual companies; it restricts a sustainable growth of the whole economy. Therefore, the measures stated in the article should be applied to maximize effectiveness of business management, investments decisions and shareholders’ wealth.