Six questions about the curse of "quarterly capitalism"
A lot of people nowadays are worried about “quarterly capitalism”: the idea that big companies are too busy meeting the short-term demands of equity markets to invest in the future.
Quarterly capitalism played a big role in a speech of Hilary Clinton’s last week. Bank of England brainiac Andy Haldane criticised it (and shareholder power in general) a recent Newsnight interview (video/write-up), and Will Hutton denounced it in his weekly column. But it’s far from a new idea; in recent years it’s been a concern of a wide range of people, from Bill Lazonick to the managing director of McKinsey*.
It all seems plausible to me – after all, human beings are often too short-termist about all sorts of things. But there are a few things about the quarterly capitalism critique that I don’t understand, and I thought I’d set them down here in the hope that people can help me out. (I'm sure there are simple answers to many of them.)
1. Where does the buyback cash go?
A lot of the critiques of quarterly capitalism focus on buybacks and other payments to shareholders: companies are going wrong because they pay out surplus cash to shareholders rather than investing it internally. (Haldane observes that British companies today are paying 60-70% of their profits back to shareholders.) But none of the buyback critiques I’ve come across talk about what happens to buy-back cash once shareholders receive it.
If the money vanished, then buybacks would obviously be bad for overall investment; likewise if shareholders spent it on something other than investment. But presumably some (many? most?) institutional investors re-invest cash from buybacks and dividends? I’ve seen it argued that perhaps they put the money into “unproductive investments”, like secondary market real estate. But as Jonathan Portes pointed out to me on Twitter, this just pushes the question further down the line – what does the seller of the real estate do with the cash from the sale?
2. Is it short-termism or just self-interest?
Most people agree that society and the economy can lose out if companies don’t invest enough. But sometimes, underinvestment might be in the interest of the company itself. Some of the critiques I’ve read aren’t clear on the difference between short-termism and corporate self-interest. But it matters, not least because it determines what sort of remedies have a chance of fixing the problem.
Let me explain. Consider two companies, Amy’s Widgets and Bob’s Gizmos that are investing in big new projects (hooray!).
Amy’s Widgets invests in a project to design and manufacture a next-generation flugelbinder. Because it has an expert salesforce, strong manufacturing skills and a good supply chain as well as a crack R&D department, things go well and the company makes a great return on its investment. Society also benefits, because people can buy cheap, high-quality new flugelbinders, which, as economists would say, generates lots of consumer surplus.
Now let's turn to Bob’s Gizmos. Bob’s Gizmos invests in a different new product, the veeblefetzer. The R&D process goes well, but Bob is kind of a flake. The firm doesn’t have the supply chains or the distribution capabilities to make the business thrive. After a few years, the veeblefetzer division is closed down. The veeblefetzer market ends up being dominated by other companies, who learn from Bob’s Gizmos’ research and from its mistakes.
In this example, Bob’s Gizmos loses money, but society gains, since the R&D and know-how that Bob’s Gizmos paid for helps create a new product and market. (In the jargon, the investment is NPV-negative for Bob, but has lots of positive spillovers.)
Now imagine that neither of these investments happened. In both cases, society as a whole loses out. But the outcomes for the two companies are different, and so is the likely motivation for the failure to invest.
In Amy’s Widgets’ case, not making the investment is against the company’s interests – to explain it, you have to assume there’s a misalignment of incentives between the company and whoever is calling the shots (perhaps the CEO’s options vest that quarter, so she curtails investment and buys back shares to jack up the stock price – a classic bit of short-termism). But Bob’s Gizmos is better off as a result of not investing: the benefits its investment produced were spillovers to the economy as a whole that it received nothing for. Bob's problem isn't short-termism, but the misalignment of incentives between the company and the world at large.
This might seem like a nit-picking distinction. But it is not a purely theoretical one. Some anecdotal examples of underinvestment fall in the Amy’s Widgets category (for example, British critiques of the decline of ICI usually assume the company turned down NPV-positive long-term investments to curry favour with the City), while others fall into Bob’s Gizmos territory (when people get nostalgic about the days of EMI backing Godfrey Hounsfield’s CT scanner experiments, or AT&T’s support for the sometimes quite blue-skies research of Bell Labs).
The distinction matters because the two different failure modes point to different problems. In Bob’s Gizmos’ case, management is doing the right thing by shareholders (and probably by its employees and suppliers too), but society is losing out. Crucially, the Bob’s Gizmos problem isn’t one of short-termism, even though the observable result (underinvestment) is the same. So tackling short-termism probably wouldn't address the observed problem of underinvestment. Since you’d fix these two problems very differently, it’s important that we’re clear on which one is happening.
3. How much of a problem is shareholder power?
Andy Haldane’s thoughtful interview seems to suggest that giving company shareholders less power might help fix things. In Duncan Weldon’s words: “Mr Haldane noted that other systems of corporate law give greater weight to other stakeholders - such as employees and customers - than the UK system…With business investment low and productivity growth weak, it may be the time to look again at the model, Mr Haldane added.”
Will other stakeholders – such as employees or customers - be more willing to invest? I can see it playing out both ways. On the one hand, I think of the Lucas Plan, the bold proposals from 1970s manufacturing shop stewards to invest the energies of their ailing employer into a wave of wonderful ethical technologies. Customers might also favour investment. Some companies' customers might even vote for NPV-negative investments, since they as customers can capture the spillovers by moving their business elsewhere. (If you were a customer of Xerox in the 1970s, you might be in favour of their experiments with GUI computers even if they wouldn’t end up dominating the market, because, hey, you could always buy a Mac!)
But the opposite might happen too. Employees are much more tied to the fortunes of their companies than diversified shareholders (am I allowed to mention CAPM?). If an investment goes wrong, a shareholder might make a small loss on their portfolio, but an employee could lose their job and their livelihood. (This asymmetry is a central point in Lazonick’s other work on the Risk-Reward Nexus of innovation.) Equally, today’s customers might care more about continuity than innovations or new product lines that might open up entirely new markets. The idea that stakeholders are more pro-investment than shareholders seems pretty unclear.
4. What about intangibles?
I can’t help thinking intangible investments, like R&D, design or marketing, are important here. We know that businesses in rich countries are investing more and more in intangibles. For the last decade or so, they’ve invested more each year in intangibles than in tangibles (according to the Corrado-Hulten-Sichel method of measurement as deployed by Jonathan Haskel and others, at least), and things are only going up.
One characteristic of intangible investment is that it has spillovers. If a company builds a factory (a tangible investment), it will get most of the benefits of the investment itself. If it develops the iPhone (a set of intangible investments including R&D, design and marketing), a lot of other people benefit too (such as all the other smartphone producers and mobile OS developers who moved into the market once Apple showed what a big deal it could be).
Now think back to Amy’s Widgets and Bob’s Gizmos. Bob’s Gizmos veeblefetzer investment had lots of positive spillovers, and so it might have been in the company’s interests to turn it down even if it wasn’t in society’s interests – it wasn’t a question of short-termism, but rather of spillovers. If intangible investment (which typically has high spillovers) is getting more common, you might expect to see more examples of underinvestment that aren’t the result of short-termism.
5. What about disruption?
We have a disruption swear-box at Nesta – innovation people talk too glibly about disruption, after all. But let me drop a few quid in the box and do it anyway. The fact is, some investment is difficult or uncongenial for incumbents to do.
This is partly a matter of corporate culture (“exploit” and “explore” are different mindsets and management styles, hence skunk works and startups and a host of other things). But it’s also a matter of incentives.
Take the energy sector, where (as Richard Jones rightly points out, there has been a calamitous collapse in R&D in the past few decades). In the energy sector, cash (what the accountants would I suppose call “cashflow from operations”) comes from big incumbents, who dig or pump hydrocarbons out of the ground and set them on fire. To the extent that the world’s long-term energy needs ought to depend much more renewables and nuclear power, oil majors may not be the best people to conduct this research.
Clearly not all investment should be disruptive. But some should, and an effective financial system ought to do a brisk job at recycling cash from mature sectors to disruptive (one more coin in the box) businesses. How much? I don’t know; but it seems a question worth asking.
6. Does short-term share-ownership cause short-termism?
Part of the quarterly capitalism critique is that the owners of shares often don’t own them for very long. The super-villain of this strand of the argument is high-frequency trading, which has introduced whole classes of investors who own securities for fractions of a second. But it’s not just HFT; holding periods for shares have fallen in recent decades even if you take out the algorithms and the quants, from six years in 1945 to six months today.
It seems pretty intuitive that short-term shareholders would engender short-termist attitudes to corporate investments. But is that true? It could also be argued that the most risk-averse shareholder is one who can’t walk away. Research by Alex Edmans of London Business School suggests that the ability to sell makes for better shareholder stewardship, not worse.
Clearly there are many risks and issues raised by high-frequency trading. But the idea that HFT or stock market liquidity leads to short-termist attitudes seems to merit more analysis.
So there we are: six questions I’d like to know the answers to. I should stress that these are genuine questions, not “gotchas” – it still seems perfectly plausible to me that short-termism and underinvestment is a problem. But if it is, it’s a problem that we’ll be better able to address the better we understand it.
Image credit: screenshot from the YouTube film: Very tempting marshmallow test