16 Jul 2015
London Business School expert says short-termism is systemic
Long-term investment is critical for developing the intangible assets that are key to the success of the twenty-first century firm, a finance expert from London Business School has said.
Alex Edmans, Professor of Finance, London Business School, made the comment in reaction to Toyota’s recent announcement of ‘long-term’ shares, which give investors a higher pay-off if they hold onto them for five years.
By locking in its shareholders, Toyota believes that it will have the freedom to undertake long-term projects, rather than being pressured to pursue short-term profit. However, Toyota’s proposal has divided proxy advisers and drawn criticism from foreign investors.
In an article written for City A.M., Edmans says that although locking in shareholders for the long term seems sensible, the reason influential proxy advisers and major pension funds voted against Toyota’s proposal is because it’s unfortunately not that simple.
“Investors typically make money by trading on private information that is not in the stock price. Since information on short-term earnings is public, private information is typically on a firm’s long-term value – its innovative capability, its customer loyalty, its corporate culture. If an investor sells a stock because its long-term prospects are poor, such selling drives down the stock price and disciplines management. Thus, the threat of selling induces management to build for the long term to begin with. This mechanism is known as ‘governance through exit’, or ‘voting with your feet’.”
Edmans says that deterring exit, by locking in shareholders, takes away one of the key tools of corporate governance.
“The crux is not whether shareholders trade in the short or long term, but whether their trades are based on short-term or long-term information. How can we ensure that it’s the latter? By encouraging investors to take large stakes.”
However, restricting short-term trading has at least three costs, says Edmans.
“First, even if a large investor learns that a firm is sacrificing long-run value, it will be unable to trade on this information. It cannot discipline managers, and so they become entrenched.
“Second, if a large investor knows that it cannot sell based on its analysis of a firm’s long-term value, then it will not bother to do this analysis to begin with.
“Third, if investors know that they have to lock themselves in for five years, they won’t acquire a large stake in the first place.”
The problem of short-termism is systemic. “Managers will only invest for the long term if investors evaluate companies based on their long-term value. But investors will only gather long-term information if they can use such information, which requires them to have the freedom to trade on it in the short term.”