The Case Against Corporate Short-Termism
When it comes to profit, patience pays offby tim koller, james manyika and sree ramaswamy
tim koller is a partner in McKinsey & Company's Strategy and Corporate Finance Practice. james manyika is a McKinsey senior partner and director of the McKinsey Global Institute, McKinsey's business and economics research arm. sree ramaswamy is a partner at MGI.
Illustrations by Gordon Studer
Published August 4, 2017
Policymakers and pundits alike have been raging against "short-termism" on the part of corporate managers for decades. The critique is well-known: pressured by Wall Street analysts and investors poised to exit at the drop of a disappointing quarterly number, CEOs inflate short-term results to the detriment of long-term performance. But there has been precious little hard evidence that a failure to think long term actually harms companies' performance — and, more broadly, the performance of the American economy. That is, until now.
McKinsey has filled this empirical gap with a systematic measurement of short- and long-termism at the level of individual companies, placing them on what we call the Corporate Horizon Index. The findings show that companies on the long-term end of the spectrum dramatically outperform those classified as short term. And it offers a basis for extrapolating the economy-wide costs of short-termism as measured by GDP and job creation lost.
This is only a first step. The McKinsey Global Institute intends to identify the firm characteristics — forms of ownership, industry and age differences, and the like — that lead firms to choose long or short planning horizons. And we want to broaden the analysis to see whether short-termism is linked to secular stagnation, declining productivity growth and the rise of competitors from emerging markets.
The Cart Before the Horse
Among the firms we identified as focused on the long term, average revenue and earnings growth were 47 percent and 36 percent higher, respectively, by 2014, and total return to shareholders was higher, too. The returns to society and the overall economy were equally impressive. By our measures, companies that were managed for the long term added nearly 12,000 more jobs on average than their peers from 2001 to 2015.
We calculate that U.S. GDP over the past decade might well have grown by an additional $1 trillion if the whole economy had performed at the level of our sample of companies that make the cut as long term, generating some five million additional jobs over this period. (In this extrapolation, of course, we must assume that the quality and quantity of labor needed would be available, and that the Federal Reserve would not take steps to restrain growth for fear of overheating the economy.)
An important message to emerge from our research is that, despite strong pressures to focus on the short term, it is possible to manage for the long term and reap considerable rewards. A small but significant 14 percent of our sample of companies did not start out as long-term strategists but shifted from a short- to a long-term mind-set over the course of the 15-year period that we measured.
Short-termism is on the Rise
We examined how a company at the median of our index in 1999 would perform in subsequent years and discovered that the median score across our entire sample has become increasingly short term over time. We detected a slight move away from short-termism in the years immediately preceding the financial crisis, but the trend toward short-term thinking resumed during the crisis and has largely continued to increase since.
This finding is corroborated by indications contained in the McKinsey Quarterly survey panel of more than 1,000 C-suite executives and board members in late 2015 and early 2016. A majority of respondents said that the pressure to generate strong financial results within two years was growing. In the two years since a similar survey was conducted, the share of respondents who reported such pressure rose from 79 percent to 87 percent. Those who felt the pressure most acutely over seven years or more dropped to zero, but those who felt the most pressure over a period of less than six months increased from 26 percent to 29 percent.
Trillions of Dollars of Value Creation at Risk
Analysis of our Corporate Horizon Index suggests that firms taking a long-term approach outperform those with a short-term view across the board.
Long-Term Firms Exhibit Stronger Fundamentals
The long-term companies with the highest index scores significantly outperformed other companies on revenue growth, which rose by 47 percent more on average for them through 2014 than for short-term companies. The long-term group slightly trailed other companies in the run-up to the financial crisis in 2008, but their revenue declined less during the crisis and subsequently increased more rapidly. From 2009 to 2014, the revenue of long-term companies grew at an average annualized rate of 6.2 percent compared with 5.5 percent for other firms.
These strong fundamentals enabled long-term companies to weather the crisis better than others. Note, too, that over the entire sample period the revenue of long-term companies was less volatile than that of other firms, with a standard deviation of average revenue growth of 5.6 percent compared with 7.6 percent for others.
The same story plays out for earnings growth. The earnings of long-termers declined less than those of other companies during the financial crisis, and rebounded much more quickly. By the end of the 14-year period, the earnings of long-term companies had cumulatively grown 36 percent more on average than those of other firms.
The outperformance of long-term companies is even more pronounced when measured in terms of economic profit, which incorporates the opportunity cost of a company's invested capital to measure how effective firms are at using their capital to grow their businesses. On average, long-term companies increased their economic profit by 81 percent more than other firms. This indicates that the higher revenue and earnings exhibited by long-term firms is no fluke, and that the value they created did not materialize overnight. Although long-term firms had higher average economic profit growth over the whole sample, the gap widened over time as long-term plans came to fruition.
Long-Term Companies Deliver Superior Financial Performance
The increased value delivered by long-term firms in terms of revenue, earnings and economic profit translated into higher market capitalization. Strangely, long-term firms experienced larger declines in market capitalization than did other firms during the financial crisis, with peak-to-trough declines of 38 percent compared with 34 percent for others. However, after the crisis, the market caps of long-term firms increased by two percentage points more per year on average than did those of other firms, delivering an additional $7 billion of market capitalization from 2001 to 2014.
If all other firms had appreciated at the same rate as long-term firms, U.S. public equity markets could have added more than $1 trillion in market value from 2001 to 2014, increasing total U.S. market capitalization by roughly 4 percent. This may not seem like much. Yet, among other things, it would have been sufficient to eliminate a substantial portion of the total funding gap for public pension plans that are among the largest shareholders of these companies.
Long-term firms also delivered greater total returns to shareholders. Over the sample period, they were approximately 50 percent more likely to be in the top decile and top quartile for total shareholder returns in their industries than were other companies, and approximately 10 percent less likely to have total shareholder returns below their industries' medians. Long-term companies (27 percent of the total sample) captured 44 percent of the growth in total returns to shareholders from 2001 to 2014.
In the industry groups that delivered above-average shareholder returns during this 14-year period, long-term companies captured an even greater share of the total returns (47 percent) while accounting for only 26 percent of the sample group. Even in industries with below-average shareholder returns, long-term companies captured a greater percentage of the total returns than would be expected given their share of the sample.
Long-Term Companies Continue to Invest in Difficult Times
The ability of the long-term companies to deliver higher and more consistent revenue growth and higher earnings relative to other firms even during the financial crisis suggests that these companies maintained consistent and sustainable sources of growth — key goals of long-term planning. For example, long-term companies invested significantly more in R&D on average than other companies over the 14 years. This trend was particularly pronounced during the financial crisis, when long-term companies continued to invest while others cut spending. Between 2007 and 2014, R&D spending by long-term companies grew at an annualized rate of 8.5 percent, compared with 3.7 percent by other companies. Because long-term companies continued to invest in future growth despite difficult economic conditions, they were rewarded.
Long-Term Companies Add More to Economic Output and Growth
Long-term companies that captured large shares of U.S. corporate growth and delivered outsized returns to shareholders also hired millions of workers to fuel their growth. Across the sample period, long-term companies had cumulatively created nearly 12,000 more jobs on average than other companies. Extrapolating from this difference, corporate America would have added roughly 5 million more jobs from 2001 to 2015 if the entire market had been long term.
Based on these estimates of job creation, more than $1 trillion of potential value could have been produced if all U.S. publicly listed companies had taken a long-term stance over the past decade. If we assume that the rates of job creation observed from 2001 to 2015 were to continue over the next decade, the average differential would grow to about 25,000 jobs by 2025. That implies additional GDP of $2.7 trillion (in 2015 dollars), or $350 billion a year, by 2025, if all companies were to match the performance of long-term firms over this period.
The Corporate Horizon Index
The Corporate Horizon Index for the United States was developed by the McKinsey Global Institute, McKinsey’s Strategy & Corporate Finance practice and FCLT Global.
The data were drawn from 615 non-finance companies that had reported continuous results from 2001 to 2015 and whose market capitalization in that period had exceeded $5 billion in at least one year. The sample collectively accounts for between 60 and 65 percent of U.S. public market capitalization (excluding financial companies). This choice was motivated by a desire to focus on companies large enough to feel the potential short-term pressures exerted by shareholders, boards, activists and others.
We identified a set of long-term companies — those with index scores above their industry median for at least 12 of 15 sample years, or that clearly switched from being short term in the first half of the sample to being long term in the second half. The idea was to capture both companies that always exhibited a long-term outlook and those that experienced the “natural experiment” of changing their outlook during the period. By these criteria, 27 percent of the sample was classified as long term.
The unweighted index is based on five variables, using data from McKinsey’s Corporate Performance Analytics database. Each variable corresponds to a hypothesis for how long-term companies behave differently from short-term ones and how these differences might manifest in financial data when companies are compared with industry peers. We hypothesize that longterm-oriented companies will differ primarily in:
- investment rates, with long-term firms investing more — and more consistently.
- the quality of their earnings, with long-term firms relying less on accruals and accounting methods to boost reported earnings.
- relying on revenue growth instead of cost reduction to increase profits, with long-term firms less likely to have many consecutive years of increasing margins.
- earnings management, with long-term firms less likely to manage quarterly earnings to meet analysts’ consensus estimates.
- reliance on financial engineering, with long-term firms less likely to use share repurchases and other non-operating methods to increase earnings per share.
Companies have been asking themselves what they can do to overcome excessive short-termism in the way they operate for many years now. In late 2014, McKinsey, together with the Aspen Institute Business & Society Program, explored options with a group of CFOs from publicly listed companies and "intrinsic" investors — sophisticated long-term institutional investors with long holding periods and concentrated portfolios. One overriding message emerged: CEOs, CFOs and corporate boards should be doing everything they can to attract and retain intrinsic investors in order to counteract pressure to adopt short-term thinking and strategies and support long-term value creation.
During these conversations, four approaches appeared to resonate the most with intrinsic investors:
Pursue long-term value even at the expense of short-term earnings. When asked to react to hypothetical trade-offs between short-term earnings and long-term value creation, past McKinsey surveys have found that only half of companies would make an unambiguously long-term decision when confronted with a major strategic challenge. In contrast, intrinsic investors overwhelmingly favor decisions that lead to long-term value creation. When faced with an unfavorable currency shift with no future strategic ramifications for the company, 19 of the 24 intrinsic investors said they would be neutral if the company took no action and simply reported lower profits. But nearly two-thirds said they would take a negative view of an order for across-the-board cost reductions.
Intrinsic investors apparently realize that companies can't predict exchange rates and don't want companies to take arbitrary cost-cutting actions simply to meet earnings expectations. We then asked, assuming exchange rates stayed the same, whether the company should accelerate cost-cutting in the following year to keep its earnings rising, even if long-term revenues could be negatively affected. Twenty-one out of 23 intrinsic investors viewed this negatively. In subsequent interviews, some investors said that this could lead to a downward spiral in which reduced investment on marketing and sales, for instance, lowered revenue growth and then, in a vicious circle, to further cuts in spending on marketing and sales expenditures to prevent short-term earnings from declining.
We also tested reactions among intrinsic investors to a new CEO's decision to continue operating a legacy unit despite the fact that it was losing money and had no prospect of being profitable. Seventeen out of 24 of the investors from our panel viewed the option of sustaining such a unit negatively, while 20 were neutral or positive about the company shutting it down despite the one-time hit to earnings. Most favored an attempt to divest the unit in the CEO's first year on the job.
Take charge of investor communications. The intrinsic investors on our panel said that they favored companies with executive teams that confidently choose how, what and when to communicate about their business. Investors said they wanted to be educated so that they understand the company they backed with their money. The information they seek included the company's competitive advantages and how its strategy builds on those advantages, the external and competitive forces a company faces, and what concrete measures the company is taking to realize its aspirations.
Intrinsic investors also want to know how a CEO makes decisions, whether the company's approach is aligned with long-term value creation, and whether the whole management team is aligned around strategy. All but one of the 24 intrinsic investors on our panel rated management credibility as one of the most important factors they consider in making investments – and part of that credibility is openness even when things aren't going well.
Stand up to artificial moves to meet earnings targets. A number of studies have shown that it is common for companies to defer investments to meet short-term earnings targets by, for instance, reducing discretionary spending on value-creating activities such as marketing and R&D. One study found that nearly two-fifths of CFOs would give discounts to customers to make purchases this quarter rather than the next. Intrinsic investors reject the premise that companies need to do whatever it takes to meet the consensus numbers when they report quarterly earnings. Only three of the 24 investors on our panel thought it was important for companies to consistently meet or beat consensus estimates for revenue or earnings. Most said that they were satisfied with a company sometimes beating estimates and sometimes missing, as long as the company was making progress toward its long-term goals.
That's consistent with previous McKinsey findings that more than 40 percent of companies missing their consensus earnings estimates nonetheless experience rises in their share prices. Moreover, intrinsic investors appear generally to oppose the issue of earnings guidance, especially on a quarterly basis. Only five of the 24 on our panel said that they would regard a company announcement that it intended to discontinue earnings guidance in a year's time as a yellow flag. In the words of one: "Long-term investors don't need a lot of detailed guidance about quarterly numbers. They need clarity, consistency and transparency from managers in communicating strategic priorities and their long-term expectations."
Rethink quarterly calls. Only four of the 24 on our panel said that they thought quarterly earnings calls were an important part of their engagement. But 19 said they valued one-on-one meetings and less frequent (though more long-term in focus) investor days or strategy conferences.
The main criticisms of quarterly calls were not the practice itself but the way they are conducted – overly scripted and subject to poor questioning. Other investors said that they found quarterly calls most helpful when they reminded investors of the company's long-term strategy and goals before diving into the short-term results. Fifteen out of 25 long-term investors said they would favor investors or analysts submitting questions in advance in order to enable companies to give prominence to the questions asked most frequently and those that were most relevant to interpreting quarterly results as indicators of long-term performance.
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The Corporate Horizon Index discussed here is based on U.S. data and is only the start of MGI's ongoing efforts to develop its understanding of this issue. However, even on the basis of the analysis thus far, it is becoming clear that companies deliver superior results when executives manage to create long-term value and resist pressure from short-term investors. We have seen large global companies succeed by taking a resolutely long-term view, yet we still find that short-termism is rising to the detriment of corporate performance, jobs and economic growth. Given the new evidence presented in the Corporate Horizon Index, all executives should reexamine their approaches — and talk openly to the long-term investors who sustain their businesses to explore ways of improving their relationships.
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