This blog post is part of the HBR Online Forum The CEO's Role in Fixing the System.
Much has been made in recent years about the pernicious influence of short-term investors on corporate performance. I believe these arguments often miss a nuance: It is not the short-term investor but short-term management that is the problem. The short-term investor does not reduce the firm's long-term competitiveness and value;short-term management does.
There is plenty of evidence to show that investors can and do trade stocks more frequently than they did decades ago. This by itself is not a surprise; after all, the costs and effort associated with trading stocks have gone down dramatically. Not surprisingly, some investors would seek to benefit from the combination of lower transaction costs and opportunity to make money from the fluctuations in prices. Asking them not to profit from such opportunities is likely to (and possibly should) fall on deaf ears.
Moreover, I fail to see any argument why such short-term traders, by themselves, destroy value for the economy as a whole. Clearly, some of these traders could get very rich even while others lose money, but these trades — unless they influence operators within companies — amount to little more than robbing Peter to pay Paul.
Indirectly though, these short-term traders can destroy value. How? Put simply, short-term trading — and the fluctuations they cause or exacerbate in short-term prices — can influence managers to make decisions that are not in their firm's long-term best interest. This conclusion draws on two arguments, each of which needs to explained briefly.
1. The short-term price of a stock can differ from that implied by the firm's long-term valuation. A firm's long-term value should correspond to the present value of future expected cash flows. However, investors at any given point in time might have limited information on aspects of the company's operations and this could bias their expectations of future cash flows.
Some types of information are not revealed to investors because managers either do not want to or are not allowed to reveal the information. Equally importantly, the average investor might be limited in his or her ability to understand the firm's operations fully and hence, his or her expectations of future cash flows might be biased. Consider, for example, the average investor's inability to understand the subtleties of fashion design or scientific research.
2. Operational decisions at the firm are often influenced by the short-term price.
There are many reasons for managers not to ignore the short-term price. The obvious one is that they are often compensated with stock options, whose value is based on the firm's current stock price. However, there are many other reasons too, and I suspect these other reasons might be more important drivers of managers' decisions. A low stock price can make the firm vulnerable to a hostile takeover, for example. Moreover, in many cases, managers have bemoaned to us the "hell we got" from their boards when the stock price fell. It apparently takes a courageous and confident board member to second-guess the market!
These short-term decisions have the potential to destroy long-term value. During the last few years, I have interviewed numerous managers and often asked them why they failed to invest in projects that — at least in their assessment — would have created long-term value. Usually, these were investments in basic R&D, customer service, and employee skills that in the short-term investors would find difficult to understand and value appropriately. (Admittedly, these investments are also in domains that are close to my heart.)
Under pressure to manage the short-term stock price — and at times meet short-term earnings target — many managers told me that they had abandoned sound projects with good long-term value because these investments would not help, and could often hurt, their stock price. Compounded over many firms, such under-investment in otherwise worthwhile projects compromises society's long-term progress. It might even be at the root of national competitiveness (or lack of it), and the economy's (in)ability to develop projects with longer gestation periods.
It is true that the root cause of the frequent underinvestment in worthwhile projects might be investors' desire to profit from short-term price fluctuations. That said, investors' short-termism per se does not destroy long-term value. Instead, the critical question to ponder is: How can managers make optimal long-term decisions even when the stock price does not reflect true long-term value?