Empirical Evidence for Stock-Market Short-Termism?

This blog post is part of a larger series on stock-market “short-termism”. See also my entries on share buybacks and progressive corporate governance reforms.

I. Introduction

To recapitulate the “myopia thesis”: managers of publicly traded firms are hostage to diversified shareholders who forego careful study of the firm’s fundamentals and instead respond to the latest, easily digestible quarterly earnings report. Rather than undertaking investments that might have a substantial return down the road, managers mimic the priorities of transient shareholders uninterested in a firm’s long-term strategy. Future-oriented firms that resist this temptation will find it more difficult to raise capital. This will then jeopardize their ability to survive long enough to reap the returns from long-term investments. 

The myopia hypothesis predicts that: 1) stock markets undervalue firms that sacrifice short-term profitability for longer-term growth 2) firms will therefore rationally forego long-term investments such as research and development (R&D) and capital expenditures (CAPEX). In this post, I will critically examine the evidence for such claims.

II. Profits, P/E Ratios and IPOs

Several economic indicators challenge the first pillar of short-termism thesis. In a recent NBER working paper, Steve Kaplan contrasts the early predictions of the myopia theorists in the 1980s with subsequent trends in corporate profits. If the short-termists of yesterday had been correct, the earnings posted by publicly held firms throughout the 80s and 90s would have evaporated over the medium-to-long term. Instead, we’ve since witnessed a steady upward march of corporate profits into now unprecedented territory.[1]

Moreover, while earnings have been on the rise over the past several decades, the price-to-earnings ratio (P/E) of the median firm listed on the S&P has risen even faster, currently at 25 compared to a historical median of 15.[2] A higher P/E ratio indicates that shareholders are valuing future earnings very highly. The very names that come to mind when one thinks of dynamic, future-oriented firms: Google, Apple, Amazon, Microsoft, Facebook all have exceptionally P/E ratios (~35), in many cases despite long periods of losses (Amazon netted more income in the final quarter of 2017 than in all 54 post-IPO quarters cumulatively). Investors act as if today’s unexceptional profits are going to grow substantially over the coming years and are pricing this optimism into current share prices. For these five firms, total profits of $101 billion in 2017 translated into a valuation worth 15% of the entire S&P 500.[3] The latest “Special Report” of the Economist magazine, while describing the potential monopoly threat that these tech giants pose, nonetheless concedes that their currently stratospheric valuations are in anticipation of future profits:

To justify its valuation, Facebook’s rate of “monetisation” will have to surge, suggesting that it extracts a bigger fee from other firms who want to reach consumers. To justify its $820bn market value, Amazon will have to increase its share of American retail to 12% (Walmart’s share today is 7%). Likewise Netflix will have to roughly double its nominal fee per user over the next ten years. Though tech firms’ profits as a share of gdp today are not extraordinarily large, Wall Street is predicting they will be in a decade’s time, with the median ratio for the five firms rising to 0.28%. That is above the 0.24% median level of Standard Oil, us Steel, at&t and ibm when they were each clobbered by antitrust regulators. The tech firms are expected to have higher returns on capital than the oligopolies of old, suggesting that they are better at extracting income per dollar of assets.

The Economist goes on to elaborate the ways in which prominent firms are leaving money on the table in the short-term to build future marketshare:

For Amazon and Netflix the rents flow in the other direction because their prices are low today: in total they subsidise their combined 240m paying subscribers to the tune of about $50 per person per year, based on the amount of additional free cashflow they would have needed to cover their cost of capital in 2017

Further corroboration can be found in the timing of IPOs. Notable examples such as Uber notwithstanding, the overall trend in IPOs has been toward more and more “premature” births of firms into public markets. The average profitability of a firm at the date of its IPO has been declining over the past several decades, as investors are willing to purchase shares in firms earlier in their life cycle.[4] Kaplan, citing IPO statistics by Jay Ritter, notes that just 4% of biotech firms that had an IPO between 2013-2016 were posting profits at the time. If publicly traded companies were indeed hobbled by myopic shareholders, this would present a massive arbitrage opportunity for investment vehicles operating on a longer time horizon. Venture capital and private equity funds are equipped for this purpose yet have not seen the abnormal profits or increased marketshare that one would expect if publicly traded firms were consistently failing to anticipate trillion dollar bills a few steps ahead on the sidewalk.[5]

III. R&D Up, Not Down, In Public Firms

The second key piece of evidence militating against the myopia thesis is that publicly traded U.S. firms, particularly those with the bubbliest valuations, are conducting more R&D than ever before, not less. Let’s begin by noting the strong upward trend in the overall private sector’s spending on R&D, which I’ve divided by total GDP (known as “R&D Intensity”):

Next, let’s look at R&D spending by the five aforementioned firms that shareholders are tripping over themselves to invest in:

The only way to reconcile the myopia hypothesis with the foregoing data is to maintain that these firms’ valuations would be even higher if they were spending less on R&D. For some reason, that counterfactual rings false. Post-recessionary declines in capital expenditures, on the other hand, seem superficially sympatico with short-termism, but can be adequately explained by reference to lower capacity utilization, and is in fact a worldwide phenomenon not restricted to the “overly financialized” Anglosphere.[6]

Let’s recall the mechanism by which short-termism is said to operate: diversified, rationally ignorant shareholders with short time-horizons turnover at high rates and punish future-oriented investments that incur immediate costs, such as R&D. We would expect, therefore, that publicly traded firms, whose shareholder profiles check those boxes, would suffer more acutely from myopia than privately held firms. Indeed, studies have found that publicly traded companies that go private register more patents post-transition, and, conversely, that privately held firms suffer a decline in patent quality after an IPO.[7][8] More directly to the point, a 2015 paper found that compared to privately held firms matched on a battery of relevant characteristics, public corporations engage in less net investment, and are less likely to capitalize on new investment opportunities as they emerge.[9]

A 2018 Federal Reserve Board working paper that uses corporate tax return data, comes to the opposite conclusion. Because private and public firms are subject to the same IRS filing requirements, the researchers were able to use the exact same measure of R&D investment when comparing the two groups, where previous studies had to impute measures of R&D for private firms. Moreover, whereas the Asker et al paper only had access to an unrepresentative sample of private firms and had to combine their measurement of capital expenditures with merger and acquisition activity as a rough proxy for net investment, the FRB study’s IRS data allows it to directly measure long-term investment, and to divide this measure into its physical and intangible (R&D) components. Beyond being far more granular, this dataset also captures the full universe of private U.S. corporations, allowing the researchers to compare a representative sample of private firms against their publicly traded counterparts, mitigating the selection effect that has plagued past comparisons. Not only do the Fed researchers find statistically significant differences between private and public firms, the magnitude of these effects is substantial:

…public firms invest…46.1 percentage points more in long-term assets than their private firm counterparts. It is not simply that public firms invest more relative to their asset base and thus out-invest private firms, they also direct a greater share of their investment portfolios to long-term assets. Public firms allocate 9 percentage points more of their total investment dollars to long-term assets than comparable private firms. The long-term investment advantage of pubic firms over private firms largely stems from their outsized investments in R&D. Public firms invest 39.2 percentage points more in R&D expenditures relative to physical assets, and dedicate 11 percentage points more of their investment budgets towards R&D than private firms[10].

Moreover, the researchers directly attribute this result to the difference in the shareholder profiles facing private vs. public firms:

The access to capital investment and the ability to spread risks among many small shareholders appears to facilitate heavier investments in R&D, arguably the riskiest of asset classes.

This result does not appear to stem from an omitted variable confounding the comparison between private and public firms. By exploiting the variation in R&D spending pre and post-IPO within the same firm, the researchers similarly note:

We find that public firms do not alter their short-term investment relative to physical assets following an IPO. These firms do, however, increase their long-term investments, and particularly investments in R&D: firms increase their R&D-to-physical asset ratios by 34.5 percentage points, and their R&D-to-total investment shares by 17.1 percentage points. Using an event study framework, we show that this increase in R&D expenditures occurs immediately upon IPO and persists for at least 10 years. We also examine changes in investment behavior following stock market delistings: results are less precise, but generally point to a reduction in R&D investments upon going private.

[1] Kaplan (2017)

[2] ibid

[3] Roe (2018)

[4] Fama and French, 2004; Ritter, 2016; cited in Kaplan, 2017

[5] Supra note 4

[6] Supra note 4

[7] Lerner, Sorensen and Stromberg (2011)

[8] Bernstein (2015)

[9] Asker, Ferre-Mensa, and Ljungqvist (2015)

[10] Feldman et al 2018