The Economics of Short-Term Performance Obsession

Al Rappaport

Q Group SeminarOctober 19, 2004

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Theory Versus Practice

• Theory—Discounted cash flows (DCF)

• Practice—Short-term earnings and tracking error

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Five Basic Questions

• Why do investment managers focus on quarterly earnings?

• Can stock prices be allocatively efficient when short-term earnings and tracking error dominate investment decisions?

• Can investment managers earn excess returns if they buy and sell stocks they believe the market has mispriced on a discounted cash-flow basis?

• Is corporate management’s focus on short-term earnings self-serving or also in the best interests of its shareholders?

• What can be done to alleviate the obsession with short-term performance and improve allocative efficiency?

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The Limitations of Earnings

• Earnings– Facts—realized cash flows– Assumptions about the future—accruals

• Accruals– Existing (incomplete) contracts

• Value– Existing plus future contracts

• Accruals/ Stock Price– Typically less than 5%

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The Appeal of Earnings

• Investment managers– Asymmetric information– Estimating distant cash flows too speculative– Short-horizon investors and the Keynes beauty

contest– Stock prices respond to “earnings surprises”

• CEOs – Belief that earnings drive company stock price– Concern with reputation– Incentive compensation

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Market Efficiency

• Informational efficiency– No free lunch

• Fundamental efficiency– The price is right

• Allocative efficiency– Degree to which stock prices allocate

resources to firms with the most promising long-term prospects

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Informational Efficiency

• The evidence– Scarcity of investment strategies and money managers that earn

excess returns• Huge expenditures for investment research—why?

– “Subsidized informational efficiency”• Conventional wisdom

– Efficiency depends on market participants disbelieving it• Paradoxical reality

– Active managers contribute to informational efficiency by closely tracking their benchmarks

• Stock prices reflect information relevant to the models investors employ and therefore an informationally-efficient market is not necessarily allocatively-efficient

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Fundamental Efficiency

• The “right price” is indeterminate– Heterogeneous beliefs and risk preferences

• The right price is unknowable today and cannot be determined at a later date – Those who contend that stocks were “mispriced” in

the past typically rely on information available only after the alleged mispricing

• Event studies– Address informational efficiency of stock price

changes, not fundamental efficiency of stock price levels

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Allocative Efficiency

• Allocative efficiency– Depends on skills of informed investors with

competing estimates of DCF value

• An ideal– A nearly informationally efficient market (no

free lunch, but occasional early bird specials) dominated by informed DCF investors.

• Today’s reality– Pervasive use of non-DCF models

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Non-DCF Models• Portfolio benchmarking• Earnings expectations game• “Fundamental” analysis that’s not fundamental

– Shortcut metrics—P/E, Price/Sales, Price/Book• Pervasive use of relative valuation (multiples, comparables)

– Relative valuation does not independently estimate absolute value of stocks and thereby does not directly contribute to allocatively-efficient prices

• Technical analysis• Indexing• Restrictions on short-selling

– Limits ability of pessimistic investors to reflect their opinions in prices• Socially responsible funds• Employees with undiversified positions in their company’s stock

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How Allocatively-Efficient Is the Equity Market?

• Who are the guardians of allocative efficiency?

• Can allocatively-efficient prices emerge in Adam Smith invisible-hand fashion given the dominance of non-DCF traders?

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Are Mispriced Stocks Exploitable?

• Limits to arbitrage in equity market– Imperfect substitute securities to hedge– Noise trader risk– Costs

• Trading commissions• Bid-ask spreads• Market impact costs• Short-sale fees and constraints

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Are Mispriced Stocks Exploitable?

• If arbitrage is not feasible, investors must develop better estimates of value than the current price

• Why should long-term investors use DCF if prices are dominated by short-term earnings?– Stock prices ultimately depend on a company’s ability to

generate cash flow

• View prices as if they reflect DCF expectations and assess whether your expectations are sufficiently different to warrant purchasing or selling shares

• Competitive advantage of skilled investors– Superior ability to anticipate long-term valuation implications of

currently available information

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Are Mispriced Stock Exploitable?

• Factors that shape returns– Size of mispricing relative to current price– Extent to which price moves toward investor’s

estimate of value– Time it takes for stock price to converge

toward investor’s estimate of value– Unanticipated information that triggers price

changes

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Corporate Executives and Earnings Obsession

• Graham, Harvey and Rajgopal (2004) survey of financial executives– Earnings the most important performance measure

reported to outsiders• Quarterly earnings for the same quarter last year• Analyst consensus estimate for the current quarter

– Failure to meet earnings targets• Sign of managerial weakness• If repeated, can lead to career-threatening dismissal• May signal presence of more serious problems

– Executives willing to forego or delay value-creating activities to meet quarterly earnings targets.

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Managing for Long-Term Value• Primary commitment to continuing shareholders and not to day

traders, momentum investors, and other short-term oriented market participants

• Managing for short-term earnings compromises shareholder value– Companies forego or delay value-creating opportunities to meet

earnings expectations– Companies exploit the discretion allowed in calculation of earnings by

accelerating revenues and deferring expenses– Borrowing from the future inevitably catches up with companies when

they can no longer deliver on expectations. When this happens a significant fraction or all of its value is destroyed (WorldCom, Enron)

• Maximizing long-term cash-flow, even in an earnings-dominated market, is the most effective means of creating value for continuing shareholders

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A Three-Pronged Attack on Short-Term Performance Obsession

• Corporate performance reporting

• Incentives for investment managers

• Incentives for corporate executives

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Corporate Performance Reporting

• The Corporate Performance Statement– Separates cash flows and accruals– Classifies accruals by levels of uncertainty– Provides a range as well as the most likely

estimate for each accrual– Excludes arbitrary, value-irrelevant accruals– Details assumptions and risks for each line

item

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Corporate Performance Statement

• If CPS information isn’t already available internally, shareholders should be concerned with management’s grasp of the business and the board’s exercise of its oversight responsibility

• Statement makes it easier for boards to champion executive compensation plans that reward long-term value creation

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Incentives for Investment Managers

– The fear of being wrong and alone induced by benchmark performance evaluation shrinks differences between the best and worst performers

– Benchmark tracking and a herd-like focus on the short-term earnings may create mispricing opportunities for long-term investors

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Incentives for Investment Managers

• The problem is not benchmarking, but– Short-horizon benchmarking– Tight tracking-error constraints– Benchmarks that limit investment breadth

• Information ratio depends on skill and breadth (Grinold)

• The problem with open-end fund structure– Withdrawal of funds due to short-term

underperformance or when equity prices fall– Discourages investments that are only attractive in

the long-run

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Incentives for Investment Managers

• Closed-end funds (Stein, 2004)– Managers can undertake longer-horizon trades– Instability of closed-end structure

• Will the best managers move to open-end form to increase assets and their compensation?

• Incentives for retaining skilled closed-end managers– Total compensation competitive with open-end alternative– Annual bonus paid on rolling three- to five-year performance– Defer some payouts against future performance– Require managers to make a meaningful investment in the fund

• Same incentives appropriate for open-end managers but fund withdrawal risk remains

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Incentives for Corporate Executives

• Problems with standard executive stock options– Performance targets are too low– Holding periods are too short– Underwater options undermine motivation and

retention– Options can induce too little or too much risk-

taking

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Incentives for Corporate Executives

• Indexed-options plans– Peer versus broader market indexes– Difficulty of constructing peer index– Overcome two of the problems with standard options

• Performance targets too low• Underwater options driven by falling equity prices

– The other two problems—short holding periods and too little or too much risk-taking—are addressed by

• Extending vesting period and requiring executives to maintain meaningful equity stakes

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Incentives for Corporate Executives

• Indexed-option plans—why has no one adopted them?– Misplaced accounting concerns– Require a higher level of performance

• Dealing with the underwater options problem– Discounted index options

• Index rises from 100 to 110• 1% discount on exercise price reduces index from

110 to 108.9—a rise of 8.9% instead of 10%

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Incentives for Corporate Executives

• Discounted equity-risk options (DEROs) for companies unable to construct a peer index– Change in exercise price=Yield on ten-year Treasury + x% of

equity risk premium – dividends per share– ERP forecast “error” pales in comparison to failure of standard

options to incorporate any shareholder opportunity cost– DEROs balance the tradeoff between setting performance at

levels that compensate shareholders for equity risk and the need to keep executives motivated

– Dividends are deducted from exercise price to remove management incentive to hold back distributions in the absence of value-creating opportunities.

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Incentives for Corporate Executives

• Restricted stock versus discounted index options or DEROs– “Pay for pulse” rather than pay for performance

– Restricted stock grants are options with an exercise price of zero

– Because three to four options are granted for each restricted share, options provide greater upside when the stock performs well while restricted stock has greater payoffs when the stock performs poorly. What’s wrong with this picture?

– Example: 20,000 restricted shares versus 70,000 standard ten-year options; stock trading at $40

• Stock must rise 40% to $56 for CEO to have an identical pre-tax gain• CEO gains more from options if stock price appreciates more than 4% annually• CEO gains more from restricted stock for any appreciation of less than 4% annually all

the way down to a near-100% decrease from price at grant date.

– Performance shares require not only that executives remain on the payroll but that the company achieve predetermined performance goals.

• Short-run earnings, revenue or return on capital goals can however conflict with maximizing long-term value

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Essential Ideas

• Short-termism is the disease -earnings and benchmark tracking the carriers.

• Accounting conveys information about a small fraction of a company’s value.

• The “right” prices are unknowable, there are only transacting investors who believe they are “wrong.”

• Prices in a “no-free-lunch” market are not necessarily allocatively-efficient.

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Essential Ideas

• The guardians of allocative efficiency are difficult to identify.

• DCF matters because prices ultimately depend on cash flow.

• Estimate price-implied cash-flow expectations and assess whether there are exploitable mispricings.

• Only those with brains, resources, a long investment horizon, and no agency conflicts are promising candidates for exploiting mispricings.

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Essential Ideas

• Corporate executives obsessed with earnings misallocate capital and compromise shareholder value.

• Maximizing long-term cash flows is best means of creating value for continuing shareholders.

• Alleviating short-term performance obsession requires meaningful changes in corporate performance reporting and incentives for investment managers and corporate managers.