The Economics of ShortTerm Performance Obsession

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The Economics of Short-Term Performance Obsession

• Al Rappaport
• Q Group Seminar
• October 19, 2004

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Theory Versus Practice

• TheoryDiscounted cash flows (DCF)
• PracticeShort-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 managements 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
• Factsrealized cash flows
• Assumptions about the futureaccruals
• 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 researchwhy?
• 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.
• Todays reality
• Pervasive use of non-DCF models

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Non-DCF Models

• Portfolio benchmarking
• Earnings expectations game
• Fundamental analysis thats not fundamental
• Shortcut metricsP/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
  companys 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 companys
  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 investors
  estimate of value
• Time it takes for stock price to converge toward
  investors 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 isnt already available
  internally, shareholders should be concerned with
  managements grasp of the business and the
  boards 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 problemsshort holding periods and
  too little or too much risk-takingare addressed
  by
• Extending vesting period and requiring executives
  to maintain meaningful equity stakes

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Incentives for Corporate Executives

• Indexed-option planswhy 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 108.9a 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 priceYield 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. Whats 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 companys 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.