Ever since the Great Recession, Americans have felt that something is profoundly wrong with the economy. Not only is it not working for them; it is not working the way it used to. Slow growth, stagnant wages, growing inequality, and a host of other economic problems have contributed to today’s economic pessimism.
In her first major economic speech as a presidential candidate, Hillary Clinton offered a coherent explanation for America’s economic dysfunction. Expanding on the theme of “short-termism,” or quarterly capitalism, Clinton said, “Large public companies now return eight or nine out of every $10 they earn directly back to shareholders, either in the form of dividends or stock buybacks, which can temporarily boost share prices. Last year the total reached a record $900 billion. That doesn’t leave much money to build a new factory or a research lab or to train workers or to give them a raise.”
With these words, Clinton not only opened up an important debate but also put on the political agenda a set of issues that have been developing for some years among academics, business schools, and forward-looking business executives. What has been missing is the link between the incentives for short-term behavior and their consequences for the economy as a whole.
In this essay we review the evidence and offer responses that could, we believe, make a difference. Let’s start with leaders from the business world. When the head of the world’s largest investment fund publicly questions the conduct of America’s leading corporations, we can be pretty sure that there’s a problem.
That’s what BlackRock Chairman Laurence Fink did last year in a letter to the Fortune 500 CEOs criticizing the short-term orientation that dominates today’s corporate behavior. “It concerns us,” he declared, that “in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.” And he concluded, “[W]hen done for the wrong reasons and at the expense of capital investment, [returning cash to shareholders] can jeopardize a company’s ability to generate sustainable long-term returns.”
This is bad for the economy in two ways. As the growth of the U.S. workforce slows dramatically, economic growth will depend increasingly on improved productivity, most of which comes from raising capital investment per worker. Failing to make productivity-enhancing capital investments will doom our economy to a new normal of slow growth.
Many business leaders say that they are reluctant to make long-term investments without reasonable expectations of growing demand for their products. That brings us to the second way in which corporate short-termism is bad for the economy. Most consumer demand comes from wages. If employers refuse to share gains with their employees, growth in demand is bound to be anemic.
Although he clearly cares about his country, Fink is also acting as the steward of $4.8 trillion in investments. In an article published by McKinsey earlier this year, he warned that although the return of cash to shareholders is juicing equity markets right now, investors “will pay for it later when the ability to generate revenue in the long term dries up because of the lack of investment in the future.”
This strategy represents more than individual greed or the pervasive influence of bad ideas. Because current incentives are so perverse, Fink argues, “It’s hard for even the most dedicated CEO to buck this trend.” The constant pressure to produce quarterly results forces executives to go along—or risk losing their jobs. That pressure comes from investors who are, in Fink’s words, “renters, not owners, who are going to trade your stock as soon as they can pocket a quick gain.”
It is all too easy to dismiss Fink’s worries as anecdotally driven alarmism. But rigorous research has generated compelling evidence that he is right. Two Bank of England economists, Andrew Haldane and Richard Davies, have constructed empirical tests of short-termism. Their conclusion: The phenomenon is real, it is economically significant, and it is rising.
Short-term thinking has spread well beyond corporations and financial markets to our society and public life. As McKinsey’s Dominic Barton puts it, “Myopia plagues Western institutions in every sector.” Programs that encourage current consumption are squeezing out long-term public investments. Whatever we may do for our children in our family lives, when it comes to our public life, we are unwilling to endure modest sacrifices even when we know that they could help bring about a brighter future for our posterity. Collective myopia is the core disease of our time. The impatient quest for quick gain overwhelms our better motives. And in the long run, we will all be worse off.
We have to do something about this, and the place to begin is with the financial sector. We need more patient builders and fewer impatient traders, more Warren Buffetts and fewer Carl Icahns. To get them, we cannot rely on cultural change or the collective conversion of CEOs and hedge-fund leaders on the road to Damascus. Instead, we must change the laws and rules that shape corporate and investor behavior.
There’s nothing wrong with getting rich, there’s nothing wrong with paying investors handsome returns, and a vibrant stock market is something we should wish for. But when the very few can move stock prices in the short term and reap handsome rewards, and when this cycle becomes standard operating procedure, crowding out investments that boost productivity and wage increases that boost consumption, the macroeconomic consequences are debilitating.
The Micro Problem
Everyone knows that something is wrong with the American economy. It has been a full decade since the annual growth rate reached 3 percent, and it has not exceeded 2.5 percent since the end of the Great Recession. Meanwhile, a wedge has grown between productivity and compensation for most workers. Individuals at the very top of the income scale have appropriated almost all the gains from growth, leaving stagnant or declining wages for everyone else. These trends have sapped the great American middle class of its dynamism and its optimism. Moreover, the increase in the financial sector as a share of the total economy has coincided with a period of declining corporate investment.
There are many explanations for slow growth and stagnant incomes in the twenty-first-century American economy. High on the list are globalization and the role the information technology revolution is playing in the disappearance of manufacturing jobs and, more recently, routine service-sector jobs as well. Other oft-cited explanations include trade agreements and the waning power of labor unions.
Without passing judgment on these claims, we emphasize an additional explanation for our economic ills. Our thesis is simple: Over the years, a set of incentives has evolved that favors short-term gains over long-term growth, and returns to corporate executives and stockholders at the expense of investment in workers and in innovation. They are:
- The proliferation of stock buybacks and dividends
- The increase in noncash compensation
- The fixation on quarterly earnings
- The rise of activist investors
These incentives are so powerful that once they became pervasive in the private sector, they began to have broad effects. No one set out to create this myopic system, which arose piecemeal over a period of decades. But taken together, these perverse microincentives have created a macroeconomic problem.
The Proliferation of Stock Buybacks and Dividends
Over the past three decades, the share of resources corporations use to repurchase their own shares has soared. For example, take the 248 companies continuously listed in the S&P 500 since 1981. That year, stock buybacks by these firms consumed a mere 2 percent of net income. Between 1984 and 1993, such purchases averaged 25 percent of net income; from 1994 to 2003, 37 percent; from 2004 to 2013, 47 percent.
Repurchases represent only one way that corporations can direct their resources to shareholders. The other major vehicle—better known to average investors—is dividends, both regular and special. Taken together, these payments have grown so much that they now consume nearly all the income earned by major corporations.
For the 454 companies listed in the S&P 500 between 2004 and 2013, University of Massachusetts Lowell economist William Lazonick found that stock buybacks consumed 51 percent of net income and 35 percent of dividends. The problem is that these kinds of heavy rewards to investors leave only 14 percent for internal investments and compensation increases for workers.
Between 2004 and 2013, some of the best-known American corporations returned more than 100 percent of their net income to their shareholders in the form of buybacks and dividends. These firms included IBM, Microsoft, Cisco, Intel, Hewlett-Packard, Pfizer, Pepsico, and Procter & Gamble. IBM spent 92 percent of its net income just on buybacks, Cisco 103 percent, and Hewlett-Packard 148 percent.
One might imagine that these trends could not go any further, but they are doing just that. Companies spent more than $903 billion on dividends ($350 billion) and buybacks ($553 billion) in 2014, almost 95 percent of net income. And they are on track to spend more than $1 trillion—$400 billion in dividends, $604 billion in buybacks—in 2015. According to data compiled by Mustafa Erdem Sakinç of the Academic-Industry Research Network, public U.S. corporations have spent $6.9 trillion in stock buybacks over the past decade, accounting for 4.7 percent of the nation’s total output during this period.
The Increase in Noncash Compensation
In the 1970s, an academic critique of the stock market by Michael Jensen of Harvard and William Meckling of the University of Rochester argued that the U.S. economy had a “principal-agent” problem and that the best way to align managers’ interests with stockholders’ interests was to give managers stock options in lieu of salary. As this idea migrated from academia to the private sector, it took off. In 1993, a change in the tax code capped corporate deductibility of executive compensation at $1 million unless amounts over that qualified as “performance-based,” thus adding to the momentum for non-salary compensation.
The results of these changes have been stunning. Fifty years ago, median CEO compensation was about $1 million (in 2011 dollars), almost all of which came in the form of salaries and bonuses. By 2011, median compensation had increased to nearly $9 million, 70 percent of which consisted of stock awards and options.
When we look at the country’s largest corporations, the picture is even more dramatic. Total compensation for the 200 CEOs of public firms with a market capitalization of at least $1 billion averaged $22.6 million in 2014. Of this total, we calculate that $16.2 million—72 percent—came in the form of stock awards and buybacks. The explosion of noncash compensation has made it easier for corporate boards to raise overall compensation to undreamt-of heights without imposing a direct hit on their bottom line.
The Fixation on Quarterly Earnings
The third trend in this incentive mix has been the growing importance of quarterly earnings reports. There is strong evidence that meeting quarterly earnings expectations motivates stock buybacks and that this behavior shapes other corporate decisions. Three University of Illinois scholars found that repurchases were much more likely to occur for firms that narrowly would have missed their earnings forecasts in the absence of these transactions. They also found that repurchases driven by the desire to manage earnings per share caused firms acting in this manner to decrease investment, employment, and R&D.
Corporate executives acknowledge that they would sacrifice the long-term well-being of their firms to meet short-term targets. A survey of CEOs and chief financial officers found that to avoid missing their own quarterly earnings estimates, 80 percent were willing to forgo R&D spending and 55 percent to delay promising long-term projects. A similar study from the Illinois authors in 2013 found that more than 80 percent of chief financial officers cite each of the following as motivations to misrepresent earnings: gains from influencing stock prices; outside pressure to hit earnings benchmarks; and internal pressure to hit earnings benchmarks and to influence executive compensation. A McKinsey survey from 2013 found that 63 percent of corporate executives said that pressure to deliver financial results in two years or less had intensified in the previous five years.
In keeping with their short time horizons for investment, today’s CEOs experience remarkably short job tenure. A 2010 study by The Wall Street Journal found that CEOs in S&P 500 firms served on average only 6.6 years—significantly less than in earlier periods. That same study found a strong relationship between CEO tenure and stock price. Of those who served more than 15 years, 12 led firms whose stock price outperformed the S&P index over their terms.
Once known as “corporate raiders,” activist investors seek to change management behavior. The economic rationale for activism is that it will keep inefficient or incompetent management on its toes, and there is no doubt that this does happen.
Much of today’s activism, however, occurs through hedge funds, which have proliferated since the start of the twenty-first century. In 2000, there were 4,800 hedge funds listed worldwide; by 2012, that number had more than doubled to 10,100. And over the past decade or so, the assets of activist funds have grown to about $100 billion.
The effect of activist investing on the health of companies and, by extension, the larger economy has been a topic of heated debate in academic circles. Led by Harvard Law School’s Lucian Bebchuk, some professors argue that activist investors are good for the economy.
Others counter that while activist pressure may produce larger gains for a handful of firms, it leaves the typical firm worse off. Columbia University Law School’s John C. Coffee Jr. notes that firms stalked by activist investors often face outcomes that may either be “a feast or a famine”—prospects that should concern boards of directors responsible for a single firm rather than a portfolio of bets.
The goals of most activist investors intensify the impact of short-term incentives on corporate managers. These investors often pressure managers to provide immediate returns on their investment in the form of buybacks and special dividends. No wonder that some managers have come to believe that maximizing shareholder value means boosting short-term returns. Many others have concluded that they cannot resist pressures to do so, even if they do not believe that it is the right thing to do. All too often, the fear is that the management decisions demanded by the activists are for the purpose of stock-price manipulation, not long-term growth. With the rise of hedge funds, activist investing has fallen prey to the casino mentality that causes enormous stock buybacks, outsized executive compensation, and fealty to quarterly earnings reports at the expense of investments in longer-term growth.
The Rise of “Short-Termism”
As pay packages for senior managers have tilted toward noncash compensation, managers’ incentives have shifted. At the theoretical level, 2014 Nobel Prize winner Jean Tirole and co-author Roland Benabou have demonstrated that performance-based pay tends to shift managers’ attention away from hard-to-quantify activities, such as long-term investment risk management, toward more easily quantifiable short-term tasks and targets. For example, deferring long-term commitments can raise earnings here and now. Higher reported earnings boost share prices, which enhances the value of stock options. And Lazonick notes that the vesting of stock awards “is often dependent on the company hitting quarterly earnings per share (EPS) targets, for which well-timed manipulative boosts from stock buybacks can be very helpful.”
Simple arithmetic tells us that without buybacks, exercising options increases the number of shares outstanding, diluting the value of previously issued shares and reducing reported earnings per share. More than a decade ago, scholars from the University of Chicago and the University of Michigan found that corporate executives use repurchases to offset actual and potential dilution, which generally accepted accounting practices require firms to report. They also found that such buybacks do not create any value for shareholders. As one of the study’s authors, M.H. Franco Wong, says, “Repurchasing your own stock for this purpose is like taking money from your left pocket and moving it to your right pocket.”
For individual managers whose compensation depends on meeting earnings targets, however, the effect is to take money from the firm’s coffers and transfer it to their own—and, of course, to shareholders, who benefit from higher stock prices. A recent survey by The Economist puts it this way: “Pay plans can corrupt managers’ motives. By buying existing shares they can offset the effect of new ones created for their personal stock-option plans. Cash leaves the firm for their pockets without being booked as a cost or reducing earnings per share.” Even worse, The Economist points out, because interest paid on debt is tax-deductible while interest earned on cash is taxable, firms can cut their tax bills by increasing net debt to finance buybacks (and dividends). In the process, firms undertake additional risks, which can come back to bite them during economic downturns.
We can debate the relative weight of these explanations for the surge in stock buybacks. There is less room for debate about their effects. As James Montier of investment management firm GMO has pointed out, during the entire postwar period, retained earnings have financed almost all business investment, while stocks, bonds, and lines of credit have played a minor role. All other things being equal, if a steadily rising share of internally generated resources goes to shareholders, the pool of funds available for investments shrinks.
Not surprisingly, so has corporate investment. As cash distributed to shareholders as a share of cash flow has surged to a record high during the past decade, the share devoted to capital investment has fallen to a record low. Among other consequences, this decline has left S&P 500 companies with the oldest plant and equipment stock in six decades. The average age of their fixed assets is now 22 years, the highest since 1956.
Some kinds of firms—such as financial institutions and consumer retailers—can do well without significant investment in R&D. But about half the world’s largest firms do depend on R&D. Among these firms, there is a direct and strong relationship between the level of R&D and long-term growth rates. When the surge and buybacks come at the expense of R&D, the effect is to reduce growth.
The same pool of internal funds serves as the source for wage and benefit increases. Although the cause-and-effect relationship is hard to prove, the surge in stock buybacks has coincided notably in time and extent with the decline in the share of GDP that goes to labor. It has also coincided with the much-discussed “breakaway” of the top 1 percent from the rest of the population.
The buyback explosion is also driving a wedge between real and reported economic performance. During the past two years, the average growth rate of sales for the S&P 500 was 2.6 percent, but earnings per share rose more than twice as fast—6.1 percent—in part because so many companies have used buybacks to reduce their total shares outstanding. Companies with the largest buyback programs have outperformed the broader market by 20 percent since 2008.
The unprecedented level of buybacks has put an artificial safety net under the bull market that has now completed its sixth year without a substantial correction. Gary Black, co-chief investment officer at Calamos Asset Management, confirms this assessment. “It does act as a floor,” he comments, adding that the repurchase spree is an “accelerant” that is “giving juice to this market.”
The most profound systemic effect of the buyback boom has been to turn the role of equity markets upside down. These markets are supposed to serve as vital sources of capital for corporations. But from the mid-1980s onward, Montier notes, the value of repurchased shares has exceeded the value of new shares issued. “Far from providing capital to the corporate sector,” he says, “shareholders have been extracting it.” Lazonick calculates that between 2005 and 2014, the net withdrawal has averaged $399 billion per year.
In addition to turning the role of the equity markets upside down, financialization depresses entrepreneurship. Paul Kedrosky and Dane Stangler of the Kauffman Foundation find that as financialization increases, startups per capita decrease, in part because the growth in the financial sector has distorted the allocation of talent. They estimate that if the sector were to shrink as a share of GDP back to the levels of the 1980s, new business formation would increase by two or three percentage points.
We have considerable circumstantial evidence to show that these trends have had negative consequences at the macro level: Beyond a certain point, the size of the financial sector coincides with lower growth, investment, and R&D in the nonfinancial sector. But to strengthen the causal link we need to show that these corporate behaviors have more negative than positive consequences at the micro level as well.
This problem has led scholars to construct new measures that capture a longer-term orientation. For instance, Robert Eccles, Ioannis Ioannou, and George Serafeim looked at a matched sample of 180 companies. Using a variety of indices, they constructed a measure that captured “high sustainability” and “low sustainability” practices. When they looked at these companies over an 18-year period, the high sustainability practices “significantly outperform their counterparts over the long-term, both in terms of stock market as well as accounting performance.”
Elroy Dimson, Oguzhan Karakas, and Xi Li constructed a measure of corporate social responsibility (CSR) activism (a subset of the broader activism measure) and examined a sample of target firms and matched firms. They conclude that CSR activities had positive effects on some firms but no negative effects on others.
In a novel approach, Jillian Popadak of Duke University transformed millions of reviews from career intelligence websites into a set of measures that capture dimensions of corporate culture. She finds that firms with increased attention to shareholder governance show “statistically significant decreases in customer-orientation, integrity, and collaboration.” In the long term, the shareholder emphasis on firm governance leads to “statistically significant decreases in both intangible assets and customer satisfaction along with increases in goodwill impairment.” Shareholders face a trade-off, she concludes, between “enhancing activities that produce easy-to-observe performance metrics and [those that strengthen] difficult-to-measure intangible assets.” The former look good in the short term; the latter help firms survive in bad times as well as keep their balance when new opportunities emerge.
In another attempt at measuring the hard-to-measure intangibles, Alex Edmans, Lucius Li, and Chendi Zhang use lists from the “Best Companies to Work For” in 14 countries to show that employee satisfaction is associated with “positive abnormal returns in countries with high labor market flexibility such as the U.S. and the U.K. but not in countries with low labor market flexibility such as Germany.” In countries such as Germany that mandate what we would call labor-force investment, employee satisfaction is not connected to corporate growth rates. In countries such as the United States with fewer government mandates, employee satisfaction is linked to high growth. But pressure to show short-term results pulls against the kinds of workforce investments that enhance employee satisfaction in less regulated labor markets.
What Can Be Done?
Whether looked at from the level of the economy as a whole or from that of the individual firm, twenty-first-century American capitalism has not delivered the broadly shared prosperity that postwar Americans had come to expect.
The proliferation of share repurchases, we argue, has had numerous bad effects—on investments, wages for average workers, and the willingness of firms to adopt a long-term perspective. The surge in noncash compensation for CEOs has intensified these problems. In the name of better aligning managers’ incentives with the interests of their companies, it has created perverse incentives to manage earnings and to report results that diverge from actual corporate performance. It diminishes incentives to seek productive investments and to make the kinds of commitments—to research and development, for example—that will show up in the bottom line five or ten years hence, not in the next quarter’s earnings.
There is a compelling case, we conclude, for reining in both share repurchases and the use of stock awards and options to compensate managers. To this end, we propose the following steps:
- Repeal SEC Rule 10b-18 and the 25 percent exemption
- Improve disclosure practices
- Strengthen sustainability standards in 10-K reporting
- Toughen executive compensation rules
- Reform the taxation of capital gains
Repeal SEC Rule 10B-18 and the 25 Percent Exemption
Prior to 1982, SEC rules did not provide companies buying back their own stock with a “safe harbor” protection against insider-trading violations, and many companies limited their open-market buying out of fear of SEC prosecution. The surge in share repurchases began in 1982 after the SEC adopted a new rule—10b-18 of the Securities Exchange Act—that enabled corporate managers to purchase large quantities of their companies’ stock without fearing that the SEC would accuse them of stock-price manipulation. This change guaranteed that companies would not be charged if their buybacks on any single day were no more than 25 percent of average daily trading volume over the previous four weeks. Nor would there be a presumption of manipulation if open-market purchases exceeded this level.
Lazonick, who has conducted pioneering studies of this shift, recommends that Rule 10b-18 be dramatically curtailed or reversed outright. If ordinary Americans are not allowed to engage in insider trading based on nonpublic information, why should company managers be allowed to do so?
Defenders of the post-1982 regulatory regime contend that this change promotes the most efficient use of capital. There is little evidence that this is the case, and much that it is not. As David Kostin, Goldman Sachs’s chief U.S. equity strategist, observes, “Managements [sic] are often poor market timers. In 2007, companies allocated more than one-third of their cash use to buybacks ($637 billion) just before the S&P 500 plunged by 40 percent during the following year. Conversely, at the bottom of the market in 2009, firms devoted just 13 percent of their annual cash spending to repurchases ($146 billion).”
Warren Buffett famously remarked that “Buying dollar bills for $1.10 is not good business for those who stick around.” But that is the point: Many of those who engage in this practice have no intention of sticking around. They plan to take the money and run. And, sadly for our economy, they get away with it.
Improve Disclosure Practices
We’re all familiar with the quarterly earnings estimates that corporations put out. What many people don’t know is that nowhere are corporate executives required to offer these estimates. A McKinsey study has found that not doing so has no negative effects on the stock price of firms that don’t. And yet, many firms persist in releasing them. We know that publicly announcing such estimates encourages short-term behavior that weakens potentially profitable long-term investments in R&D and new ventures. Building on leading investor Robert Pozen’s analysis, we recommend that firms stop issuing quarterly estimates and instead focus on meaningful long-term metrics.
Strengthen Sustainability Standards in 10-K Reporting
One of the most important and long-lasting results of the Great Depression was passage of legislation in 1933 and 1934 that created the architecture for regulating the securities market. Central to the theory of those acts is the concept that transparency is a critical component of a healthy market. The result was disclosure requirements intended to protect the public and investors. Over the years these requirements were formalized into generally accepted accounting standards and supported and enforced by the Securities and Exchange Commission.
But as Robert Eccles and Jean Rogers of the Sustainability Accounting Standards Board (SASB) point out, as important as the development of standard financial accounting was, “the world is now a very different place—facing megatrends such as population growth, food scarcity, climate change, and resource constraints. Today, financial accounting alone cannot capture the complete picture of a company’s value.”
In this day and age, a complete picture of a company’s value and future can be taken only if sustainability information is evaluated side by side with financial information. Eccles and Rogers argue that for sustainability information to be meaningful it must be based on the notion of “materiality”—in other words, the standard must be relevant to the success of business in a given sector. Thus, as they point out, in the pharmaceutical industry, companies face material risks from a growing market in counterfeit drugs; in the software and IT services industry, companies face material risk from cybercrime; the property insurance industry faces material risks from climate change. In other words, for investors to truly understand a business they must have information of a nonfinancial nature.
Of course, financial metrics are easy to understand and easy to produce, which is why they still constitute the bulk of corporate disclosures. But the SASB is working to create metrics such as “energy intensity” that can eventually be used as a standard part of 10-K reporting. The SEC already requires that companies disclose “all material information” in their 10-K forms. Stronger rules on the inclusion of nonfinancial data will help to shift the focus toward longer-term growth.
Toughen Executive Compensation Rules
Another SEC rules change (this one in 1991) allowed top executives to exercise their stock options as soon as they received them, sell the acquired stock immediately—and retain the gains. This change should also be reversed, and a minimum holding period should be imposed.
In addition, to the extent that stock awards are used as part of total compensation, they should be based not on the short-term performance of the firm’s stock but rather on the long-term performance of the actual business. Pozen has suggested granting these awards in the form of restricted shares that vest only if long-term performance goals are met—and then requiring executives to hold the vested shares for a period of years, or even until retirement. We endorse these proposals.
Reform the Taxation of Capital Gains
Some tax experts have proposed eliminating the distinction between ordinary income and capital gains, and that may well be a sensible proposal. Without going all the way down that road, however, we could restructure the treatment of capital gains to encourage longer time horizons on the part of managers and activist investors. For example, BlackRock’s Fink has proposed lengthening to three years the holding period needed to qualify for capital gains treatment while taxing trading gains at an even higher rate than ordinary income for investments held less than six months. To encourage truly patient capital, the capital gains rate could be stepped down to zero over a period of (say) ten years.
Of course, we need to examine this proposal in the broader context of tax reform. But one thing is clear: Our current tax code is doing little to deter short-termism, and the interaction between the code and executive compensation packages may actually be exacerbating it. We can do better.
Ending Quarterly Capitalism
A traditional function of corporations has been to use information and experience to invest the bulk of their earnings better than their shareholders are able to do. But if, under the theory of maximizing shareholder value that has come to dominate corporate America, publicly held corporations now return more to shareholders than they receive from them, one may wonder why they continue to exist in their current form.
These doubts intensify when we compare the performance of publicly held firms with that of nonpublic firms. A recent study by three leading business professors finds that “compared to private firms, public firms invest substantially less and are less responsive to changes in investment opportunities, especially in industries in which stock prices are most sensitive to earnings news.” These findings are consistent, the authors conclude, with the proposition that “short-termist pressures distort their investment decisions.”
Another study demonstrates that publicly held status allows CEOs to extract more value from their firms than if they headed comparable private firms. The authors state, “[W]e find robust evidence of a substantial pay premium in public firms that survives even after controlling for firm and CEO characteristics.” Moreover, “This public pay premium persists after accounting for differences in equity risk, dividend policy, and CEO turnover between public and private firms.”
When we compare family-owned businesses to those whose ownership is widely dispersed, the differences are even more pronounced. A study by three business advisers found that although family-owned firms don’t do as well during boom times, they outshine their peers when the economy slumps. Summed across full business cycles, family-owned firms outperformed the others in every country studied. Among the reasons: Family firms emphasize organic growth rather than flashy acquisitions, they are better at retaining talented workers, and—surprisingly—they are more successful at generating overseas sales. Overall, say the authors, “Executives of family businesses often invest with a 10- or 20-year horizon,” and they “tend to manage their downside more than their upside, in contrast with most CEOs, who try to make their mark through outperformance.”
These businesses are more than vestigial relics of a vanishing past: The number of publicly listed corporations in the U.S. stock market has dropped by more than half since the peak in 1997. One-third of U.S. businesses with revenues of $1 billion or more are family-owned. In France and Germany, that figure rises to 40 percent, and it exceeds 50 percent in India and Southeast Asia. If these firms outperform publicly held businesses while incurring fewer risks, it calls into question our basic assumptions about the rationale for the public entities at the center of our economy.
We are not calling for the abolition of the public corporation. Our point is rather that our economy would work better if public corporations behaved more like private firms—if they made long-term investments, retained their workers, grew organically, and offered reasonable but not excessive compensation to their top managers, based on long-term performance rather than quarterly earnings. To make this happen, we must restructure the incentives that shape the decisions of CEOs and boards of directors. By reining in stock buybacks and reducing short-term equity gains from compensation packages, we can move significantly down this road. And we should.