What Buffett and Dimon get right and wrong on short-sighted finance

What Buffett and Dimon get right and wrong on short-sighted finance
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Firms should stop issuing quarterly earnings guidance to avoid encouraging short-term behavior. So argued Berkshire Hathaway CEO Warren Buffett and JPMorgan Chase CEO Jamie Dimon this past week.

Eliminating such guidance reduces pressures on firms to slash research and development (R&D) spending, cut wages, layoff employees and engage in other cost-cutting actions that harm the long-term prospects of firms. The arguments and conclusions Buffett and Dimon put forth are compelling but don’t go far enough to eliminate short-termism.

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After all, fewer than one-third of S&P 500 companies issue earnings guidance. Rather than simply halting earnings predictions, what would it look like if we instead redesigned capitalism for the long-term?

 

Quarterly earnings guidance has been implicated in the rise of corporate short-termism over the last few decades, but it is only one contributor to short-term pressures on firms.

The rapid pace of technology development, rising uncertainty surrounding returns to such development as well as increased exposure to global competition have made short-term returns significantly more attractive for investors.

This preference, however, also arises in the absence of compelling long-term, strategic plans. Removing a mechanism that enables the market to exert more short-term pressure helps, but it doesn’t fill the vacuum left if firms fail to develop, execute, evaluate and communicate progress toward long-term goals.

An illustration of a value-enhancing investment that would not have been possible with a short-term focus is the Summit supercomputer from IBM that was revealed this past week — the fastest, “smartest” computer in the world.

This supercomputer is significant not because of the impressive speed records that it sets, but because of the ecosystem of new technology development that it will facilitate, ultimately leading to new firms, jobs and economic growth.

Projects advancing human health, energy and artificial intelligence that were previously out of reach are now feasible. It’s difficult to overestimate the economic impacts of this new technology as well as the costs if we fail to make such investments. 

Summit was built following a commission by the Department of Energy in 2014, but would not have been possible without the decades of investment in R&D and development of human capital made by IBM and its collaborators that preceded the commission.

These long-term investments with uncertain payoffs, however, are exactly those on the chopping block when firms face the ever-increasing pressures to maximize short-term returns to shareholders. 

In this sense, firm survival, economic growth and societal prosperity are at stake when firms bow to short-term pressures from the markets.

Going private, however, is not the solution for firms or the economy; public markets are critical to wealth creation for individuals as part of retirement and pension plans, as well as providing financing for large, capital-intensive firms.

So, then the question becomes: How can firms work with markets to attract patient capital? 

Eliminating earnings guidance may appear to reduce information, diminishing market efficiency. However, since earnings guidance is only an estimate of future earnings and, thus, subject to uncertainty and forecast error, the true informational value of such guidance is limited.

Markets would actually benefit from more information, but of the right kind; after all, transparency on corporate actions is needed to allocate capital effectively. However, traditional financial metrics, while essential, do not allow investors and other stakeholders to evaluate progress toward this long-term value creation.

This is in part because of the time horizons embodied in traditional financial metrics (i.e., last year’s financial performance) and also because such measures are narrow in scope, failing to capture the impact of firm decisions on stakeholders critical to a firm’s long-term success, such as employees, suppliers, the environment and community.

Thus, companies need metrics and mechanisms that facilitate a long-term focus, engaging long-term investors that allow the value creating, economy-enhancing investments required to ensure the next generation of job and wealth creation.

If firms seek patient capital, they should broadcast the information that these investors require; a well-articulated, long-term vision, along with metrics that allow markets and stakeholders to evaluate progress towards that vision.

It’s not enough to stop feeding the short-term beast; companies need to provide insight into their more distant vision that will attract and retain the patient capital that allows investments that will fuel future growth.

This is not entirely uncharted territory. The new Long Term Stock Exchange (LTSE)  advocates creation of forward-leading performance indicators that are relevant to specific firms, categorization of R&D spending into short and long-term projects and reporting of earnings per share net of share buybacks, for example.

While LTSE metrics explicitly focus on a longer time horizon, the Sustainability Accounting Standards Board (SASB) advocates reporting across a broader set of metrics, capturing the impact of firm decisions across multiple stakeholders that affect the long-term performance of the firm.

More specifically, SASB has been crafting sets of reporting standards that incorporate environmental, workplace and product safety issues, as well as other metrics of ethical and social practices specifically relevant for each industry.

These metrics are chosen based on an evaluation of what information is material to the economic decisions of a firm’s stakeholders. This last point is critical; these are the types of metrics essential to convey a firm’s true economic position.

None of this suggests that reporting on current performance isn’t important — it absolutely is. But if we want to redirect capitalism toward a long-term perspective, we need to redesign it, focusing on long-term firm strategy.

Eliminating quarterly earnings guidance is a simple, if obvious, starting point for some firms, but will do little to provide the information needed to attract and retain the long-term investors necessary for next generation of wealth creation and economic growth.

Articulating long-term, strategic objectives and capturing progress toward them is the more durable and effective solution. 

Rachelle Sampson is a visiting professor at Georgetown’s McDonough School of Business. Her recent research exposes rising short-termism in U.S. firms and capital markets, outlining implications for firm productivity and growth. She is the author of, "Are US Firms and Markets Becoming More Short-Term Oriented? Evidence of shifting firm and investor time horizons, 1980-2013," available via SSRN.