The Economics of Short-Term
Performance Obsession
Al Rappaport
Q Group Seminar
October 19, 2004
Theory Versus Practice
• Theory—Discounted cash flows (DCF)
• Practice—Short-term earnings and
tracking error
2
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 shortterm performance and improve allocative efficiency?
3
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%
4
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
5
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 informationallyefficient 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 ShortTerm 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 risktaking
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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.
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