We have long maintained that time frame mismatches contribute to many of the thornier investing and corporate governance problems. We recently contributed an article on irrational short-termism to the International Corporate Governance Network annual review that will be published at its annual conference in Paris next month. We thought it worth excerpting a small portion of it here.
In “The Short Long,” two Bank of England officials examined how investors discounted future cash flows when valuing some 624 large capitalization companies listed in the UK and US from 1986-2009. Overall, they find that cash flows that are five years in the future are valued as if they are eight years away; cash flows 10 years in the future are valued as if they will not occur for 16 years, and cash flows more than 30 years away are “scarcely valued at all.”.
In 13 of the 20 years examined investors overestimated the discount rate, or, to put it another way, investors were irrationally short term in their analysis. In nine of those 13 years, the irrationality was statistically valid, as it was over the entire period. However, perhaps the most disturbing finding is that eight of those nine statistically significant years were in the second half of the time period examined, indicating that short-termism is getting worse. Or, as the authors state: “Myopia is mounting”.
Indeed myopia appears to be endemic according to the findings. Investors were irrationally short term, in a statistically significant way, across the following economic sectors: materials, information technology, industrials, energy and utilities, consumer, health, and financials. Overall, they estimate “excess discounting of between 5% and 10% per year.”
While a 5-10% error may not seem like much, the fact that it is a yearly factor means it, too, compounds over time. They cite example upon example of investments which should have positive net present values, and, should, therefore, be made, but will not with such excessive discounting. “This I a market failure,” they write. “It would tend to result in … long-duration projects suffering disproportionately… including infrastructure and high-tech investments… often felt to yield the highest long-term (private and social) returns and hence offer the biggest boost to future growth.”
The Bank of England study is available at www.bankofengland.co.uk/publications/speeches/2011/speech495.pdf. The full ICGN article also discusses an IRRC Institute/Mercer study showing excess unexpected turnover in the public equity portfolios of institutional investors. That study is available at www.irrcinstitute.org/pdf/IRRCMercerInvestmentHorizonsReport_Feb2010.pdf.
–August 14, 2011