Thursday 23 November 2017

Executives' obsession with share prices putting their companies' futures at risk

Recent data has shown that US firms are hoarding cash and choosing not to invest
Recent data has shown that US firms are hoarding cash and choosing not to invest

AQUARTER-by-quarter management style and a pay-driven obsession with company share prices may be impairing the long-term prospects of US stocks as executives live off their companies' seed corn rather than disappoint a market obsessed with short-term results.

US corporations are holding a record $1.74trn (€1.39trn) in liquid assets, according to the Federal Reserve's quarterly "flow of funds" report. That's up 16pc since the end of the last recession in June 2009.

A variety of explanations have been posited for this -- ranging from fear of regulation to a reluctance to repatriate gains and pay taxes.

The tax argument may play a role, but to judge by foreign companies' headlong drive to invest in the US and by the healthy return on net worth earned by non-financial corporations in recent years, it is tough to blame Washington or even the economy for this one.

Economist Andrew Smithers, of asset allocation adviser Smithers & Co in London, said changes in corporate behaviour are part of a secular change over two decades, driven by executive compensation practices and the bonus culture.

As he notes, most executives get bonus payments, often in shares, based on metrics such as earnings per share, return on equity and return to shareholders. All of which can be gamed and all of which might encourage short-termism.

"A decision to allow profit margins to fall will almost certainly hit profits in the short term, but a decision to raise prices or cut costs in order to limit or prevent such a fall will increase the longer-term risks of losing market share," Mr Smithers wrote in a note to clients.

Similarly, buying new equipment can cut profits short-term, but provide long-term benefits, he said.

"As the calculations on which bonus payments are based depend on short-term changes, the growth of the business culture has naturally increased resist-ance to cuts in profit marg-ins and has inhibited inves-tment," Mr Smithers said.

In other words, it seems likely that US firms are hoarding cash and choosing not to invest -- not because of economic and policy uncertainty, but because the managers are not paid to invest for the longer-term.

Whereas chief executive turnover at US firms was at 12.5pc annually in 1992, it increased by half to 18.5pc by 2005 and was, at least anecdotally, much higher than in the 1950s and '60s. It is perhaps no coincidence that the bonus culture and high turnover developed alongside a much more gimlet-eyed view of long-term research and development.

The issue for equity holders is that, while this approach flatters profit margins in the short term, it reduces the scope for a firm's long-term growth.

If you don't maintain a car and run it into the ground it is indeed cheaper, and might be a viable strategy if you don't own the car and only want to drive it so far.

That may well describe the strategy of a generation of chief executives, who quite naturally want to maximize the benefit they can extract during their time on the playing field. A manager who is sticking around for only six or eight years has an incentive to cuts costs, goose profits and cash out her options.

Further evidence for this behaviour is found in the fact that US publicly traded firms hold more cash, and have been stockpiling it more quickly, than both their international and privately held peers over the past decade.

This may be because the bonus culture is less embedded outside of the English-speaking world and among privately owned companies.

For US industry generally this is troubling because it implies that, 20 years or so into this experiment, many companies and industries have been living off the investments made by previous generations, while not replenishing the stock.

While US industry has produced wonders in recent decades, the innovation has been concentrated in technology start-ups and healthcare, which benefits from a parallel universe of funded research.

A possible partial remedy would be to force CEOs to become long-term holders of the majority of the shares they are granted in their companies, perhaps by mandating a 30-year taper-ing schedule of allowable ex-CEO share sales.

To judge by the returns to shareholders in the past 15 years, the current system does investors no favours.

In theory, this problem will be self-limiting, as US companies lose market share to foreign and private competitors. But the damage to pension funds and investors in the meantime will be huge.

James Saft is a Reuters correspondent.

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