On Long-Term Corporate Investments

by: David Merkel, CFA

There is a statement commonly made that firms in the US aren't doing as well as they can in the long-run because the calculation of quarterly earnings inhibits long-term investment. I'm not sure that such statements are true or false, but I will try to explain the problem or lack thereof in this post.

Common reasons for alleging the problem

  1. The division between management and ownership means that managements often act in their own interests rather than those of shareholders.
  2. Management incentives are calculated over too short of a period of time.
  3. Quarterly earnings distract from long-term planning.
  4. Accounting methods do not allow for capitalizing certain types of investments, and so they don't get done to the degree necessary.
  5. Investing for the long-run will create greater returns.
  6. It is easier to simply buy back stock or pay dividends in the short run. Investing more will create greater returns.

I'd like to get rid of a few of these arguments quickly. First, there is no evidence that investing more produces greater returns, and there is evidence that stocks that do buybacks and pay dividends tend to outperform. There is evidence in specific cases that buying back stock at high prices destroys value, but what high prices are is often only know in hindsight. That said, I encourage corporate boards and managements to have their own conservative estimate of the private market value of their firm, and only to buy back stock when the price is below that estimate.

Second, there is no evidence that long-term investing produces greater returns on average. Here's why: longer investments are less certain than shorter ones, and require longer-term capital to finance them, which is more expensive.

I remember the Japanese making their long-term investments in the 1980s - they were regarded as very farsighted. They invested a lot at what seemed like low ROEs, but their stock market kept going up, and they were hailed as geniuses that would bury the barbaric capitalism of the US. As it was, the ROEs were low, and in many cases negative.

I liken it to trying to hit a home run in baseball. It's a high-risk, high-return strategy, but tends to lead to worse results than just trying to get on base. Many good returning projects for firms are small, and short-term in nature. Incremental improvement can go a long way.

Reasons 1-4 have a little more punch in my opinion, but they are all solvable by setting up an alternative accounting basis that facilitates long-term projects, using that as the definition for pro-forma earnings to present to Wall Street, and using it for management performance measurement and compensation.

There is a trick here, though. Management and the board have to be intelligent enough to have both:

  • A long-term investment that they know with high probability will be a success, and
  • A means of measuring the progress toward the goal over a long period of time.

Both of those are tough. Long-term projects can go wrong for a lot of reasons - cultural change, technological change, economic change, competitive change, change in the ability to keep the company as a whole financed, and more. And, it's not as if I don't see project timelines in presentations that managements give to investors and analysts. Long-term investing does get done, even if the GAAP or tax accounting treatments don't favor it in the short run.

As I have mentioned before, corporate valuation depends on free cash flow, and GAAP accounting does not affect that. As such, quarterly GAAP earnings should not affect the willingness of companies to take on long-term projects that they think will be winners.

That leaves management incentives, which are always a problem. Most good incentive plans are a mix of short and long-run items. The mix will depend on the maturity of the industry, and the relative opportunities faced by the firm.

Conclusion

If there is a problem here, boards and managements have adequate tools at their disposal to try to solve the problem, with the added risk that the cure could prove worse than the disease. As an example, consider trying to get sleepy pipelines and utilities to innovate on long-term projects that are hard to manage and measure. Well, that was Enron, Dynegy and a variety of companies that learned that there aren't a lot of ways to dramatically improve performance in a mature business.

But there may be no problem here at all. The US has been one of the better performing markets in the developed world, and in general, industries that invest a lot do not outperform industries that do less investing. We may not need to adjust our methods at all.

Also, we might not need as many tax incentives from the government to promote investing either. In my opinion, the good investments will get done. Investments that require tax incentives just encourage management teams to do tax farming.

Management teams are less short-term focused than most imagine. If they don't invest a lot for the long-term, it may just be that there aren't many attractive long-term investments capable of providing returns greater than the cost of longer term capital needed to finance the investments.

Disclosure: None