Myopic Management _ ACCA Qualification _ Students _ ACCA Global

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<ul><li><p>Home &gt; Students &gt; ACCA Qualification Student Journey &gt; Qualification resources &gt; ACCA Qualification &gt; F9 Financial Management &gt; Technical articles</p><p>Relevant to ACCA Qualification Papers F9 and P4</p><p>For many years, managers of large businesses have been accused of focusing on short-term rather thanlong-term performance. Managers, so it is argued, often prefer projects that generate quick returns ratherthan those with slower, but ultimately higher, returns. Such myopic behaviour can create a host ofproblems for the business, for the broader economy and for society as a whole. These problems includereduced investment returns, the destruction of shareholder value, business collapses and the underminingof corporate governance. Furthermore, it can lead to a loss of public trust in large businesses and agrowing sense of unfairness in the way in which society is organised.</p><p>In this article we explore the causes of management short termism and the remedies available.</p><p>WHY FOCUS ON THE SHORT TERM?</p><p>Modern finance theory is founded on the notion that the purpose of a business is to maximise the wealthof its shareholders. This means that the role of managers, who are employed to act on behalf ofshareholders, is to maximise the value of ordinary shares over the long term. In practice, however,managers may not seek to do this. This may be because they have a different time horizon to that ofshareholders. There may be powerful incentives for managers to adopt a short-term focus in order tomaximise their own welfare. These incentives are often linked to the ways in which their remuneration isstructured. Where managers are in line for bonuses based on short-term share performance, or whereshare options are about to mature, they may be encouraged to make short-term decisions that boost theshare price.</p><p>Incentives may also be linked to management tenure and contracts. Where managers are unlikely to staywith the business for a long period and there are bonuses linked to current performance, they may preferto invest in projects with lower net present values, but with higher returns in the early years, than projectswith higher net present values, but with higher returns in later years. Although the latter projects willultimately bring greater benefits to the business, the managers will not be around to reap the benefits oftheir actions. For similar reasons, managers may try to cut back on discretionary expenditure such asresearch and development, staff training or marketing campaigns that would lead to a reduction in currentprofits even though it would enhance long-term value. Even where managers do not intend to leave, theymay feel under pressure to produce quick results, particularly if their employment contracts are short termand have to be renewed frequently.</p><p>We have seen that the interests of managers and shareholders may conflict because of the difference intime horizons between the two groups. However, shareholders may also adopt a short time horizon.Where this occurs, it can reinforce myopic managerial behaviour. By aligning their behaviour to the sametime horizon, managers may feel that they are responding to shareholder needs and will expect to berewarded accordingly. Thus, where they judge that shareholders are focused on the forthcomingquarterly, or half yearly, profit announcements, they may strive to produce results that meet expectations. </p><p>Frequent reporting of profits can intensify the pressure on managers to achieve quick results. This isbecause it can lead to the premature evaluation of performance (1). (For this reason, the European UnionParliament rejected a proposal in 2004 to make quarterly reporting mandatory for large companies (2)).Frequent financial reporting may be particularly damaging where there is no accompanying managementcommentary that would help shareholders to see the results in context.</p><p>The misuse of financial metrics may also promote myopic management behaviour. It has been arguedthat accounting ratios like ROCE and ROI, which focus on the efficiency of capital investment, encouragemanagers to avoid investment in long-term innovation. They may lead managers to minimise theinvestment in assets appearing in the financial statements in order to boost the percentage rate of return.Even DCF methods are not immune from encouraging short-term thinking. According to Salter:</p><p>..when the internal rate of return (IRR) metric is used, the return naturally goes up as the time horizoncomes down. So, when companies plan investments and keep score according to efficiency measures,they inevitably invite investment decisions; where uncertain, empowering innovations requiring long leadtimes for development are sacrificed for more certain, efficiency innovations requiring much shorter timehorizons for profitable results. (3)</p><p>THE EVIDENCE</p><p>There is evidence to support the existence of management short termism. A survey of US chief financial</p><p>M YACCA HOME MEDIA CENTER TECHNICAL ACTIVITIES HELP &amp; SUPPORT GLOBAL SITE </p><p>Myopic management | ACCA Qualification | Students | ACCA Global</p><p>1 of 4 4/22/2014 9:09 AM</p></li><li><p>officers, for example, found that they placed great emphasis on meeting or exceeding two keybenchmarks: profits for the same quarter of the previous year and the consensus of analysts estimatesfor the current quarter. The survey also found that in order to meet the desired level of quarterly profitsnearly 80% would be prepared to cut discretionary spending (such as investment in research anddevelopment and advertising expenditure) and more than 55% would be prepared to delay a newinvestment project even though it resulted in some sacrifice in value. (4)</p><p>A more recent survey of FTSE100 and 250 executives by PwC also provides evidence of short-termthinking among managers. When given a choice between 250,000 tomorrow and 450,000 in threeyears time, the majority of respondents chose the former (5). By doing so, however, they were applyingan annual discount rate of more than 20% to the future benefits, which is likely to be much higher than thecost of capital of their business. Excessive discounting of future cash flows by managers has importantimplications for the allocation of resources within a business. It can lead to the rejection of investmentprojects that would otherwise be profitable and to favouring projects with a short time horizon.</p><p>This evidence concerning short-term thinking is accompanied by a trend towards shorter managementtenures. The tenure of CEOs of large US businesses, for example, has fallen significantly over time. Forthe period 20002007, the average tenure was less than six years. (6)</p><p>THE ROLE OF SHAREHOLDERS</p><p>We saw earlier that shareholders may be the driving force behind the short-term focus of managers.Some believe that institutional and private shareholders are preoccupied with movements in quarterly andhalf yearly profit figures and make share investment decisions on this basis. This, in turn, leads managersto run their business in a way that meets shareholder expectations concerning short-term profits. It mayalso lead managers to provide earnings guidance to shareholders to help manage their expectationsconcerning the future share price.</p><p>Shareholder concern for the short term, however, suggests a clear gap between theory and practice. Intheory, the value of a share is represented by the future discounted cash flows that it generates. As aresult, shareholders should be concerned with the ability of a business to generate long-term cash flowsrather than on its ability to meet short-term profit targets.</p><p>To explain this gap it has been argued that using discounted cash flows can be a time-consuming, costlyand speculative process (7). Shareholders do not have access to inside information that could help themto predict cash flows with reasonable accuracy. They, therefore, rely on short-term profit performanceinstead. In other words, shareholders engage in short termism because of a lack of good qualityinformation concerning long-term prospects. While this may provide a partial explanation, other, morepowerful, reasons are likely to exist. One such reason is that shares are held by shareholders forincreasing short periods.</p><p>In the UK, shares of listed businesses are now held for around six months compared with eight years in1960 (8). It seems that shareholders are acting increasingly like share traders and less like owners. Thismeans that shareholders are likely to become less concerned with the future stream of dividends overtime and more with concerned short-term share price movements (which, in turn, are likely to beinfluenced by short-term profit performance). It also means that shareholders are less likely to beinterested in the future direction of the business. There is less incentive to monitor the behaviour ofmanagers because the benefits of doing so are often long term. There is also less incentive to engagewith the business and, if a business gets into difficulty, its shares are more likely to be sold. The end resultis that corporate governance is weakened and managers become less accountable. Furthermore, thestock market is reduced to little more than a casino.</p><p>Various reasons have been cited for the rise of short-term investing behaviour. One important reasonmay be the short-term focus of institutional shareholders. It has been argued that there is often quarterlyevaluation of fund managers performance, which increases pressure to produce short-term returns. Thisshort-term focus, however, may be at odds with the longer term requirements of those investing in thefunds. The speculative activities of hedge funds have also been cited as a further reason for the rise inshort-term investing. One widely-used practice of hedge funds is short selling. This involves selling sharesthat have been borrowed from a broker, or other third party, with the intention of buying back the shares ata later date to return to the broker. During the period between selling and buying back the shares, thehedge funds hopes to benefit from a decline in the share price. Where this activity is simply a response tomarket inefficiencies, however, it should not provoke short-term behaviour among managers.</p><p>THEORY AND EVIDENCE</p><p>The claim that shareholders adopt a short-term focus is difficult to square with the efficient markethypothesis (EMH). In an efficient market, the value of a share should reflect the long-term future cashflows arising from holding that share. If we accept that stock markets are efficient, this implies that acritical mass of shareholders do not adopt a short-term view when making share investment decisions.The fact that some shareholders do is, therefore, not really important. Indeed, some argue that short-termshareholders have a positive role to play by bringing liquidity and stability to stock markets.</p><p>There is increasing evidence, however, that the stock market is not always efficient and that share pricesdo deviate from fundamental economic values. There is a growing body of literature on behaviouralfinance, for example, which suggests that shareholders are not always rational when making investment</p><p>Myopic management | ACCA Qualification | Students | ACCA Global</p><p>2 of 4 4/22/2014 9:09 AM</p></li><li><p>decisions. This can result, among other things, in speculative share price bubbles and extended bull runsin share prices.</p><p>Although short termism in financial markets is widely discussed, there has not been much evidence tosupport its existence. One recent study, however, examined 624 businesses listed on the UK FTSE andUS S&amp;P indices over the period 19802009 to see whether the pricing of shares was affected by shorttermism. If so, it should be evident by the excessive discounting of future cash flows from shares overand above the risk-free rate. The findings of the study suggest that short termism does exist and that it isprevalent across all industry sectors. According to the study:</p><p>In the UK and US, cash flows five years ahead are discounted at rates more appropriate eight or moreyears hence; 10-year ahead cash-flows are valued as if 16 or more years ahead; and cash-flows morethan 30 years ahead are scarcely valued at all . (9)</p><p>Interestingly, there was much greater evidence of short termism among the sample businesses in the finaldecade of the study. It seems, therefore, that short termism is on the rise.</p><p>If shareholders have a short-term perspective it would, of course, be entirely rational for them to constructmanagerial reward systems that encourage managers to take a short-term view. Hence, bonuses may beheavily weighted towards current profits and share options may be given short vesting periods.</p><p>WHAT ARE THE REMEDIES?</p><p>It is clear from the above that management myopia does not stem from a single cause and that a varietyof measures may be needed to address this phenomenon. These measures should deal with theincentives that drive the behaviour of both managers and shareholders and also deal with the interactionbetween the two groups. The following are some of the measures that have been proposed:</p><p>Management rewards and contractsIt is frequently argued that management rewards should be linked more closely to long-term performanceand to the strategic aims of the business. Various suggestions have been made to achieve this link suchas share options having longer vesting periods, less weight being given to bonuses based on annualprofits and the use of non-financial targets as the basis for rewards. (Non-financial measures, such asinvestment in staff training, can often be lead indicators of long-term financial performance.) It has alsobeen suggested that managers should be given long-term contracts to help them forge a closer bond withthe business.</p><p>The behaviour of shareholdersTo encourage shareholders to invest for the long term, a loyalty dividend has been proposed for thosewho hold shares for a certain period of time. This dividend would be over and above the dividendnormally paid to shareholders. It has also been suggested that rewards for fund managers should belinked to long-term investment performance and that details of the reward structure for fund managersshould be published so that those investing in the funds can make more informed decisions.</p><p>To help counteract the importance attached to quarterly or half yearly financial reports, various remedieshave been suggested. For example, it has been suggested that additional reporting of the long-termprospects of the business should be included in the annual financial reports. It has also been suggestedthat closer interaction with shareholders will help enhance their relations with senior managers andencourage them to take a long-term view. (10)</p><p>Corporate governanceWeak corporate governance procedures allow short termism to thrive. A cornerstone of the CombinedCode is the role of independent non-executive directors in promoting the interests of s...</p></li></ul>