Retooling the Economy: Four Key Steps to Breaking Wall Street’s Obsession With “Short-termism” and Achieving Real, Authentic Growth
According to author Ed Hess, the nation’s recent financial woes are indicators of just how harmful the Wall Street-driven focus on short-term growth can be. He warns that before we can achieve truly sustainable economic recovery, we must first eradicate the short-term fixes that are so popular with Wall Street.
One need not look further than the recent financial crisis to see how the pursuit of growth for growth’s sake can negatively affect a company and the U.S. economy as a whole. Lehman Brothers, AIG, and Toyota are prime examples of how poor-quality growth and the failure to manage risks associated with growth can bring a company to its knees. Unfortunately, in the case of Lehman Brothers and AIG, their focus on short-term growth led not only to their collapse but also to the near-collapse of the U.S. economy.
Ed Hess says that in an economic system where nearly 70 percent of U.S. corporations’ stock is owned by institutions on average for just 12 months or less, we shouldn’t expect companies to always make responsible decisions when it comes to growth. And while the focus remains on achieving the short-term growth that Wall Street finds most appealing, the economic rebound will prove a “jobless” and unsustainable fantasy so long as economists and politicians limit their efforts to stimulus plans and modest banking reforms.
“By focusing on these short-term fixes, they are missing the bigger picture—that something fundamental and systemic is wrong with the U.S. economy, namely our short financial attention spans,” says Hess, a professor at the University of Virginia’s Darden Graduate School of Business and author of the new book “Smart Growth: Building an Enduring Business by Managing the Risks of Growth” (Columbia Business School Publishing, 2010, ISBN: 978-0-2311505-0-7, $27.95).
“ To achieve a true economic turnaround, we must turn our focus to a pursuit of growth and innovation. Our current capital system is structured to impede those aspirations. The short-term perspective that dominates boardrooms and Wall Street is an impediment to a real recovery, because it often creates an illusion of growth and postpones investments that would make a long-term difference.”
When it comes to growth, Hess knows what he is talking about. Smart Growth features the findings of much of his research on sustainable growth, including the Darden Private Growth Company Research Project, which was funded by the Batten Institute at the Darden Graduate School of Business and the Darden School Foundation. The book introduces a research-based growth model called Smart Growth. Using it Hess challenges the “grow or die” and “bigger is always better” ethos that permeates Wall Street and boardrooms in America—a dangerous mentality that often deters real growth and pressures businesses to create, manufacture, and purchase non-authentic earnings just to appease Wall Street.
For the nation’s economy to achieve sustainable growth, its businesses must also take on a similar mentality, shedding themselves of the Wall Street rules that Hess says cause an unhealthy focus on quarterly earnings and unrealistic continuous growth.
“If we are to retain national competitiveness, ensure social cohesion, and empower the American Dream so that successive generations have a chance for better economic life, fundamental change in the system is necessary,” says Hess.
“I am not anti-growth. I want our economy to be among the strongest, most prosperous in the world. My point is that growth should not be assumed. It should be a conscious decision made only after evaluating the risks of not growing versus the risks of growth and devising ways to mitigate the risks of the chosen path. Our economic system is still rife with problems, and, as such, any growth we achieve now will likely be unsustainable.”
Here are a few important steps that must be taken before sustainable growth can be achieved in the U.S.:
• Eradicate “short-termism.” The first step to retooling our economy is to confront openly and honestly the short-term interests that dominate the U.S. capital markets. As previously mentioned, nearly 70 percent of U.S. corporations’ stock is owned by institutions, which on average hold stock for 12 months or less. Such short-termism fueled the real estate balloon and the derivatives manipulations that brought down the economy when they collapsed like a house of cards. To change the rules of the game in a way that mitigates the dominance of short-termism in the current system, four concrete steps must be taken:
1. Public companies must be required by the SEC, the listing exchanges, and by their boards of directors to disclose with complete transparency their “non-authentic earnings.” (More on non-authentic earnings below.)
2. The short-term “renting” of stock must be discouraged by increasing the holding period for long-term capital gains to three years and by imposing similar transaction fees upon tax-exempt short-term stock “renters,” as well.
3. Executive compensation should be more properly aligned with the long-term creation of real growth by requiring management to be held accountable for the results of their decisions for three years after their service ends, or face compensation “clawbacks.”
4. Public companies must be required to disclose their short-term and long-term growth and innovation portfolios so investors can better evaluate and allocate their capital to smart, rather than illusory, growth.
Stop tying executive compensation to quarterly earnings. Wall Street’s pressure to demonstrate higher earnings each quarter stacks the deck in favor of using short-term results to determine executive compensation. CEO tenures at large public companies now average less than six years. “As touched on above, CEOs are rarely around to take responsibility for long-term negative effects of short-term decisions on which their pay was based,” says Hess.
Discourage companies from creating “non-authentic” earnings. The erroneous assumption that business growth should be continuous and linear pushes companies to spend time, money, and intellectual capital creating “non-authentic” earnings. What are “non-authentic” earnings? They are the numbers manufactured creatively by accountants and investment bankers from accounting elections, valuations, reserves, and adjustments, and from investment transactions, structured financial engineering, related party transactions, channel stuffing, and changes in credit policies. In most cases these earnings are legal—just inferior in quality because they do not represent the fundamentals of the business that are important for long-term, smart growth. Greece and Lehman Brothers have shown us that such “financial gaming” can also be used to hide liabilities. Wall Street’s creativity obscures what is “real” and champions form over substance.
“Authentic earnings represent business the ‘old-fashioned way’—the sale of more goods and services on customary commercial terms to more unrelated customers in arms-length transactions,” says Hess. “Authentic earnings are higher quality indicators of growth because they represent information about the underlying vitality, differentiation, market acceptance, and strength of the company’s customer value proposition. Any government intervention or efforts by businesses that encourage only short-term growth resulting from non-authentic earnings will not help to raise the economy out of its current malaise. In fact, they may only result in the misallocation of capital away from opportunities for real growth and innovation.”
Place a renewed focus on R&D. The way today’s system functions, CEOs are routinely forced to delay value-creation projects, or to decrease important discretionary spending in areas such as R&D to meet quarterly earnings targets. “All of these factors impede real growth, job creation, and economic recovery,” says Hess. “And keep in mind that these issues don’t just affect the nation’s heavy hitters. Smaller companies also succumb to Wall Street’s pressures to grow. Would a CEO of a young job-creating growth company go public if he or she truly understood that to do well as a public company they are forced to get on an unrealistic growth treadmill? Patient venture capitalists would be a better funding alternative for them, but the pressures to grow and expand Wall Street-style are often too great for up-and-coming business owners to ignore.”
“Real growth and innovation need enabling environments both in the capital markets and inside of companies,” says Hess. “If we want more jobs and more real growth, we have to attack the short-term mentality that dominates our capital markets and we have to make the earnings games transparent.”
For additional information see Professor Edward D. Hess’ Website at www.EDHLTD.com.