Financial and societal advantages of long-term strategy – the evidence

This article by John Mansfield, MI’s Global Lead on remuneration, first appeared on South Africa’s ‘Business Day’

The debate over the merits of short-termism versus long-termism has raged for many years but has now finally been put to bed.

A 15-year longitudinal study by McKinsey (yes the same one) from 2001-15 involving 651 non-financial US companies (60% to 65% of the total US market cap) found that the long-term focused companies surpassed their short-term focused peers on several important financial and economic measures.

The findings were published in a report by the McKinsey Global Institute in February 2017 entitled, Where companies with a long-term view outperform their peers.

The reported gains are:

• Average job creation for the 164 long-term-oriented companies over the 15-year period was 11,600 above the average for the 451 short-term-oriented companies: long-termism added about 2-million jobs;

• McKinsey estimates that if the entire market were long-term, 8-million more jobs could have been added (5-million in the US and 3-million overseas); and

• 5%-million more jobs in the US would have unlocked as much as $1-trillion in additional GDP, or 0.8% of GDP per year.

The figures presented below reflect the extent to which the average gains for long-term-oriented companies exceeded average gains for short-term-oriented companies:

• Average company revenue up 47%;

• Average company earnings up 36%;

• Average company economic profit up 81% (profit less opportunity cost of capital);

• Average market capitalisation up $7bn;

Above-average returns to shareholders: there is 50% greater likelihood of being in the top quartile, or decile, at the
end of the period measured. What this implies, in the broadest sense, is that those companies that do not embrace long-termism are underperforming relative to their potential, irrespective of their absolute levels of performance.

It also means SA’s economy has upside potential in terms of GDP growth and job creation should all corporates embrace long-termism.

Furthermore, it is not unreasonable to suggest that the gains reflected in the study could have been even larger had the long-term-oriented companies been operating under a governance model that encouraged long-termism. As it happened, they operated under the prevailing agency model, which explicitly rewards short-termism.

Milton Friedman spawned the agency theory in 1970 and Michael Jensen and William Meckling developed the agency model in their Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure, published in the Journal of Financial Economics in 1976.

Its underlying tenets are that maximising shareholder value is the number one priority of boards and managers, and shareholders are “owners” and boards and managers are “agents”. But the agency model is currently being challenged on a number of fronts and is probably no longer fit for purpose. It is seen, inter alia, as the most likely cause of fiduciary-duty and corporate failures.

In addition, the notion of ownership, which is integral to agency theory, seems to have caused the excesses in executive pay that are so widely reported. Since 1976 this notion has led to the granting of shares to directors and management to align their interests with those of shareholders.

In the US, for example, about 62% of executive pay is now in the form of equity, compared with 19% in 1980. The hope has always been that by giving executives “skin in the game”, boards and managers would behave more like owners and so improve the real performance of their companies.

However, corporate performance has actually declined over this period — the relationship is inversely correlated.

So, agency theory seems to be at the root of three spectacular corporate faults: fiduciary duty and corporate failures; excesses in executive pay; and locking out long-termism.

In practice, this looks very much like “three strikes and you’re out”.

The message is clear: the health of the financial and economic system depends on getting the role of the shareholder right. If we expect boards and managers to perform their fiduciary duties, embrace long-termism and do a better job of managing executive pay, we simply have to provide them with a governance model that makes all of this possible.

The good news is that a start in this direction has already been made. Harvard professors Joseph Bower and Lynn Paine have developed a new theory of the firm and named it the company-centred model.

It is intended to replace the agency model and was published in the May-June 2017 Harvard Business Review in an article titled The Error at the Heart of Corporate Leadership. The authors state: “The time has come to challenge the agency-based model of corporate governance. Its mantra of maximising shareholder value is distracting companies and their leaders from the innovation, strategic renewal and investment in the future that require their attention.

“A better model, we submit, would have at its core the health of the enterprise rather than near-term returns to its shareholders. Such a model would start by recognising that corporations are independent entities endowed by law with the potential for indefinite life.”

These are very encouraging sentiments and will resonate widely. A company-centred model of corporate governance could well provide the spark SA needs to drive and optimise job creation and GDP growth.