Podcast transcript: What is market short-termism’s perceived impact on ESG investments?
34 min approx | 14 Apr 2023
“Thinking about how you future-proof your business in a climate change environment, how you build the workforce of the future. Those are things that necessarily take a longer-term investment horizon to come to fruition. I think the biggest pools of capital in the world feel very acutely that quarterly capitalism and short-term behavior is a major problem for their business.”
Hello. I’m Myles Corson from Ernst & Young, host of the Better Finance podcast. I’m delighted to share this special episode as part of our new ESG reporting series.
A majority of public companies today are investing time, resources and leadership effort into sustainability. However, there is a significant disconnect between companies and investors when it comes to maintaining a focus on long-term value creation and sustainable growth and avoiding short-term thinking. In a recently published EY survey on corporate reporting, 80% of investors surveyed said that too many companies fail to properly articulate the rationale for long-term investments in sustainability, while 53% of finance leaders surveyed said they face short-term earnings pressure from investors, which impedes their longer-term investments in sustainability.
In the introduction, you heard from Ariel Babcock. At the time of this conversation, Ariel was the Managing Director of Research at Focusing Capital on the Long Term, known as FCLT Global. She has since taken a new role as Head of Investment Stewardship at Fidelity Investments, and I would like to take this opportunity to congratulate her and wish her continued success.
In this episode of the podcast, Brian Tomlinson, an Ernst & Young Managing Director focused on ESG reporting, and Ariel discuss how the integration of ESG into the core of the business is supporting the movement towards long-termism. As a production note, any views expressed by Ariel throughout the podcast are her own and do not reflect the views of Fidelity Investments.
With that, I’ll hand it over to Brian.
Hello everyone. Today we’re going to be talking about short-termism in our capital markets, how much of a problem is it, and also in the context of ESG. Delighted to be joined today by Ariel Babcock from FCLTGlobal who is their head of research. We’re going to get into a really great conversation about how you think about long-termism and short-termism in our capital markets and what some of the solutions for that might be.
Just to set up that conversation, I wanted to do an introduction into how people have talked about short-termism and identified it as a problem in our capital markets. First of all, there’s consensus from different groups and market participants that short-termism is a real problem. If you look at CEO surveys and investor surveys, there is a concern that our capital markets are somewhat myopic and that can constrain decision making that has a longer-term time horizon. Interestingly, the SEC was sufficiently minded a couple of years back to convene both a roundtable on this topic and also to seek comment from market participants across issuers and investors around the extent of the problem of short-termism.
Now there are some really seminal examples of short-termism in our capital markets. The classic would be companies which would cut investments such as R&D in order to hit a short-term earnings target. Now the data says that that type of behavior does exist broadly in our markets. Interestingly, CFOs when surveyed say that they expect their peers to behave accordingly too, and if you think about it, that’s kind of a classic example of the way that there are interaction effects between management decision making and between perceived capital markets pressures.
Now the interesting thing about long-termism, you can’t just look at one single datapoint and say this company is short term. This company is long term. You’re looking at basket of different proxies, and a number of studies use different ways of thinking about that from human capital retention to net investment and so on.
There has been a little bit of pushback against the premise of short-termism, some of that motivated by concerns around shareholder rights, the background concern being you can gin up a lot of concern around short-termism and how the capital markets are responsible for pushing short-termism. Maybe you can use that as an excuse for undermining shareholder rights which has been part of the capital markets discussion over the last decade or so.
One thing that short-termism does appear to do is constrain some of the appetite for investing in ESG, because ESG naturally can have a medium to long-term payoff. If you’re making investments in human capital or corporate purpose, decarbonization, often these things will take, decades to pay off, and is outside of the time horizon of short-termism. So, there is concern that short-termism can push against the appetite for investing into ESG.
So, as you can see, largely consensus that short-termism is a problem, much less consensus about what the solution set for short-termism might be, and that’s where FCLT comes in, because FCLT has been a leader in this space, thinking about long-termism, how to cultivate it both within issuers and investors. We’re going to focus today on the issuer side. So, I first of all, Ariel, wanted to say welcome.
And then wanted to give you an opportunity to introduce yourself, FCLT and where you sit in this ecosystem on long-termism.
Brian, thank you so much for having me. I think this is excellent framing for the sort of problem that we’re trying to solve. So, if you take a step back, FCLTGlobal is a non-for-profit research organization. We’ve been around for about six years. We’re supported by 75 global member organization that span the investment value chain, so big asset owners like pension funds and sovereign wealth funds, big asset management firms, both in the public and the private market space and multinational public companies.
The idea writ large is that focusing capital – and we’re talking about business and investment capital – focusing capital on longer-term horizons would be more supportive of sustainable, prosperous economic growth, and that focus benefits both the savers on the one hand whose capital is being invested and the communities on the other hand, in which the companies are operating. And if you think about the problem really from a economics perspective, what we’re really talking about is market failures.
Across the investment value chain, there are savers on the one hand that have very long-term goals for their capital. They’re saving for retirement. They’re saving to fund their children’s education. They’re saving to buy a home, things like that. On the other hand, you have companies who similarly have very long-term goals for their organizations, and they need capital to fund those growth initiatives, and then in the middle, you have a whole lot of other players, asset owners, asset managers, sometimes capital market participants, the structure of the markets, boards, management teams, regulators who interrupt those long-term goals.
So, what we’re really trying to do at FCLT is identify those pain points across the investment value chain and then bring an evidence-based approach to say, what’s the source of this short-term pressure? What’s causing this behavior that’s actually producing a poorer or long-term outcome and eroding value creation potential, and how can we think about some practical solutions that market participants could put to work right now inside their own organizations that would help alleviate some of those pressures or better focus them on the longer-term perspective. That’s really the heart of everything we do at FCLT, and I love the perspective that you offered at the beginning.
I think the biggest pools of capital in the world feel very acutely that quarterly capitalism and short-term behavior is a major problem for their business, and that’s why they founded our organization in the first place. All of our members feel that pressure acutely and are working hand-in-hand with us to try to solve that.
Fundamentally issuers and investors essentially have aligned interests, but it is the complexity of market intermediation that then causes those aligned interests to essentially start talking past each other. In the context of that investor-corporate dialogue there’s often a blame game going on about the sources of short-termism. Well, if only you investors were only more long term, or if only you corporates would talk more about the long term, it’s a coproduced problem which also, means it’s a coproduced solution. If we just take one issuer cutting one discretionary piece of spending to hit one earnings target, that doesn’t seem like a huge problem, but then actually large companies all across our economy doing that quarter after quarter after quarter, that starts to present a systemic problem for our economy, and you identified that as a market failure.
There’s good evidence in support of that from the economic research perspective. The CFA institute did a great study that looked at companies from 1996 to 2018 and found that those who failed to invest in things like R&D, capex and sales and growth initiatives underperformed in the medium term, so in the three- to five-year period post those cuts. And if you total up that systematic underperformance, we lost out on $1.7 trillion worth of growth over that period, and that is a real pain not just to the investors in those businesses on an issuer-by-issuer basis but also to the economy overall and the people who could have been employed by those businesses.
And we have research that corroborates a similar thing. We looked at companies in the ten-year period post the financial crisis and found that those who consistently maintained their investment in things like R&D, headcount and pieces like that, resisted the temptation to cut in the depths of the financial crisis, their stocks were hit harder in the midst of that recession, but they actually rebounded more quickly off the back end. And if you look at the totality of their performance over their period, they meaningfully outperformed their shorter-term peers.
So there is strong data that backs up the idea that if you can take that longer-term perspective and withstand the pain of committing to your investments in the short term, to your point, Brian, some of those things might be ESG-style investments.
It’s great to have this identified as being something which has benefits at multiple levels, at economy-wide levels, for workers, for companies themselves. I wanted to ask you about some of the other upsides in addition to those conventional business benefits that might be derived from a long-term time horizon.
The word resilience is something that corporate boards especially keep coming back to. What we’ve seen is that those longer-term oriented businesses are also more resilient, so taking that evidence from the financial crisis again. The firms who had a long-term strategic plan, had well-communicated KPIs, stuck to their investment and capital allocation decisions, resisted the pressure to cut, to hit that quarterly EPS target, those are the firms who succeeded over longer periods of time, and so this is a conversation that we’re having with companies in our membership and elsewhere right now where we’re seeing a period of market volatility and market turbulence. The instinct of many is “I’ve got to hoard capital. I’ve got to cut things.” That’s actually not consistent with a long-term strategy if you think that the market dislocation is temporary.
Nothing that we’ve seen so far with the exception of maybe a couple of sector-specific trends, especially related to the geopolitical situation, nothing we’ve seen so far would suggest a change in terms of direction. The boards that we’ve been talking to are very focused on scenario planning, stress testing their long-term strategies, thinking about what that means for the business, how they can place their bets accordingly, and then how they communicate that back out, because one of the key things about long-term oriented firms is that they’re very good at appropriate communication to stakeholder audiences, and that includes the investment community. The investment corporate dialogue is a real key piece of the puzzle in driving company behavior one direction or the other and attracting long-term shareholders that are aligned with your long-term strategy is something that is hugely beneficial for the business, but there’s actually academic evidence that supports that finding. So, if we look at long-term block holders and companies with those block holders, they are more consistently investing in R&D, more consistently producing less volatile returns over time, and they’re also rated from an employee perspective as great places to work.
They similarly do better in an activist scenario, and we’re hearing a lot about activist investors knocking on the doors of businesses lately. If you’ve got those long-term block holders in your shareholder base who have bought into the strategic vision of the company and are there with an aligned horizon, you’re much better able to withstand those activist attacks.
This is perfect because the next piece I wanted to talk about were some of those capital markets benefits and how you access them, because it’s important for companies to understand that short-term pressures are real, but it’s also a problem if you were to have significant agency over, and one of the ways in which you have agency over that is the way in which you talk to your capital markets, your capital markets stance. As you mentioned, you can use disclosure as a means of attracting a different class of investors. We know that investors that are more focused on ESG are often more patient. If you have a short-term earnings surprise, you miss consensus guidance, an ESG-focused investor is much less likely to do the Wall Street walk than an investor that’s not thinking about ESG, because that short-term earnings surprise is just somewhat less salient than it would be to a different type of investor.
It also makes logical sense, too, that an ESG-focused or a sustainability-focused investor would have a longer-term investment horizon naturally. Many of the factors that you talk about from an ESG investing lens are not quarterly factors. If you care about things like emissions or the composition of the workforce, those are things that are very long-horizon factors. You’re not going to prioritize the quarterly number in the same way because you’re looking for performance over a longer period of time. So their natural tendency is to have that long-term perspective embedded in their investment strategy.
It’s interesting, isn’t it, that the short term is in many ways embedded into the cycle of the way in which companies talk to the capital markets, because we have the quarterly earnings call, and as we discussed, I don’t think the quarterly earnings call is necessarily a source of short-termism, depending on how you use the quarterly earnings call and the attendant communications around corporate performance that go with that.
I wanted to use that as a kind of opportunity to talk a little bit about the earnings call and a little bit about earnings guidance which I know FCLT has produced a lot of information about. We noted that the National Investor Relations Institute a few years ago, leveraging FCLT’s work significantly, said that they now disfavor short-term EPS-based earnings guidance which is a really good guide, and there’s also that concern that short-term earnings guidance, not only does it cause companies to kind of communicate to the capital markets about short-term metrics, but also just within the company it also absorbs massive amounts of time to produce these short-term figures. So you have both the external stance that is short term and then the internal focus that is also short term.
Can you talk to us about how FCLT thought about recalibrating the guidance piece in the context of that quarterly earnings call?
I’ve essentially been on a crusade for the past five years to eliminate quarterly earnings per share guidance, and I think, if you look at the data, I’m winning. When we started off, about a third of the companies in the S&P 500 gave quarterly EPS guidance. That number is down to about one in five, so just about 20% today, and hopefully continuing its swift demise.
So why am I an EPS crusader? You touched on a couple of things that I want to unpack a little bit, Brian. One of the things is the mechanism and the behavior causes inside the issuer itself. You’ve committed publicly to hit a number. You’re coming towards the end of your quarter. All of the evidence and research suggests that the pressure is enormous on management to deliver that number or a slightly higher number, to meet or beat that expectation that they’ve set in the marketplace.
We also know from a couple of surveys that you’ve cited and some other research that managers will do completely legal things to make sure that number is achieved, so things like cutting marketing spend or delaying the purchase, there’s a behavioral factor that happens inside the company that, when you take a step back, does it matter for the success of our long-term strategy if that contract is booked on June 30th versus July 1st? The answer is no, but people are tempted anyway because of the quarterly number.
When a company is issuing guidance you attract short-term investors to your stock who are there to play the numbers. People are taking a perspective, betting one direction or the other that the company’s guidance is credible, and it cause short-term churn and volatility around earnings reporting periods which is the opposite of what management’s intention in issuing that guidance was in the first place. So, their idea was to not surprise the market. We’ll give them the number in advance. It’s like giving them the answer to the test and then no one will be surprised, and the stock will be fine. We actually see the exact opposite happen. If you look at the volatility around earnings report dates of companies who issue guidance, they’re far more volatile than their non-quarterly-guiding peers.
On the valuation side, management teams think that if they’re very good at issuing guidance, they’ll earn a valuation premium compared to their peers for their superior forecasting ability. This is not proven out by the data. If you look at companies who issue quarterly guidance, there’s no valuation premium for those who meet or beat the number.
What does exist which I think surprises people is that the companies who are better at long-term guidance actually do earn a premium. The companies who issue guidance of a year or longer, there is a statistically significant valuation premium as compared to their non-long-term-guiding peers. If you want to know what your guidance policy should be, you should think about forecasting on a year or longer basis and really using the quarterly call to focus people on progress towards that long-term goal rather than to focus them on progress in the past 90 days. As compared to the prior 90 days, if you think about it as a buildup to achieving a longer-term objective or KPI, that’s a better cadence and setting for a conversation that’s more focused on the business’ competitive advantages and long-term drivers of growth.
We want the guidance and the earnings call to work together to be a forum in which we talk about a longer-term time horizon. One of the ways in which companies can do that is by folding more ESG-type disclosures into the context of the quarterly earnings call. Now the pandemic was a very interesting cauldron for that experiment because essentially prior to the pandemic we had almost no disclosure around ESG themes on earnings calls, and then a survey of earnings transcripts saw 800%, 900% increases in references to ESG in earnings call transcripts during the pandemic.
Now for many, there’s a concern that the earnings call is the least auspicious of all of the companies’ opportunities to talk about ESG because of that short-term time horizon availability of metrics and data and so on. That means that it’s even more important to do it and to use that quarterly cadence to reassert the underlying ESG strategies and long-term investments that are going to drive value in the long term. I wanted to use the conversation that we’ve had so far about that capital allocation piece and how companies can think about pushing back against short-term pressures in the way they think about applying capital.
Now during the pandemic, we had pushback around buybacks where we had companies who had been shipping capital out the door to their shareholders in the form of buybacks and then very rapidly when the pandemic hit, were suddenly short of cash and calling for bailout. There was a public frustration about how can that have happened. Also we have that have broader piece about, will the capital markets tolerate investments that need to made in things which have a seven, ten, 15 or even 30-year ultimate payoff. You think of decarbonization where really we’re investing over 25, 30-year time horizons to achieve the type of net zero impetus that we want to achieve.
So, it’s really interesting to get FCLT’s sense on how that capital allocation piece works and some of the recommendations that you can make to companies to enable a long-term capital allocation stance.
I’ll first react to your prior observation on the presence of ESG in earnings calls in the midst of the pandemic. It was so fascinating to watch that evolution, and I think my own personal hypothesis on that one is that in the absence of certainty about their short-term prospects, companies had a natural instinct to just talk about the long term. And so we heard this long-term tone throughout those conversations in the middle of the pandemic that I really had been encouraging companies to stick with, but I’m not sure that’s what we’ve seen quite frankly. There was a moment of optimism there that has faded a little bit, and we’re trying to light that spark again.
But to your question around kind of capital allocation decisions, FCLT on an annual basis publishes something called the FCLT Compass, and that looks at asset flows, investment decisions, portfolio-level allocation decisions on the part of the investment community and corporate capital allocation decisions from the issuer community and attaches investment time horizons to those various allocations.
For an investor, we’re looking at things like turnover of the assets in various asset classes to measure their intended versus actual investment time horizons. Then from a company, you can put a time horizon on various categories of investment. Cash obviously has zero-time horizon. There’s no expectation of a return, whereas things like R&D tend to have a seven- to ten-year time horizon. So what we saw in the first year of the pandemic, was that companies actually did a phenomenal job investing in long-term things. We saw capex go up. We saw R&D go up.
On the R&D perspective, because what we’re seeing is, while the total capital spent on R&D has been steadily increasing over the past years, there’s a clustering of that R&D around short-term projects. We’re not going to get the kinds of investment that would deliver major technological innovation or disruption, new categories of products, things like that.
Major innovative breakthroughs don’t happen in a one- to three-year timeframe. They happen in a five- to ten-year timeframe, and so if all the R&D spending is clustered at that short end, what you’re going to get is incremental innovation, so the 2.0 version of something that already exists rather than a new category and that’s disappointing for the markets.
The sad thing about 2021 is that buybacks and dividends are back in a big way. We did a bit of analysis, and 117 percent of S&P 500 earnings were spent on dividends and buybacks in 2021. That means companies were spending more than they actually earned in net income, either buying back their stock or issuing dividends to shareholders. The best thing we can hope for is that the people who earned those dividends are redeploying them into the places of greatest capital need. That’s the academic argument. There’s no data that supports that theory.
This was always part of the justification for something like a buyback which is you don’t have to disrupt your dividend trajectory which you want to be stable and incrementally growing over time. You can redistribute capital to other areas of the economy where they can be used more efficiently. But as you say, we don’t know if that’s really part of the mechanism in this instance.
You can test that theory from an economic perspective, holding a whole lot of assumptions true. Those assumptions are not real-world assumptions and don’t apply in real-world capital markets environment. I have yet to see a study, and I’d love to see one that demonstrates that capital return to shareholders actually goes to support new economic growth initiatives.
And if you look at some of the economic history of the last 20, 30, 40 years, you’ll see that some of the really transformative technologies have often been created through long-chain university research projects. The research projects and government initiatives, which are then repurposed and used by the private sector to our benefit. It’s a great model in many ways, but it’s one that’s often unrecognized in terms of the discourse on long-term research. Just having talked a about that capital allocation piece and some of the challenges there, I wanted to get some final thoughts on ESG in the context of long-termism. Early on we were essentially saying that short-termism can slightly get in the way of progress on ESG, but ESG naturally has something of a long-term time horizon in terms of investments. Now ESG risks can crystallize very dramatically over the short term, and we’ve seen all sorts of examples of how that can happen, in terms of driving ESG investments, we’re often talking about a three, five and beyond kind of time horizon. So when you’re talking to companies about ESG, what are the kind of themes that are presenting themselves?
The conversation has really shifted around ESG over the last five or so years, and it’s a natural evolution of taking a more sustainable approach to capitalism. If you distill the E, environmental, S, social, and G, governance factors down, they don’t belong in a three-letter bucket. They’re very different factors, and the levers that you pull to tackle issues that are included in each of those buckets are very different levers.
The G factors predominantly sit at the board level of the organization. E and S factors are tackled typically elsewhere with board oversight, and the ways in which you invest behind those things are also different. So, what we think about a lot at FCLT is actually the levers that drive longer or shorter-term behavior and how those integrate with an ESG perspective. What do you need to really build a long-term organization? You have to get your governance structures right. You have to get your incentives right to help close that principal agent gap and have people focused on the right horizon and the right set of KPIs. You have to get metrics right. The yardstick you use to measure and define success drives behavior one direction or another. If you're using a short yardstick, you’re going to have short results.
Then the final thing is engagement, engaging not just with your shareholders but also with the broader key stakeholder community, and that includes employees, the communities in which you operate, and your supply chain partners. If you think about ESG at the corporate level, there are a lot of factors that are very material for a company, depending on the industry and the geography of operation and being able to identify and sort through the really material factors versus the immaterial factors and then embedding those factors into your long-term strategy and growth objectives so that you're actually getting the benefit. ESG can be a cost, but it can also be an opportunity, and so if you think about investing behind those things as an opportunity for growth and value creation, that’s where you're really seeing smart boards and smart company management teams pivot to try to say, aha, how am I going to use this to enhance my competitive advantage and future-proof my business over time? Those are the companies that are really seeing the value creation potential.
It’s thinking about ESG in many ways as often a short-term cost but a long-term source of value creation and resilience and also, as you say, making sure that companies understand that ESG is not one thing. It’s a category of differently calibrated issues, and that those issues vary systematically by sector.
It’s key that companies engage with ESG through that lens of materiality to narrow down the set of issues to a set of priority issues which gives you a high minimum baseline of issues to focus on and construct strategies around and decide how you're going to apply capital to them. Because very often I think when companies are engaging with ESG, it sort of seems like just an amorphous cloud of issues. It’s everything, whereas actually once you’ve gone through that narrow funneling process of prioritization, you quite rapidly get down to a fairly small set of business-critical issues that need to be focused on.
And you can see the companies who have done that hard work because their sustainability teams are integrated in the business units, and their sustainability report is not a separate thing that’s on a separate part of the website. It’s integrated information sitting right alongside their conversations about their long-term plans and strategies.
That’s a really important note for us to start to conclude on which is that issue of, if long-termism is a whole firm concept, ESG is also a whole firm concept. If you are working within a company where ESG is somewhat still siloed or somewhat has a philanthropic or CSR focus, that needs to change. Now the regulatory developments around ESG are starting to push for much more integration of ESG into the core of the business. That’s a good thing. It’s an absolutely terrific conversation. We covered a lot of ground. We have this broad consensus that short-termism is something of a problem for our capital markets, but there is a readily available solution set for companies in terms of how they talk to the capital markets, how they think about constructing their disclosures, how they think about applying capital, how they think about wrapping structure around identifying and prioritizing ESG issues, and how all of that flows through the whole firm, all the way from the board down to the business unit level.
I would encourage people who are interested in this topic to check our website. All of our research, toolkits and our suggestions for organizations are available there. We’re a nonprofit, so they’re freely available. One of the things that our research benefits from is community feedback. So if anyone thinks, this is bonkers or this is brilliant, we’d love to hear from you either way.
Thank you so much, Ariel. Appreciate you being with us.
Embracing long-term value creation, with its emphasis on stakeholders, society and sustainability, is quickly becoming a strategic imperative for the C-suite and boards around the globe. The finance function has and will continue to have a critical role in how nonfinancial information is meaningfully communicated to all stakeholders.
Thank you to Ariel and Brian for sharing their perspectives on this important ESG topic. And thank you to our subscribers and listeners for your continued support. If you’ve enjoyed this episode, please subscribe or leave a rating or review and look for future episodes covering the sustainability landscape. You can find related links at ey.com/betterfinance.
I look forward to speaking with you on the next episode of the Better Finance Podcast, a series that explores the changing dynamics of the business world, and what it means for the finance leaders of today and tomorrow.
The views and opinions expressed are those of the individuals and do not reflect the official policy or position of EY or any other organization.