In a world that desperately needs long-term investment, we face a daunting shortfall. Global long-term investment collapsed during the Great Recession of 2008 and has not recovered since. Across advanced economies, real private business investment fell by 10 to 25 per cent from 2007 highs, and recovery has been slow.
Business investment is a key determinant of long-term growth, and essential for creating jobs. The world is facing a vast unmet infrastructure challenge: Investments of nearly $60-trillion (U.S.) are needed in roads, rail networks, airports, sea ports, water and telecommunications by 2030. Moreover, in industries with the biggest need for innovation, such as health care, research and development spending is declining.
In this context, long-term investment is needed now. Yet short-termism is actually on the rise.
Indeed, it has become the norm in our capital markets. Almost all public companies dedicate significant resources to meeting quarterly earnings guidance, and assess their performance relative to it. Since more than 50 per cent of a typical company's value comes from activities that will take place three or more years in the future, businesses are clearly failing to make profitable investments as a result. Seventy-eight per cent of executives surveyed in a Financial Analysts Journal study reported that they would take steps to improve quarterly earnings at the expense of long-term value creation. Many institutional investors, in turn, have a narrow focus on performance. They use short-term incentive strategies to reward fund managers and are hypersensitive to the news cycle.
In an effort to appease short-term investors, many companies are resorting to share buybacks rather than long-term investments. In some cases, this may be a rational attempt to return cash to shareholders by managers unable to find profitable investments. Yet, the sheer scale suggests that many companies are shortchanging "essential capital expenditures necessary to sustain long-term growth," as BlackRock CEO Larry Fink noted in a recent letter to S&P 500 executives.
Companies that unduly prioritize share buybacks are failing to invest adequately in their work forces, in their research capabilities, in innovation and in the infrastructure required for sustainable long-term growth. But as CEO tenure continues to shrink, many executives will be gone before the impact is felt.
The problem affects our entire society: Corporate management underinvests in longer-term prospects, savers miss out on potential returns and society as a whole loses out on growth and innovation.
Given the evidence that short-term strategies and behaviour have grown entrenched in today's capital markets, we need to rethink the framework for capitalism to help prioritize long-term investment. The best place to begin is for long-term owners to act and invest in a way that creates sustainable value for current and future shareholders. With BlackRock's Mr. Fink and Canada Pension Plan Investment Board president and CEO Mark Wiseman, I co-chair the Focusing Capital on the Long Term initiative. Together, we have developed a four-part framework for reorienting capital markets.
1. Reorient institutional investors
Institutional investors own 70 per cent of the largest 1,000 U.S. public companies. Globally, institutional investors in member countries of the Organization for Economic Co-operation and Development manage $83-trillion in assets, about a quarter of which is managed by pension funds. These funds have the size and clout to champion long-term thinking, plus a vested interest in generating greater economic value from their assets.
As part of our long-term investing initiative, we gathered leaders from nine investment management organizations, with more than $6-trillion in assets under management, to develop ways to get fund managers to reorient their strategies and practices. We established five core areas where institutional investors should take action:
- Articulate investment beliefs to provide a foundation for a sustained long-term investing strategy.
- Develop a comprehensive statement of risks, risk appetite and risk measures, appropriate to the organization and oriented to the long term.
- Select and construct benchmarks focused on long-term value creation.
- Evaluate internal and external asset managers with an emphasis on long-term expectations.
- Use investment strategy mandates as a mechanism to align asset managers’ behaviour with the objectives of the asset owner.
These areas collectively provide a framework for institutional investors to improve long-term outcomes for their portfolios, the companies in which they invest and, ultimately, all stakeholders.
In Canada, institutional investors are ahead of the curve. For example, six of Canada's largest pension plans have signed the draft OECD Principles of Long-Term Investment Financing by Institutional Investors. This is a good place to start.
2. Unlock value through active ownership
Engagement by asset owners with their companies – either through the acquisition of a meaningful ownership position or through dialogue with boards and management – is another important means of unlocking long-term value.
Recognizing that engagement carries its own costs and that not all asset owners are large enough to engage on their own, a range of strategies should be considered: monitoring of companies in which they have a stake, building coalitions with other investors, taking a significant ownership position, holding seats on the board of the company.
While working behind the scenes is typically the most effective approach, there are times when exerting public pressure, such as voting on shareholder proposals or forming microcoalitions with other large investors, is most effective.
3. Improve investor-corporate dialogue
Such dialogue can help empower management to make long-term decisions. Companies should build a long-term strategy and share it with investors, measure long-term performance, relative to a set of metrics specific to that strategy, and report to and engage investors on long-term value creation.
Management needs to think beyond a product or investment cycle, and beyond the tenure of the directors and CEO. Defining what fraction of an enterprise's value comes from activities five, seven or 10 years out can help suggest an appropriate horizon.
4. Shift the focus of corporate boards
Last year, McKinsey and CPPIB surveyed more than 600 C-suite executives and directors around the world about the source of pressure most responsible for their organizations' emphasis on short-term financials over long-term value creation. The most common answer, given by nearly half of respondents, was the company's board.
We need to remind directors what their fiduciary duty really is. Most legal definitions cite two aspects: loyalty and prudence. The logical implication is that a director should help an enterprise thrive for the long term.
Next, boards must spend sufficient time and effort to assess long-term strategy. These discussions may require directors to meet more frequently, but the emphasis should be on quality time that allows rich, free-flowing discussions about both financial and non-financial objectives and metrics. As part of our initiative, we surveyed non-executive board directors, and 62 per cent indicated that reporting on long-term strategy, and disclosing organizational health metrics, would most help them cultivate a long-term orientation. Also, boards should become far more active in building dialogue with institutional shareholders. It's key for boards and management to persuade large investors to act as a counterforce to short-term myopia.
Finally, as we ask directors to engage more deeply in their work and sit on fewer boards, we should give them significant raises. They should be compensated substantially more than today's average annual amount. But even more important than the amount is how this pay is structured. To get directors thinking more like owners, it's logical to ask that a lot of compensation be paid in stock and to ask them to put a bigger portion of their own wealth into the mix.
As we look at the investment value chain, it's clear that too many incentives are aligned to encourage short-term action. This cannot persist if we intend to stimulate growth, increase innovation, create jobs and solve our biggest societal challenges.
Canadian institutional investors and companies are already taking a prominent role in addressing this problem. However, turning back the tide of short-termism is a global challenge that requires simultaneously reorienting institutional investors, unlocking value through active ownership, improving investor-corporate dialogue and shifting the focus of corporate boards. To succeed, we need business leaders willing to engage in co-ordinated, persistent and collective action that can restore capitalism for the long-term – and for all of us.
Dominic Barton is the global managing director of McKinsey & Co.