Attracting Long‐Term Investors Through Integrated Thinking and Reporting: A Clinical Study of a Biopharmaceutical Company

Faced with a large percentage of investors that chase short‐term returns, companies could benefit by attracting investors with longer‐term horizons and incentives that are more consistent with the long‐term strategy of the company. The managers of most companies take their investor base as a “given” that cannot be changed through their actions or words. Using the case of Shire, a biopharmaceutical company with a strong commitment to the goals of improving the safety of its products and the reliability of its supply chain, the authors of this article suggest that companies have the ability and the means to change their investor base in ways that are consistent with their strategy. One of the most promising ways of attracting such investors is integrated reporting, which provides companies with a means of credibly communicating the commitment of its top leadership to diffusing integrated thinking across the organization and to building strong relationships with important external stakeholders. In the case of Shire, both a commitment to integrated thinking and the adoption of integrated reporting appear to have helped the company attract longer‐term investors, which in turn has strengthened management's confidence to carry out its strategy of stakeholder engagement and investment.     

Identifying and Attracting the "right" Investors: Evidence on the Behavior of Institutional Investors

This article summarizes the findings of research the author has conducted over the past seven years that aims to answer a number of questions about institutional investors: Are there significant differences among institutional investors in time horizon and other trading practices that would enable such investors to be classified into types on the basis of their observable behavior? Assuming the answer to the first is yes, do corporate managers respond differently to the pressures created by different types of investors– and, by implication, are certain kinds of investors more desirable from corporate management's point of view? What kinds of companies tend to attract each type of investor, and how does a company's disclosure policy affect that process? The author's approach identifies three categories of institutional investors: (1) “transient” institutions, which exhibit high portfolio turnover and own small stakes in portfolio companies; (2) “dedicated” holders, which provide stable ownership and take large positions in individual firms; and (3) “quasi‐indexers,” which also trade infrequently but own small stakes (similar to an index strategy). As might be expected, the disproportionate presence of transient institutions in a company's investor base appears to intensify pressure for short‐term performance while also resulting in excess volatility in the stock price. Also not surprising, transient investors are attracted to companies with investor relations activities geared toward forward‐looking information and “news events,” like management earnings forecasts, that constitute trading opportunities for such investors. By contrast, quasi‐indexers and dedicated institutions are largely insensitive to shortterm performance and their presence is associated with lower stock price volatility. The research also suggests that companies that focus their disclosure activities on historical information as opposed to earnings forecasts tend to attract quasi‐indexers instead of transient investors. In sum, the author's research suggests that changes in disclosure practices have the potential to shift the composition of a firm's investor base away from transient investors and toward more patient capital. By removing some of the external pressures for short‐term performance, such a shift could encourage managers to establish a culture based on long‐run value maximization.     

Far Beyond the Quarterly Call: CECP's First CEO‐Investor Forum

The authors begin by describing how the existing structure of corporateshareholder communications encourages short‐term planning and performance evaluation horizons. Then, after summarizing the substantial evidence that corporate management, boards, and investors are concerned about the failure of current corporate‐shareholder communications to reflect longer‐run corporate investment and its expected payoffs, the article holds up the long‐run plans presented by the CEOs of five large public U.S. companies (and the CFO of IBM) at the first ever CECP CEOInvestor Forum as providing a promising model for the future. Such presentations are also evaluated against a set of criteria the authors propose for assessing the effectiveness of those presentations—criteria that were developed through extensive investor and CEO feedback. The article concludes by discussing the three main programs that make up CECP's Strategic Investor Initiative to further the development of such longterm plans. One program is focused on identifying different kinds of investors, with the aim of helping management attract longer‐term shareholders. A second program is designed to improve the ways companies communicate with their non‐investor stakeholder groups, with particular emphasis on The Statement of Material Audiences and its role in identifying the critical stakeholders and their contributions to the long‐run success of the company. Third and last is the development of a common language and tool‐kit for longterm plans, with the aim of bringing about the broad adoption of longterm plans as a mainstream element in corporate‐shareholder communications.     

VALUE MAXIMIZATION AND STAKEHOLDER THEORY: COMPATIBLE OR NOT?

Complicating the current corporate governance controversy is a major disagreement about the fundamental purpose of the corporation. There are two main views on what should constitute the principal goal of the firm. Most economists tend to endorse value maximization—that is, maximization of the value of the firm's debt plus equity—or a version of value maximization known as “value‐based management” (VBM) that aims to maximize shareholder value. The main challenger is “stakeholder theory,” which argues that the corporation exists to benefit not just investors but all its major constituencies—employees, customers, suppliers, the local community, and the federal government, as well as shareholders. Thus, whereas the success of a corporation under VBM could be assessed simply by its long‐run return to shareholders, under stakeholder theory a company's success would be judged by taking account of its contributions to all its stakeholders. Using statistical analysis of various measures of corporate success in satisfying non‐investor stakeholders, the author investigates whether a broader focus on multiple stakeholders is necessarily inconsistent with the pursuit of long‐term shareholder value. His main findings in fact suggest just the opposite—namely, that long‐term value creation appears to be a necessary condition for maintaining corporate investment in stakeholder relationships. More specifically, the author's study shows that companies with higher levels of value creation tend to have stronger reputations for treating stakeholders well while companies that create little value end up shortchanging not just their shareholders but all their constituencies. For profitable companies that have previously failed to devote the optimal level of resources to their non‐investor stakeholders, the message of this article is that investing in stakeholders can add value—and, in fact, it pays for companies to spend an additional dollar on stakeholder relationships as long as the present value of the expected (long‐run) return is at least a dollar.     

Loyalty‐Shares: Rewarding Long‐term Investors

In the face of growing concern about investors' excessive focus on quarterly earnings, recent research has found new evidence of the benefits of a committed long‐term shareholder base, whether in terms of higher profitability, R&D investment, greater integration of ESG factors, or a reduced cost of capital. In light of this evidence, this article takes up the challenge of proposing a market solution to this problem. Although much has already been done in the financial industry to lengthen the outlook of executives by imposing longer vesting periods for stock options, a significant fraction of institutional shareholders continues to have a short‐term orientation. The authors propose that companies try to attract a more long‐term‐oriented shareholder base by modifying the form of the common share contract to include a special reward for buy‐and‐hold investors. The type of contract proposed—called a “loyalty share”—is a call‐warrant attached to each share that is exercisable at a specified time‐horizon—say, three years—and exercise price, but is nontransferable and hence has value only if the share is held for the entire length of the specified “loyalty period.” Such a reward is expected to encourage a longer‐term valuation outlook, since those shareholders seeking the loyalty reward are likely to be those who are most confident about the company's ability to increase its value through the expiration of the loyalty period.     

Three Common Misconceptions About Markets (or Why Earnings Smoothing,Guidance, and Concern About Meeting Consensus Estimates are Likely to be Counterproductive)

Although many executives strive for stable earnings growth, finance theory and research have long suggested that the most sophisticated investors aren't especially concerned about “normal” levels of variability in reported earnings. More recent research by the authors and their McKinsey colleagues also suggests that extraordinary efforts to achieve steady growth in earnings per share quarter after quarter aren't worthwhile and may actually hurt the companies that undertake them. While such efforts to smooth earnings involve real costs, the research finds no meaningful relationship between earnings variability and valuation multiples or shareholder returns. Based on these findings, as well as considerable experience in advising companies, the authors offer the following advice to senior executives:

• Managers shouldn't shape their earnings targets or budgets just to meet consensus estimates. Companies that reduce spending on product development, sales and marketing, or other contributors to long‐term growth are sacrificing long‐term performance for the appearance of short‐term strength.
• As the year progresses, managers should likewise avoid costly, shortsighted actions to meet the consensus. Resist the temptation to offer customers end‐of‐year discounts to boost current‐year sales, or to resort to creative accounting with accruals. Investors recognize these for what they are: borrowing from next year's earnings.

Finally, companies should reconsider the practice of quarterly earnings guidance. Instead of providing frequent earnings guidance, companies should design their investor communication policies to help the market to understand their strategy, the underlying value drivers of their business, and the most important risks associated with the business—in short, to understand the long‐term health and value of the enterprise.     

UNIVERSITY OF GEORGIA ROUNDTABLE ON: Enterprise‐Wide Risk Management

For many years, MBA students were taught that there was no good reason for companies that hedge large currency or commodity price exposures to have lower costs of capital, or trade at higher P/E multiples, than comparable companies that choose not to hedge such financial price risks. Corporate stockholders, just by holding well‐diversified portfolios, were said to neutralize any effects of currency and commodity price risks on corporate values. And corporate efforts to manage such risks were accordingly viewed as redundant, a waste of corporate resources on a function already performed by investors at far lower cost. But as this discussion makes clear, both the theory and the corporate practice of risk management have moved well beyond this perfect markets framework. The academics and practitioners in this roundtable begin by suggesting that the most important reason to hedge financial risks—and risk management's largest potential contribution to firm value—is to ensure a company's ability to carry out its strategic plan and investment policy. As one widely cited example, Merck's use of FX options to hedge the currency risk associated with its overseas revenues is viewed as limiting management's temptation to cut R&D in response to large currency‐related shortfalls in reported earnings. Nevertheless, one of the clear messages of the roundtable is that effective risk management has little to do with earnings management per se, and that companies that view risk management as primarily a tool for smoothing reported earnings have lost sight of its real economic function: maintaining access to low‐cost capital to fund long‐run investment. And a number of the panelists pointed out that a well‐executed risk management policy can be used to increase corporate debt capacity and, in so doing, reduce the cost of capital. Moreover, in making decisions whether to retain or transfer risks, companies should generally be guided by the principle of comparative advantage. If an outside firm or investor is willing to bear a particular risk at a lower price than the cost to the firm of managing that risk internally, then it makes sense to lay off that risk. Along with the greater efficiency and return on capital promised by such an approach, several panelists also pointed to one less tangible benefit of an enterprise‐wide risk management program—a significant improvement in the internal corporate dialogue, leading to a better understanding of all the company's risks and how they are affected by the interactions among its business units.     

From Stock Selection to Portfolio Alpha Generation: The Role of Fundamental Analysis

In this roundtable sponsored by Columbia Business School's Center for Excellence in Accounting Research and Security Analysis, a group of successful investors discuss their approaches and methods. A common saying among financial economists is that stock prices are set not by the average investor, but “at the margin” by the most sophisticated and influential investors. The intent of this roundtable is to furnish a portrait of such “marginal” investors, one that turns out to be quite different from the quarterly earnings‐driven, momentum traders often depicted by the media and deplored by corporate executives. In response to the common charge of short termism leveled by corporate managers, most of the investors at the table claimed to take large, multi‐year positions in companies they believed to be well‐managed, but temporarily undervalued. Instead of being attracted to earnings momentum, and rather than simply capitalizing current earnings at industry‐wide multiples to arrive at price targets, the analysis of these investors begins with a “deep dive” into a company's financials, which is often reinforced by primary research—visits with management, customers, suppliers. The aim of such research is to identify, well before the broad market does, companies that promise to earn consistently high and sustainable returns on invested capital.     

Beyond Financial Reporting An Integrated Approach to Disclosure

A company's market value is a key determinant of its future success, affecting its ability to raise capital, recruit and retain key employees, and make strategic acquisitions. Confident, well‐informed investors are necessary for achieving and maintaining accurate valuation of a company's stock. But standard disclosure practice has left many companies releasing a great deal of data while conveying only limited understanding to outsiders. This article presents the outline of an integrated approach to corporate disclosure in which each of the three major elements–required financial reports, supplemental disclosure, and interactions with investors and intermediaries–are consistent and mutually reinforcing. Such an approach begins with required reports that refiect as closely as possible the economic reality of a company's business. But if GAAP income statements and balance sheets are often useful for communicating current and past performance, they are not designed to convey management's strategic vision and the company's prospects for creating value. To achieve and maintain accurate valuation, management must supplement mandated financial reporting with voluntary communication that highlights value drivers and helps investors understand both the company's strategic goals and management's progress in meeting those goals. Finally, management must interact with investors and capital market intermediaries in ways that provide them with a clear and compelling picture of the company's prospects, which should help both analysts and institutional investors become more effective monitors of the firm's performance. Through consistent communication that goes well beyond the sell side's focus on quarterly earnings per share, management will discover that it has the power to set the agenda for how the company's performance is evaluated by the market. In the process, companies are also likely to find that their investors (and analysts) are more patient than they thought, while their operating managers feel less pressure to take shortsighted steps to boost EPS. Both of these expected benefits of an integrated disclosure policy should end up increasing a company's value.     

Is Carl Icahn Good for Long-Term Shareholders? A Case Study in Shareholder Activism

The increase in activist campaigns by entrepreneurial investors and hedge funds in the past decade has raised considerable debate about their benefits for average shareholders. Although critics have longed charged that the proposals for change by such active investors typically do not increase the longer-run efficiency and values of the targeted companies, more recent studies have provided evidence of success, both in terms of increasing the market value of such companies and achieving at least some of the investors' expressed objectives. This article attempts to add to these findings by examining the case of a single well-known investor, Carl Icahn, whose career as a shareholder activist now spans at least three decades. The authors report, first of all, that Icahn's targets have included companies from a remarkable variety of industries, and that his stated objectives have varied with the industries of the targets. Although more of Icahn's targets appear to have been overleveraged than underleveraged, a significant minority have had payouts ratios that were judged to be too low and more cash than they needed. In terms of Icahn's effect on other shareholders, the authors report a significant positive stock price reaction—on the order of 10%—to the announcement of Icahn's taking a position in the target firm. When examining the subsequent performance of the target firms, the authors found a very large difference between those firms that were either taken private or acquired (within 18 months)—over a third of the target companies—and those that remained independent. The authors report that although the acquired group achieved significant positive stock market returns, the firms that remained independent suffered very negative (-60%) returns. Although Icahn's proposed changes could be responsible, as critics charge, for the performance of the latter group, the authors suggest that the success of many of these companies in fending off Icahn without enacting most of his proposed reforms is a more plausible explanation. At the same time, the authors report that Icahn was successful in achieving at least one of his stated objectives in well over half of the cases in which the target companies remained independent.     

An Unconventional Conglomerateur: Henry Singleton and Teledyne

Capital allocation involves decisions about raising and returning capital, and about acquiring and selling companies—all of which can have major effects on shareholder value. Rather than judging CEOs by growth in revenues or earnings, the author argues that they should be judged by increases in the per share value of the companies they manage and also in comparison with the returns generated by peer firms and the broader market. Successful CEOs have been able to overcome the “institutional imperative”—the tendency of managers to focus on the sheer size of their enterprises and to avoid doing things that might be seen as unconventional. In this chapter from his recent book, The Outsiders, which provides accounts of eight remarkably successful and long‐tenured CEOs, the author describes the successful management by Henry Singleton of the conglomerate Teledyne from 1963 to 1990, a period during which the company's shareholders enjoyed annualized returns of over 20%. During the 1960s, the company produced high returns mainly by making large acquisitions funded by new equity issues. During the 1970s and '80s, by contrast, Teledyne used massive share repurchases to return excess capital to shareholders. Thus, Singleton adjusted his capital allocation strategy in response to changes in product and financial markets—and to changes in the perceived difference between market and intrinsic values. When investors provided capital with relatively low required rates of return, as in the 1960s, Singleton was an aggressive buyer investor in a wide range of businesses. But when interest rates were high and equity valuations were low, as in the 1970s and early 1980s, Singleton used share repurchases to create value by reducing investment and limiting growth. The company's shareholders were well rewarded in both environments.     

Financial Planning and Investor Communications at GE (With a Look at Why We Ended Earnings Guidance)*

In this edited version of a talk given at a conference of accounting academics and corporate practitioners, the Vice Chairman and Chief Financial Officer of General Electric describes the company's internal budgeting and financial planning process, and how the information generated by this process is communicated to investors. The company's business model—the common thread running through all its different businesses—is to make large investments in technology that make possible the firm's equipment sales, which in turn provide the basis for a profitable long-term services business. The main role of the company's internal analysis and planning process is to help management allocate capital in a way that produces long-run growth in revenues and earnings but, most important, a competitive return on investor capital. Another major aim of the company's planning process is to help management identify and manage major risks that could interfere with management's ability to carry out its strategic investments and goals. The company's focus on risk management is both reflected in, and facilitated by, a forecasting process that puts less emphasis on the accuracy of “point estimates” and pays greater attention to the range and distribution of possible outcomes. “What we really care about,” as the author says, “is the quality of the thinking and the dialogue among our managers that takes place around the forecasting process.” And it is the output of these internal processes, and “the quality of the thinking and dialogue” behind it, that are “the essence of what the company is trying to communicate to analysts and investors.” Instead of holding up quarterly earnings targets—a practice the company ended in 2008—management's communications with investors are intended to create “a continuous flow of information and feedback about the ongoing performance, investment opportunities, and risks confronting the firm.” In the author's words, “Ending the firm's longstanding practice of holding up earnings target s to the Street, and then trying to meet them, helped us rid ourselves of needless pressures and burdens… that can get in the way of managing for long-run growth and profitability.”     

STRATEGIC PERFORMANCE MEASUREMENT SYSTEMS: TRANSLATING STRATEGY INTO RESULTS

A large and growing number of companies worldwide are adopting strategic performance measurement (SPM) systems to help them execute their business strategies. SPM systems use some combination of financial, strategic, and operating measures to evaluate management's success in improving operating efficiency and adding value for shareholders. In many cases, the SPMs also provide the primary basis for rewarding top management, divisional operating managers, and, increasingly, rank‐and‐file employees. Some SPM systems are based entirely on a financial measure like economic value added (or EVA), which encourages managers to consider the opportunity cost of investor capital in making all operating and investment decisions. Other systems are based heavily on nonfinancial considerations, such as the balanced scorecard's emphasis on customer and employee satisfaction, operational excellence, and new product introduction. In this article, the author uses the findings of his recent survey of 113 North American and European companies to shed light on a number of questions: What are the most popular measures in such systems—are they primarily financial, nonfinancial, or amix of the two? To what extent is incentive compensation tied to such measures—and how far down in the organization are such measures (and incentives) extended? What are the most formidable challenges to implementing SPM systems in large corporations, with often diverse collections of businesses and tens if not hundreds of thousands of employees? Among the article's most notable conclusions, a majority of companies expect in the next three years to publish SPM targets and results in their annual reports. The most commonly cited financial SPMs will be cash flow, return on capital employed, and other variations of EVA. The most frequently cited nonfinancial SPMs are customer satisfaction, market share, and new product development. The greatest challenge in implementing SPMs is translating the vision and strategic objectives at the corporate level into performance measures that are relevant to activities at the business unit level, and securing buy‐in from business unit managers and employees.     

Domestic and Foreign Earnings, Stock Return Variability, and the Impact of Investor Sophistication

We examine the importance of foreign earnings relative to domestic earnings for a sample of U.S. multinationals using variance decomposition. Our methodology represents an alternative and complementary approach over the prior literature, which is based on traditional regressions and earnings response coefficients. We document that domestic earnings are more important in explaining the variance of unexpected returns than are foreign earnings and that the relative importance of domestic earnings is a decreasing function of investor sophistication. Last, we classify institutional investors as either short‐ or long‐term oriented following Bushee [1998]. We find that the variance contribution of foreign earnings increases with the level of investment by long‐term investors. In contrast, there is no significant relation between the degree of ownership by short‐term (or transient) investors and the variance contribution of domestic and foreign earnings. Overall, our results are consistent with Thomas's [1999] finding that investors on average underestimate the persistence of foreign earnings.     

Financial Reporting Practices of China's Listed Firms

The long‐term success of financial markets depends on the widespread availability of reasonably detailed and reliable financial information. Individual investors depend critically upon companies' regulatory filings and voluntary disclosures to assess their long‐run risks, payoffs, and, ultimately, their intrinsic values. However, a recent string of accounting frauds involving Chinese firms listed on overseas markets has drawn attention to the accounting and governance risks associated with investing in Chinese firms. This article provides a brief overview of the information environment of Chinese capital markets and the primary forces that affect the incentives of Chinese listed companies to provide timely and accurate financial reports. The evidence reviewed here indicates that the adoption of world‐class standards and regulation, although necessary, is not sufficient to generate incentives for transparency. The long‐term health of China's capital markets will also depend upon other reforms that are designed to accomplish the following: (1) improve the protection of investor rights through an effective, independent judiciary court system that promotes civil lawsuits, and through credible regulatory enforcement; (2) strengthen market development activity, especially with respect to foreign investors; and (3) limit political rent‐seeking behavior and deter politicized business decisions, especially in China's state‐owned enterprises. Together, such reforms have the potential to improve corporate governance in China and better align the incentives of the state and majority shareholders with those of minority shareholders, while increasing the ability of accounting to serve a contracting function and the demand for timely information for valuation purposes.     

Why EVA Bonus Plans Failed—and How to Revive Them

Most companies rely heavily on earnings to measure their financial performance, but earnings growth has at least two important weaknesses as a proxy for investor wealth. Current earnings growth may come at the expense of future earnings through, say, shortsighted cutbacks in corporate investment, including R&D or advertising. But growth in earnings per share can also be achieved by “overinvesting”—that is, committing ever more capital to projects with expected rates of return that, although well below the cost of capital, exceed the after‐tax cost of debt. Stock compensation has been the conventional solution to the first problem because it's a discounted cash flow value that is assumed to discourage actions that sacrifice future earnings. Economic profit—in its most popular manifestation, EVA—has been the conventional solution to the second problem because it includes a capital charge that penalizes low‐return investment. But neither of these conventional solutions appears to work very well in practice. Stock compensation isn't tied to business unit performance, and often fails to motivate corporate managers who believe that meeting consensus earnings is more important than investing to maintain future earnings. EVA often doesn't work well because increases in current EVA often come with reduced expectations of future EVA improvement—and reductions in current EVA are often accompanied by increases in future growth values. Since EVA bonus plans reward current EVA increases without taking account of changes in expected future growth values, they have the potential to encourage margin improvement that comes at the expense of business growth and discourage positive‐NPV investments that, because of longer‐run payoffs, reduce current EVA. In this article, the author demonstrates the possibility of overcoming such short‐termism by developing an operating model of changes in future growth value that can be used to calibrate “dynamic” EVA improvement targets that more closely align EVA bonus plan payouts with investors’ excess returns. With the use of “dynamic” targets, margin improvements that come at the expense of business growth can be discouraged by raising EVA performance targets, while growth investments can be encouraged by the use of lower EVA targets.     

Expected Mispricing: The Joint Influence of Accounting Transparency and Investor Base

We examine how accounting transparency and investor base jointly affect financial analysts' expectations of mispricing (i.e., expectations of stock price deviations from fundamental value). Within a range of transparency, these two factors interactively amplify analysts' expectations of mispricing—analysts expect a larger positive deviation when a firm's disclosures more transparently reveal income‐increasing earnings management and the firm's most important investors are described as transient institutional investors with a shorter‐term horizon (low concentration in holdings, high portfolio turnover, and frequent momentum trading) rather than dedicated institutional investors with a longer‐term horizon (high concentration in holdings, low portfolio turnover, and little momentum trading). Results are consistent with analysts anticipating that transient institutional investors are more likely than dedicated institutional investors to adjust their trading strategies for near‐term factors affecting stock mispricings. Our theory and findings extend the accounting disclosure literature by identifying a boundary condition to the common supposition that disclosure transparency necessarily mitigates expected mispricing, and by providing evidence that analysts' pricing judgments are influenced by their anticipation of different investors' reactions to firm disclosures.     

Expectations‐Based Management

The authors begin by summarizing the results of their recently published study of the relation between stock returns and changes in several annual performance measures, including not only growth in earnings and EVA, but changes during the year in analysts' expectations about future earnings over three different periods: (1) the current year; (2) the following year; and (3) the three‐year period thereafter. The last of these measures—changes in analysts' expectations about three‐ to five‐year earnings—had by far the greatest explanatory “power” of any of the measures tested. Besides being consistent with the stock market's taking a long‐term, DCF approach to the valuation of companies, the authors' finding that investors seem to care most about earnings three to five years down the road has a number of important implications for financial management: First, a business unit doesn't necessarily create shareholder value if its return on capital exceeds the weighted average cost of capital—nor does an operation that fails to earn its WACC necessarily reduce value. To create value, the business's return must exceed what investors are expecting. Second, without forecasting returns on capital, management should attempt to give investors a clear sense of the firm's internal benchmarks, both for existing businesses and new investment. Third, management incentive plans should be based on stock ownership rather than stock options. Precisely because stock prices reflect expectations, the potential for prices to get ahead of realities gives options‐laden managers a strong temptation to manipulate earnings and manage for the short term.