Do You Have the Courage to Keep a Long-Term Focus?
The following post is an answer to a question recently asked in my Quora session: “How does a company balance long-term and short-term investments? Especially now, during such market volatility?” To read all of my answers, visit the session here.
Some businesses are still fighting for survival in the short term as the pandemic continues to wreak havoc on our economies. However, companies’ focus should generally lie on long-term value creation—it’s that simple. That doesn’t mean maximizing today’s share price but rather the company’s collective value to its shareholders, now and in the future.
If investors knew as much about a company as its managers do, maximizing its current share price might be equivalent to maximizing its value over time. But in the real world, investors can only rely on a company’s published financial results and their own assessment of the quality and integrity of its management team. In large corporations, it’s difficult even for insiders to know how financial results are generated. Investors in most companies can’t know, for example, whether management is improving the margins by finding more efficient ways to work or by skimping on product development, resource management, maintenance, or marketing.
Since investors don’t have complete information, a company can easily pump up its share price in the short term or even longer. One global consumer products company consistently generated annual growth in earnings per share (EPS) between 11 percent and 16 percent for seven years. Managers attributed the company’s success to improved efficiency. Impressed, investors pushed the company’s share price above those of its peers—unaware that the organization was shortchanging its investment in product development and brand building to inflate short-term profits, even as revenue growth declined. Finally, managers had to admit what they had been doing. Not surprisingly, the company went through a painful period of rebuilding. Its stock price took years to recover.
Managers who create value for the long term do not shortchange product development, reduce service quality, or skimp on safety.
While stock markets do a great job of factoring in public information, they are not omniscient and cannot price information they don’t have. Think about the analogy of selling an old house. The seller may know that the boiler makes a weird sound every once in a while or that some of the windows are a bit drafty. Unless the seller discloses those facts, a potential buyer will have great difficulty detecting them, even with the help of a professional house inspector.
Despite the challenges investors face, the evidence strongly suggests that companies with a long strategic horizon create more value than those run with a short-term mindset. Banks that had the insight and courage to forgo short-term profits during the early-2000s US real-estate bubble, for example, earned much better total shareholder returns (TSR) over the longer term. In fact, when my colleagues and I studied the patterns of investment, growth, earnings quality, and earnings management of hundreds of companies across multiple industries between 2001 and 2014, we found that companies that focus more on the long term generated superior TSR, with a 50 percent greater likelihood of being in the top decile or top quartile by the end of that 14-year period. In separate research, we found that long-term revenue growth—particularly organic growth—is the most important driver of shareholder returns for companies with high returns on capital. What’s more, investments in research and development correlate powerfully with long-term TSR.
Managers who create value for the long term do not take actions to increase today’s share price if those actions will damage the company down the road. They don’t shortchange product development, reduce service quality, or skimp on safety. When considering investments, they take into account likely future changes in regulation or consumer behavior, especially with regard to environmental and health issues.
Today’s managers face volatile markets, rapid executive turnover, and intense performance pressures, so making long-term value-creating decisions requires courage. But it is the fundamental job of management and the board to demonstrate that courage, despite the short-term consequences, in the name of value creation for the collective interests of shareholders, now and in the future.
I’m a core leader of McKinsey and Co.’s Strategy and Corporate Finance practice. To learn more about the impact of coronavirus on a company’s value, check out my book Valuation: Measuring and Managing the Value of Companies, 7th Edition, co-authored with Marc Goedhart and David Wessels.
Thanks for reading! I'd love to hear from you. Feel free to leave a comment below.
Measuring and Managing the Value of Companies
The seventh edition of Valuation is a handbook that can help managers, investors, and students understand how to foster corporate health and create value for the future—goals that have never been more timely. Available Now.