How a long term orientation pays off: Lessons for listed companies

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1 How a long term orientation pays off: Lessons for listed companies Posted on March 18, 2017 Introduction As we intuitively understand, the best companies typically take a long term view and are not distracted by short term considerations. They avoid short cuts and do what it takes to do well in the long run. Unfortunately, the pressure on listed companies to generate short-term financial performance continues to increase. And the balance between short-term accountability and long-term value creation has been difficult to achieve for many companies. In 2013, BlackRock, the Canada Pension Plan Investment Board (CPPIB) and McKinsey came together to create the Focusing Capital on the Long Term initiative to conduct research on how to encourage a more long-term orientation among companies. The initiative has now grown into a not-for-profit organization, FCLT Global, co-founded by BlackRock, CPPIB, the Dow Chemical Company, McKinsey and Tata Sons. Understanding long term orientation What do we mean by long term oriented companies? Long-term oriented companies differ from their peers primarily in the following ways: Long-term companies are less likely to grow their margins unsustainably in order to hit short-term targets. Long-term firms invest more than their peers and more consistently. Long-term firms attach a lot of importance to the quality of earnings. They rely less on accruals and accounting methods to boost reported earnings. Long term firms are more focused on fundamental value and less worried about metrics closely tracked by Wall Street such as earnings per share. Instead of EPS, which can be influenced by actions such as share repurchases, they are more likely to focus on the absolute rise or fall of reported earnings.

2 Long-term companies are not obsessed with earnings guidance and the need to meet the guidance. They are more likely to miss earnings targets by small amounts (when they easily could have taken action to hit them) and less likely to hit earnings targets by small amounts (where doing so would divert resources from other business needs). Does long term orientation pay off? Do we have hard numbers to show that a long term orientation pays off? Research by McKinsey Global Institute, led by Dominic Barton, Global Managing Director of McKinsey indicates that firms with a more long term orientation ultimately end up delivering more value to shareholders and to the economy: During the period , the revenue of firms with a long-term orientation cumulatively grew on an average 47% more than the revenue of other firms, and with less volatility. The cumulative earnings of such firms also grew 36% more on average over this period than those of other firms, and their economic profit (profit adjusted for capital costs) grew by 81% more on average. Long-term oriented firms invested more than other firms from 2001 to Although they started this period with slightly lower R&D spending, cumulatively by 2014, long-term companies on an average spent almost 50 % more on R&D than their peers. Long term firms continued to increase their R&D spending during the financial crisis while other companies cut R&D expenditure. From 2007 to 2014, average R&D spending for long-term companies grew annually at 8.5 % vs. 3.7 % for other companies. On an average, the market capitalization of long-term oriented companies grew $7 billion more than that of other firms between 2001 and Their total return to shareholders was also superior. Although the market

3 capitalization of the long-term firms fell more during the financial crisis than other firms, their share prices recovered more quickly after the crisis. Long-term oriented firms added nearly 12,000 more jobs on an average than other firms from 2001 to If all the publicly listed firms in the US had created as many jobs as the long-term firms, five million additional jobs would have been created in the US over this period. Based on potential job creation, the value unlocked by long term companies was worth more than $1 trillion in forgone US GDP over the past decade, or 0.8% of GDP growth on an average. Dealing with short termism Research by FCLT indicates that the causes of corporate short-termism are many. Two causes commonly cited are investor pressures and the way management teams are incentivized and compensated. The irony is that while executives may feel that investor pressure forces their hand, the short-term objectives and metrics companies set also push investors to shorten their horizons to match the data available to them. Indeed, when executives are asked where they feel short-term pressure on them comes from, nearly 40% point to executive teams and boards of directors themselves! There are no easy answers on what companies can do to combat excessive shorttermism in the context of their organizations. But possible responses have begun to take form. FCLT Global has codified these points as the ten key elements of a long-term strategy. Express a clear statement of purpose, mission, and vision. Explain how the company s business model creates long-term value by identifying key value drivers at the reporting unit level. State management s view of the market, major trends impacting the market, growth potential, the company s relative positioning and underlying assumptions.

4 Highlight sources of competitive advantage such as talent or other assets that enable the company to execute its strategy better and win in the marketplace. Disclose strategic goals ultimately tied to drivers of value creation (e.g., returns on invested capital, organic revenue growth) in the context of current and future market trends, and the company s competitive advantage. Lay out a detailed execution roadmap that defines short, medium, and longterm actions linked to key milestones and strategic goals. Provide medium- and long-term metrics and targets that indicate the company s ability to deliver on its strategy, such as customer satisfaction, brand strength and product pipeline investment and returns. Explain how the selected metrics will be measured and tracked consistently. Explain how capital and non-capital investments and resource allocation will yield sustained competitive advantage and the creation of long-term value. Provide an overview of risks and their mitigation plans, including sustainability challenges (e.g., environmental, social, and governance issues). Articulate how executive and director compensation tie to long-term value creation and strategic goals.

5 The road ahead Rather than blaming activist investors and the financial markets, companies and their top leaders probably need to look inwards if they are serious about embracing a long term orientation. As a recent Economist article commenting on the Mckinsey report points out, S&P 500 CEOs departing in 2015 had an average tenure of 11 years, the highest figure for 13 years. Activist hedge funds own less than 1% of the stock market. The average share is traded many times because of a cohort of highfrequency computerized traders. And the trading masks the sharp rise of passive funds, which already own 13% of the market and which hold shares for fairly long periods of time. Also, the financial markets may be far less myopic than what we think. The bond market lends to the government for 30 years for an interest rate

6 of just 3%. Equity investors place huge values on firms that won t make serious profits for several years. Amazon is the world s fifth-most valuable firm (after Apple, Alphabet, Microsoft and Berkshire Hathaway), with market capitalization in the range of $ bn. About 75% of that value is based on profits that will be generated only 10 years or more from now. Dominic Barton, writing in the Harvard Business review in 2011 on the same topic, has pointed out that we can draw inspiration from companies like Hyundai and Apple. Hyundai, which experienced quality problems in the late 1990s made a strong comeback by reengineering its cars for long-term value. This strategy was communicated by the introduction of a 10-year car warranty in That radical, unprecedented move, viewed by some observers as a formula for disaster, helped Hyundai increase U.S. sales four times in three years and paved the way for its entry into the luxury market. Apple s ipod, released in 2001, sold just 400,000 units in its first year, during which Apple s share price fell by roughly 25%. But the board took a long view. By late 2009 the company had sold 220 million ipods and revolutionized the music business. Lessons for Indian companies Indian companies can learn a lot from this report. Let me take specifically the example of an industry which is often equated with India s rise as a global economic power. Yes. I am talking about the Indian IT Services industry. The industry has entered a new phase in the last one year or so. Overall growth has declined sharply, the traditional business (application maintenance) has become commoditized and the new segments (digital) demand a radically new set of capabilities. For long, revenue growth has been the key metric in this industry. It was assumed that as revenues grew, profits would also grow proportionately. Now in this new environment of slower growth, the industry has to keep in mind both revenue growth and margins and strike the right balance between the two. Going forward, the IT Services companies will have to learn to say no to some types of business and also get better at selling new offerings that are more profitable. How the industry keeps costs under control while ensuring that the right kind of investments are not cut, is going to be the challenge going forward.