Saturday, January 5, 2013

"Short-termism" and the Stock Market

              I read again today about the negative impact of "short-termism" on the ability of the American stock market to allocate capital properly.  By short-termism is meant the tendency of stock market investors to focus on quarterly announcements rather than the long-term.  As a result, executives anxious to maximize their company’s stock price become obsessed, allegedly, with producing good numbers for the next quarter rather than doing what is best in the long run.  The result is a misallocation of capital.

              The article took it for granted that short-termism properly characterized American capital markets and went directly to examining its potential impact.  This is odd for three reasons.

              First, if you spend time reading the massive academic literature on market inefficiency you will find papers on all sorts of anomalies, but short-termism is not one of them.  This is not surprising.  If short-termism led to mispricing it would be relatively simple for long-term investors, like Warren Buffett and pension funds, to exploit it.

              Second, the entire technology sector provides a counter-example.  Many, if not most, technology companies trade at values far greater than can be rationalized on the basis of current earnings.  Facebook is a high profile example.  To explain the prices at which these technology companies trade, it must be assumed that the market is looking decades into the future.

              Finally, an intense interest in next quarter’s earnings announcement does not mean the investor is focused on the short-term.  Here I can speak from personal experience.  I have been an active investor in Apple for decades.  As such, I recognize that the value of Apple is determined primarily by its long-run prospects for continued innovation and growth.  (See a previous post on valuing Apple).  Of course, I can make projections on how Apple will do in the future – what products they develop and how those products will be priced and received by customers, but that exercise is by necessity somewhat speculative.  How do I get objective evidence against which to measure the accuracy of those long-run projections?  The source is short-run announcements regarding current products and earnings.  Apple, quite wisely, does not publicly release a detailed five-year plan describing all projects in the pipeline.  As a result, Apple investors must be content with “short-term” announcements as the source of information for evaluating their long-run projections.  For that reason, those short-term announcements are critically important to Apple investors, but not because those investors are focused on the short-term.  Rather, it is because short-term news is the only source of objective evidence with which to assess long-term evaluations!

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