Fixing capitalism, one disclosure at a time
Effort to prod firms to focus on long-run comes with real firepower, worthy intentions
Capitalism is often accused of fostering short-termism, making companies chase quarterly profit numbers to satisfy shareholders.
A better criticism is that the targets corporate executives aim for are grossly simplified, thanks to the twisting line of responsibility from corner office to fund manager to pension fund and ultimately to the savers who own the company.
These distorted incentives sometimes lead to short-termism; at other times, shareholder enthusiasm pushes executives to focus far too much on the long run, as in the wild mining boom that turned to bust in 2011, or the dot-com bubble.
The accounting firm EY, nine multinational companies and a group of pension funds and fund managers have an idea to help. They want to quantify progress toward targets the traditional financial accounts don’t pick up—say, the percentage of revenue from new products or processes, as a proxy for how innovative a company is.
With Vanguard, BlackRock and Europe’s Amundi on board, the initiative has significant firepower.
The Embankment Project for Inclusive Capitalism, or Epic, sounds like yet another of the dozens of efforts to soften capitalism, and indeed grew from concerns among a group of institutional investors marshaled by Lynn Forester de Rothschild’s Coalition for Inclusive Capitalism.
Yet it takes baby steps toward solving the genuine difficulty of communication in the long chain of oversight from ultimate owner to company manager, and perhaps even to the employees who do the real work.
At the heart of the problem is a lack of trust, known to academics as the “agency problem.” Investors distrust fund managers, and so rush to fire them if they underperform even for quite short periods.
Fund managers, in turn, don’t trust corporate executives to do the right thing or reveal the true state of the business, so they attempt to measure progress on long-term goals using what- ever gauges are immediately available. Sometimes that is indeed quarterly profits, but frequently other things matter at least as much, and often more: Twitter’s user numbers, Facebook’s revenue growth, Tesla’s weekly car production, Apple’s new product launches.
Epic sets out to standardize these measures to make it easier for companies to tell their story about the future, and for investors to measure it.
Reliable metrics should help. We all have a natural tendency to value what we measure, and to try to optimize the result. Managers may scrimp on things that are hard to quantify but vitally important to the long-term health of a company—corporate culture, employee training, brands, product quality, social acceptance—to meet other, usually financial, goals.
If new measures make it easier for a company to show progress on nonfinancial goals vital to its long-run success, that should matter to shareholders. It might even offset short-term disappointment on quarterly profits.
I like the idea, but have some doubts.
First, investors already use any number of alternative sources of information to evaluate companies, including online reviews by employees and customers, discussions with suppliers, patent applications and anecdotes about management behavior. Some are susceptible to formal measures that will make them easier for investors to assess, but many aren’t.
Second, there are limits to disclosure. The basic logic of explaining the long-run business model and setting out ways to track how well the company is progressing is worthwhile. But companies don’t do this. Instead, they produce annual reports full of relentless good news, glossy pictures and verbiage.
Europe has mandated annual reporting from this year on nonfinancial measures including employee treatment, board diversity and the environment, but there’s no standard measure, so expect firms to report whatever measure they score best on.
Many of the business-plan progress scores are likely to be sensitive, things executives want to keep secret from competitors.
Worse, many business plans would go down badly with customers, suppliers or staff if they were clearly set out, too. Keeping pay and costs lower than rivals while relying on heavy marketing to sell subpar products to dumb people isn’t the sort of thing any executive should admit in public.
Those who create smart processes to allow low-skilled workers to be quickly integrated into a fast-food chain—so keeping pay low while avoiding havoc from the inevitably high staff turnover—won’t tell anyone.
Third, many of the suggested metrics are inherently easy to manipulate, relying on surveys of staff or suppliers, or on loose definitions such as employee time spent on innovation.
Measurement is going to be far more subjective than profit figures, let alone cash flow.
Fourth, publication will be voluntary, at least for now. Businesses that pamper their highly productive staff in an effort to boost R&D will surely boast about it. Those that don’t can just keep quiet. Don’t expect scandalous tell-all annual reports just yet.
Still, big data is allowing more and more anecdotes to be collected together, and perhaps Epic’s gauges will one day— along with parallel projects such as the Sustainability Accounting Standards Board—be a contender for formal, audited reports from companies.
That will lead to the final problem: companies explaining that investors shouldn’t bother with the formal figures, as the firm has better proprietary measures, just as they do with the current financial disclosures.
There will always be an agency problem, and that will always be a form of short-termism. Ultimately shareholders are always trying to assess how companies are progressing toward their long-run objectives.
If companies fail to show progress in the short term— whatever the metric being used—they will be marked down for it, and quite rightly.