FAST RESULTS and short-term earnings have become the obsessive goal of most American companies. The pursuit of these objectives diverts resources from investment in modern plant and equipment, research, technology and training to clever financial manipulations. It sacrifices market share to high quarterly earnings. And it discourages workers from making long-term commitments to companies.
Almost two decades ago, the French writer Jean-Jacques Servan-Schreiber predicted in The American Challenge that the United States would be so economically advanced by 1980 that it would "stand alone in its futuristic world . . .holding a monopoly of power," dominating Western Europe in every basic area where power matters: culture, politics, the military, and economics.
But the American challenge failed to materialize. In the years following publication of Servan-Schreiber's book in 1968, it was American industry that lost position in the world marketplace. This decline occurred in industries where U.S. firms were long considered invulnerable: advanced computers, semiconductors, aircraft, machine tools, telecommunications, pharmaceuticals, scientific instruments, industrial chemicals, engines, turbines, plastics, steel, automobiles, synthetics, insurance, engineering services, banking and many others.
America's startling and humbling losses are an insidious form of economic decay. Much like dry rot, they are only partially visible -- masked by inflation, unproductive mergers, profitless growth, and clever financial manipulations. And like dry rot, the economic decay -- evident in diminishing profits, lagging reinvestment, and waning technological supremacy -- is spreading, undermining the foundations of one industry after another.
We can take action now to reverse the trend by implementing new regulations and using tax policy to get at the root causes.
By ceding the future to the present, American firms have greatly reduced their capability to cope with foreign competitors whose actions are shaped by long-term perspectives. It is the short view of American business, more than anything else, that threatens the long-term vitality of our economy.
Among the more popular excuses for this myopia is that American business schools are equipping managers with a sophisticated array of analytical tools that favor the short term over the long term. But blaming business schools for the short-term focus of American companies is akin to blaming West Point for involvement in wars; the business schools merely equip managers with the tools the economic environment demands. If business is to take a longer-term focus, it requires an economic environment that permits and encourages long-term action.
The creation of such an environment hinges on a reduction in the two principal pressures for short-term performance: the demands of investors for immediate returns, regardless of longer-term consequences; and the inability of small business to secure long-term money.
Control of America's major corporations has steadily shifted from individual investors to financial institutions -- pension funds, insurance companies, foundations, investment companies, educational endowments, trust funds, banks. This shift has far-reaching consequences, because individuals and institutions invest in the stock market for sharply different reasons: Individuals are primarily investors looking for long-term performance; institutions are pursuing short-term profits. Thus, just when U.S. business needs to be making long-term investments to meet global competition, the new owners -- the institutions -- are pressing for quick results.
Institutions now hold so much equity and are such a powerful presence in stock markets that corporate executives often are at the mercy of their demands. The raw economic power of institutional investors can be measured in two ways: their stock holdings and their willingness to get rid of stocks that fail to produce quick earnings.
Institutional stock holdings have risen rapidly over the past three decades. By the mid-1980s, institutions held more than35 percent of all equities listed on the New York Stock Exchange (NYSE), double their share in 1960. By 1990 they are expected to own half. Already, institutions have half to two-thirds of the stock of the nation's 200 largest corporations.
Yet their biggest impact comes not through mere ownership but through the growing pace of their transactions. In 1953, when institutions controlled about 15 percent of the equities listed on the NYSE, their trades constituted a quarter of stock market transactions. Today, institutional trades constitute almost 90 percent of transactions.
As a result of such hyperactive trading, the fundamental focus of the stock market has been transformed from long-term investing to short-term speculation. This shift can be gauged by both the rising volume of large-block stock transactions (10,000 shares or more) by institutions, and the quickening pace at which the entire value of stocks listed on the NYSE is traded.
The exchange reports a two decade trend of steady increases of large-block transactions, and they are overwhelmingly by institutions. In 1965 there were, on average, only nine large-block transactions a day, constituting 3 percent of the daily volume of the market. By 1985 the average number of such trades had soared to more than 2,100 a day, constituting more than 51 percent of volume.
Because institutions own such a large share of all stock, and trade that stock so zealously, there has been a sharp increase in the turnover rate of the entire NYSE (the pace at which the total value of stocks listed on the exchange is traded). In 1965, when individual investors dominated market transactions, the turnover rate was roughly 16 percent a year. By 1985 it was 54 percent. At the 1965 rate, it would take six years for the entire value of the stock market to turn over, but today it takes a little less than two years.
In the speculative, short-term-oriented equity markets that now exist, only a few American firms, such as General Electric, IBM, General Motors and Exxon have sufficient profits and assets to make the commitments that long-term global competitiveness requires without sacrificing shorter-term earnings. Most companies are obliged to focus their efforts and resources on results that can bolster the price of their stock. Corporate executives know what happened to Gulf Oil when a financial group saw an undervalued stock and attempted a takeover; Gulf's recourse was to surrender its independence to SOCAL. Most managers also realize that even if they can fend off an unwanted takeover, as Martin Marietta and Phillips Petroleum did, the company can be seriously harmed in the process, as both of them were.
Active trading, speculation and relentless demands for short-term results are undermining the performance and imperiling the survival of U.S. companies by fostering several harmful phenomena:
The "paper entrepreneurship" that Robert Reich describes -- the speculative mergers and takeovers, "greenmail," and inflation of corporate earnings through accounting transactions. In 1985, the value of these mergers exceeded $125 billion, more than 300 percent greater than in 1980. Pension funds provide much of the financing for this speculation.
The increased use of firms' capital for buybacks of their own stock to make it less attractive to raiders. In both 1984 and 1985, firms spent more than $100 billion in stock buybacks versus $29 billion in 1983. If these funds had been used to modernize plant and equipment, total capital investment would have been 25 percent higher.
Corrosion of the venture capital market. Pension funds and institutions now provide more than a third of all venture capital. Because of their insistence on short-term results, venture capital funds are being transformed from providers of long-term money and technical support to speculators demanding quick results.
The shift of research and development from long-term efforts that can produce major breakthroughs to short-term "safe" projects that can produce quick results. The National Science Foundation reports that a growing number of businesses are directing their research toward minor refinements of existing technologies, rather than major technological breakthroughs. Yet it is the real breakthroughs such as microelectronics, computers, and xerography that have created entire new industries and significant improvements in older ones, as well as major bursts of productivity and competitiveness.
The preoccupation of corporate executives with the short term is heightened by the way they are compensated. Most companies respond to, and thereby reinforce, the unrelenting pressures for short-term performance by basing pay and promotion decisions primarily on immediate financial results, such as quarterly earnings and sales. Research at the University of Rochester's Graduate School of Management indicates that in any given year, firms whose stock performance ranks in the top 10 percent will increase executive pay by a real 5.5 percent, while firms whose stock performance ranks in the bottom 10 percent will cut executive pay by4 percent. Not surprisingly, when corporate leaders were asked in a 1985 survey about their single overriding objective as chief executives, 51 percent said, "creating shareholder value." Only 18 percent responded that their top priority was to become the market or industry leader.
Institutional investors adhere to a short-term trading focus because they are expected to get quick results. Fund managers are judged on the basis of quarterly, even on monthly, earnings. A 1985 survey of 308 of the nation's largest institutional investors found that when selecting stocks, only 4 percent considered the quality of the company's products -- normally a sound gauge of a firm's long-term competitiveness.
The growing volume of pension holdings makes the short-term focus of the funds extremely influential. The value of corporate equities held by these funds, less than$85 billion in 1970, exceeded $325 billion in 1983, stands at around $500 billion today, and is projected to reach $1 trillion by 1990. The frenzied movement of this much money shapes the priorities and performance of the entire stock market.
When the trend toward greater institutional ownership got underway three decades ago, it was viewed as a stabilizing influence: Most observers assumed that institutions would eschew short-term speculation in favor of longer-term investment. That potential still exists. Indeed, the institutions' vast pool of capital does represent a major national asset, but only if their managers take a more patient view of investments and returns.
Capturing this potential will require a change in the economic rules so that long-term investment becomes more attractive to financial institutions. This means, first, that federal regulations should be modified so that managers will be compensated not on the basis of transaction costs or management fees, but according to some measure of the long-term performance of the fund.
A second and perhaps more effective way to establish an environment for long-term investment would be to impose a tax on short-term gains of pension funds' stock trades.
As short-term speculation becomes less profitable, participation in corporate raids and greenmail will also become much less attractive to pension fund managers.
Not least of all, creating an economic environment that favored long-term investment over speculation would be likely to boost the returns of institutional funds. Even though institutional money managers annually collect more than $6 billion in management fees and commissions, they are inept speculators. In the bullish stock market of 1984, 74 percent of the managers specializing in equities performed worse than the Standard & Poor's 500 stock index, and 71 percent of the fixed-income managers underperformed the Shearson Lehman government/corporate bond index. These figures, moreover, hide the fact that speculation by money managers produced a loss of capital for many funds.
Had most workers and their firms invested their pension funds in government or corporate bonds or a stock portfolio based on the S&P's 500, they would have done better than their money managers did and paid fewer commissions in the process. If the speculative spirits of money managers can be dampened, then the flexibility of business can be increased, and pension fund returns improved.
The American economy still has all the ingredients for strong competitive growth. Yet mounting pressures by financial institutions for quick results and short-term earnings are shackling the flexibility of business to improve its global competitiveness. As a result, America's remaining economic advantages, and thus our economic future, are quickly slipping away.