Decisions of Managers in Conflict between the Short-Term and the Long-Term

Table of Contents

Acknowledgements

ABSTRACT

List of Figures

List of Appendices

1 Introduction
1.1 Management decisions - influenced by intertemporal choice
1.2 Research background
1.3 Research aim
1.4 Research question and objectives
1.5 Overview

2 Literature review
2.1 Introduction
2.2 Definitions
2.3 The starting point
2.4 Recent developments
2.5 Current state of research
2.5.1 Economic factors
2.5.2 Organizational factors
2.5.3 Individual factors
2.6 Measures

3 Research design and methodology
3.1 Research strategy
3.2 Design and methodology
3.3 Sources of data
3.4 Data analysis
3.5 Ethics
3.6 Applicability, reliability, replication and validity
3.6.1 Applicability
3.6.2 Reliability
3.6.3 Replication
3.6.4 Validity
3.6.5 Summary

4 Findings
4.1 Introduction, interview topic, and reaching an understanding
4.2 Influencing factors
4.3 Case studies
4.4 Summary
4.5 Measures

5 Analysis, discussion, interpretation
5.1 Relevant influencing factors
5.2 Relevance and grouping of influencing factors
5.3 Relevance of indirect factors
5.4 Relevance of direct factors
5.4.1 Economic factors
5.4.2 Organizational factors
5.4.3 Individual factors
5.5 Discussion of measures
5.5.1 Indirect factors
5.5.2 Economic factors
5.5.3 Organizational factors
5.5.4 Individual factors

6 Conclusion and recommendations
6.1 Conclusion
6.2 Highlights
6.3 Relevance
6.4 Recommendations

References

Appendices

Acknowledgements

In the first place, I would like to thank Dr Jonathan Smith for being my supervisor and for giving me helpful feedback whenever it was necessary whilst allowing me the room to work in my own way.

This research project is based on ten interviews with busy managers. Therefore, my special thanks go to them.

Also, I would like to thank my future wife, Anke, for her support and patience.

Further thanks go to

Gerald, Jens, Nicole, Nina, Marc, Rainer, Ursula, Volker, and all other people who supported me with this work.

ANGLIA RUSKIN UNIVERSITY

ABSTRACT

ASHCROFT INTERNATIONAL BUSINESS SCHOOL MASTER OF BUSINESS ADMINISTRATION

DECISIONS OF MANAGERS IN CONFLICT BETWEEN THE SHORT-TERM AND THE LONG-TERM - AN ANALYSIS OF KEY INFLUENCING FACTORS

By NICOLAS BREITFELD

August 2010

This research is about decision-making by managers with a focus on decisions where a conflict between short-term and long-term is present (also known as the problem of intertemporal choice). The discussion in this area has been an ongoing one for many years. Many critics argue that managers focus too much on short-term because of increasing pressure from institutional investors which leads to suboptimal long-term development of their company. But there are other reasons which favour a short-term orientation. In the course of research on this topic, I found that it is not yet clear which factors are the most important ones for managers and their ultimate decisions. Therefore, the main goal of this research is to discover the most important influencing factors and to analyse their relevance.

This research is driven by an explorative approach and includes an extensive literature review combined with ten interviews with managers from different companies. The background is that a great deal of research has been done on this topic, but seldom with a broad approach such as this. Often research focuses on one factor, e.g. pressure from financial markets, bonuses, or others. One finding is that influencing factors stem from many areas and an interdisciplinary approach is necessary for further research. The findings of this research represent a good basis for that by exploring the most important factors that influence managers. It categorizes the influencing factors into indirect and direct factors, the latter representing the economic, organizational, and individual dimension. In addition, four findings are emphasized: too much pressure from financial markets result in the question whether quarterly earnings statements and predictions are still necessary; the importance of corporate strategy and its communication, the need for interdisciplinary research (e.g. combined with psychology), and the importance of developments in society and their interaction with management decisions.

Luxury is indeed possible in the future - innocent and exquisite; luxury for all, and by the help of all; but luxury at present can only be enjoyed by the ignorant; the cruelest man living could not sit at his feast, unless he sat blindfold.

(John Ruskin, Unto This Last, 1862)

List of Figures

Figure 1: Intertemporal choice (source: Laverty, 1996, p.828)

Figure 2: Turnover of shares of New York Stock Exchange-listed companies (source: New York Stock exchange Fact Book (2006) cited in CFA Institute, 2006, p.12)

Figure 3: Chain reaction resulting from publication of short-term results (source: Author’s illustration)

Figure 4: Differences between qualitative and quantitative research (source: Bryman and Bell, 2007, p. 28)

Figure 5: Overview of Interviewees (source: Author’s illustration)

Figure 6: Most frequently mentioned reasons for short-term orientation (source: Author’s illustration)

Figure 7: Influencing factors on short-term and long-term decisions (source: Author’s illustration)

Figure 8: Grouping of influencing factors (source: Author’s illustration)

Figure 9: Summary of findings (source: Author’s illustration)

List of Appendices

1. Interview Guidelines

2. Example interview (number four)

1 Introduction

1.1 Management decisions - influenced by intertemporal choice

Decision-making - this is one of the main tasks of a manager. Often, this has to be done in complex situations and the results can lead to far ranging consequences.

One kind of decision is the choice between a short-term and a long-term alternative. But even in that particular instance there are many factors that influence a manager’s decision. For example, an orientation on the short-term is required in order to

- Satisfy shareholders by paying dividends
- Surpass a given financial quarterly guidance or previous results
- Reach bonus targets
- Secure a good reputation in his current position in a company
- In contrast, long-term orientation is needed for
- Investments in research and development (R&D) or new markets
- Long-term survival of the company
- Establishing a good relationship with and trust of stakeholders
- Sustainable development
- But what does this have to do with the research in this paper?

It is about the decisions of managers. And a decision is a conscious choice between two alternatives with the aim of sorting out the best alternative (Küpper, 2006). The present research focuses on decisions where a conflict between short-term and long-term is present. Loewenstein & Thaler (1989) describe this sort of decision as an intertemporal choice. Intertemporal choices are ‘decisions in which the timing of costs and benefits are spread out over time’. (Loewenstein & Thaler, 1989, p.181) The following graph might demonstrate this with one example. There are two alternatives, A and B. Alternative A starts paying back immediately with a medium rate of return although it remains stable. Alternative B requires some upfront investment and starts paying back later but with a much higher rate of return than A (beginning from point t). The basic question now is:

What influences a manager to decide in favour of either A or B?

illustration not visible in this excerpt

Figure 1: Intertemporal choice (source: Laverty, 1996, p.828)

Based on the theory of investment decision-making, this choice should be the result of a calculation of discounted cash flow (Kruschwitz, 2009). The main problem is supposed to be the calculation of the correct discount rate. But a manager not only has to deal with financial decisions where the respective cash flows can be predicted easily, but also with non-financial decisions where consequences other than cash flow have to be predicted. And even if cash flow predictions are possible, there are still many other factors that influence a decision, as the present research will demonstrate.

1.2 Research background

Starting my career at a medium sized enterprise in the pharmaceutical industry, I witnessed such a dilemma personally for the first time. As the result of several factors that followed a strategic change, management decided on specific revenue goals for the year-end. As a result, this was achieved by means of highly discounted advanced sales which later proved painful, when low margins, decreased earnings and fewer sales resulted at the beginning of the subsequent period. This had to be balanced once again by further discounts - a vicious circle.

I had another experience in a multinational company where quarterly guidance had to be met and a steady increase in revenues and earnings were desired. One reason communicated internally for this was the steadily increasing pressure from the financial markets. But this increase sometimes could only be achieved in exchange for cost cuts in personnel, marketing activities, and R&D spending. In addition, this short-term steering led to a great deal of more work in many departments.

During these and other situations, I experienced that these decisions had a broad range of impacts on the company, the employees, shareholders, and stakeholders. Positive results could be an increase in revenues, earnings, share price, and any relevant incentives. But negative effects can also emerge, such as job cuts, increased workloads, etc. Therefore, such decisions are very important for the positive development and survival of a company. As a result, I decided to start the present research project in order to further investigate reasons for different behaviour with the goal of better understanding of the respective decisions.

1.3 Research aim

This field of discussion has existed for a long period of time. Many publications have dealt with the discussion of specific reasons for management to decide in one or the other direction. Most of this research deals with specific reasons for the behaviour, e.g. pressure from financial markets to give quarterly earnings guidance. Taking into account the amount of literature available, I have found more statements that criticize short-termism than support it. Even Jack Welch stated in an interview with the Financial Times (Guerrera, 2009) that he ‘never meant to suggest that setting, and meeting profit expectations quarter after quarter in an effort to boost a company's share price should be the main goal of corporate executives’ .

In addition, many measures which work against a management orientation focused too much on short-term success have been worked out. But, in my opinion, two areas have not been sufficiently dealt with to enable one to start implementing measures.

First, only few analyses focus on the individuals whose job it is to make decisions, namely managers. This is also stated by Laverty (1996, p.847) who has said: ‘understanding how managers form, interpret, and resolve problems of intertemporal choice is critical to advancing the debate. In general, there has been a limited study of ways in which executives deal with the future’ . Not much has changed since this remark was made.

Second, this topic is influenced by many factors and touches on different fields of science (for example, management, behavioural finance, psychology, sociology, and many others). Therefore, it is a topic which from the start requires a much broader research approach. Before going into in depth discussions and analysis of specific influencing factors and the resulting measures that can be taken, an awareness of the main drivers is necessary. Seldom has a research project on this topic begun with a broad analysis of whether the appropriate factors have been analyzed. And very often relevant research has been done only in the field in which the researchers were educated.

This is the reason for the present research project in which I will try to close some of these gaps. My goal is to start with the foundation - the manager. The first step necessary is to ask managers about their behaviour and considerations when faced with such decisions and choices. Only the manager himself can reveal which drivers most affect his decision personally. Only then can an analysis of why the resulting factor is so important take place, and it can then be evaluated in a further step. In combination with the most important and recent (management) literature on the topic, a starting point for further and more focused research can be set up. Depending on the result of the manager’s responses, first evaluations of key influencing factors and possible measures for further treatment might be possible. At the end of the present research, it should be clear for the reader what the next steps should be and what kind of further research on this topic will help to shed more light on the issue.

1.4 Research question and objectives

The present research is driven by an explorative approach to discover the major motivations of managers when dealing with short-term vs. long-term decisions. Thus, the research question is:

What are the key factors that influence manager decision-making when conflict exists between the short-term and the long-term?

Due to the outlined factors influencing this field of research, many issues have to be covered. Unfortunately, a research project like this is restricted in time and resources. Therefore, I have tried to choose the most important aspects of this topic as the basis for my research. The result is the following list of objectives to be covered during the present research:

- To discover all major relevant factors that influencing the decisions of managers for the short-term or the long-term, (my so-called ‘influencing factors’).
- To determine the key factors and their relevance in the following areas
- Economic success
- Corporate governance
- Ethics, Corporate Social Responsibility and Sustainability
- To evaluate anew and critically discuss measures already proposed for implementing and supporting the preferred orientation to specific factors

1.5 Overview

Based on the research question and the above-mentioned objectives, the structure of the research will be as follows.

First, an introduction of the most important terms will be presented. In addition to the already-mentioned terms ‘short-term’ and ‘long-term’, other terms are often used in the literature which have to be defined to enable common understanding.

The next step in Chapter Two will be an extensive analysis of the literature. Here, I will try to work out the most important publications dealing with the topic, those which are relevant, popular, and contemporary.

In Chapter Three, I will present my research methodology. Here the qualitative approach has been chosen in order to make possible a quite in depth analysis of a manager’s thoughts when confronted with the relevant situations. Ten interviews have been conducted and intensively analysed.

The results of the interviews will be laid out in Chapter Four, with a subsequent discussion and interpretation in Chapter Five.

As a result, the research question along with as many objectives as possible will be answered and brought to a conclusion in chapter six, along with recommendations for further research.

2 Literature review

2.1 Introduction

‘Financial analysts fixate on quarterly earnings at the expense of fundamental research. Corporate executives, in turn, point to the behaviour of the investment community to rationalize their own obsession with earnings. “ Short-termism ” is the disease; earnings and tracking error are the carriers.’

This statement was made by Alfred Rappaport (2005, p.65). For many people, this might come as a surprise and a cause for confusion because it was Alfred Rappaport who introduced the term ‘shareholder value’, which is often related to an improvement in short-term earnings to boost share price.

The implications of shareholder value and financial markets are a very important part in the discussion of the causes and consequences of short-termism. But this is not the full story. As mentioned earlier, many fields of research impact this topic and have to be examined to see the full picture. In this chapter, a broad overview of the literature will be given. After the definition of some basic terms, a discussion of short-termism will begin with a short overview of historic and recent developments. The main section discusses the relevant influencing factors as an introduction to the following research. Finally, some measures will be described which are currently being proposed by the research community.

2.2 Definitions

Some terms which appear regularly in discussions of the topic are not commonly understood and need therefore to be defined.

short-termism:

‘Doing things that make you better off in the short-run but worse off in the end.’

(The Economist, 2009)

Often the term ‘(managerial) myopia’ is used with the same meaning. But some authors differentiate here and say ‘myopia’ refers to the manager’s lack of ability to evaluate the future (Marginson & Mcaulay, 2008; Miller, 2002). Due to the fact that this study does not intent to go into depth in psychological matters, I will not use the term myopia and stick to the term ‘short-termism’ with the meaning of suboptimal decision making.

Corporate Governance

‘The system of checks and balances, both internal and external to companies, which ensures that companies discharge their accountability to all their stakeholders and act in a socially responsible way in all areas of their business activity.’

(Solomon, 2007, p.14)

Agency Theory

‘Agency Theory identifies the agency relationship where one party, the principal, delegates work to another party, the agent. The agency relationship can have a number of disadvantages relating to the opportunism or self-interest of the agent [ ] Managers are supposed to be the ‘agents’ of a corporation’ s ‘owners’ , but managers must be monitored and institutional arrangements must provide some checks and balances to make sure they do not abuse their power.’

(Mallin, 2007, p.12-13)

(Shareholder) Value

‘A company’ s value depends on its long-term ability to generate cash to fund value-creating growth and pay dividends to its shareholders.’

(Rappaport, 2005, p.65)

Institutional Investors

‘The largest and most influential shareholders today are institutions — including pension funds, mutual funds, private investment (or “ hedge ” ) funds, endowments and sovereign wealth funds — many of which serve as agents for the providers of capital, their ultimate investors. For example, one-third of U.S. corporate equity today is held by mutual funds and hedge funds.’

(The Aspen Institute, 2009, p.2)

2.3 The starting point

The discussion around short-term and long-term is rather an old one but always with a different appearance and emphasis. However, one topic has attracted a great deal of attention to this discussion: the feeling that America is at a disadvantage regarding optimal investment allocation. This topic became very 7 important in the 80’s and 90’s. Michael E. Porter (1992) summarizes his findings in an extensive research project in the Harvard Business Review in 1992. The findings include the fact that the US is at a disadvantage in certain economic areas compared to Germany or Japan, such as:

- Less investment in the US for R&D and corporate training
- Less long-term portfolio investment
- Higher hurdle rates
- Higher profitability but less return for shareholders
- Etc.

He analyzes many different circumstances within these countries and works out several reasons for the differences. One example is the differing approaches to corporate governance. In the US, owners are typically situated on the agent side while in Germany and Japan owners are more typically the principals. Therefore, the influence of the owners is more direct in Germany and Japan which has consequences for the allocation of capital. In the US capital moves very quickly, which leads to a short-term orientation, whereas in Germany and Japan a long- term orientation is preferred. Several other factors are listed and at the end he gives recommendations to improve the situation of the US, which are divided under three headings: public policy, institutional investors, and corporations. For corporations he lists implications like:

- Finding long-term owners and giving them a direct voice in government
- Nominating significant owners, customers, suppliers, employees, and community representatives to the board of directors
- Transforming financial control systems into position-based control systems (e.g. track market share and customer satisfaction; track the company performance against significant competitors, etc.)
- Etc.

As we will see later, many of these recommendations are still valid.

Michael T. Jacobs (1991) came to similar conclusions with his analysis, which resulted in the publication of his book called Short-Term America. Starting also with the example of less R&D investment by American companies in comparison to Japan and Germany, he states that America suffers from short-termism, both at the corporate management level and within the financial community. The two main reasons are:

1. ‘Market evolutions and new technologies permit stocks and business loans to be treated as financial commodities rather than investments in a corporation based on relationships involving dialogue, oversight, and control.

2. New laws, changes to existing laws, and broader interpretation of regulations in recent years have made it harder for capital providers and capital users to communicate effectively.’

He also refers to differences in the financial systems of Germany and Japan compared to the US. For example, the relationship of capital borrowers and lenders is based more on cooperation in Germany and Japan which leads to lower costs of capital as a result of lower risk.

These two examples show that the discussion of short-termism has been held primarily on the economic level, and few authors have discussed other factors. Laverty (1996) gives a good overview of the literature available up to that point of time.

2.4 Recent developments

In the meantime, several developments and events have occurred with differing impact on the discussion and on further research. From ongoing globalization to an increase in the speed of everybody’s life (Rosa, 2005), to various economic turbulence, such as the growth and collapse of the dot.com industry, the Asian crisis, and recently the financial crisis resulting from the bubble in the US housing market. These all show that extreme events are starting to happen more often and within shorter time periods. The extremity of these events and their increased frequency has initiated several discussions, such as the question whether our economy is too focused on the short-term. For example, there is the question whether capital markets are still able to regulate themselves, as Adam Smith stated with his description of the invisible hand. Or do they need more regulation, as Weck (2009) has laid out in his analysis, which asks whether a change in our capitalist system is needed. In addition to three other recommendations regarding companies, politics, and the financial sector, he urges economists and shareholders to focus on the long-term instead of the short-term by ending quarterly guidance, changing to long-term incentives, following initiatives like the global compact^[1] (2010), and so on. This shows that the discussion has broadened in comparison to the original non-economic topics. A lack of ethics, partly based on an increase in human greed (Giersch, 2010), has also been mentioned often in connection with the causes of the crisis.

Starting in the 13th century in Germany, there once existed the ideal of the honourable merchant (Emslander 2006).^[2] But public awareness today is that this ideal has disappeared. Reasons include, for example, several scandals caused by companies which went bankrupt as the result of fraud and the unethical behaviour of their managers. One popular example in this regard is the fall of Enron (Mallin 2007). Measures needed to be taken to avoid such events in the future and to improve the stability of companies as well as, in the end, of our financial system. This was one major driver for the topic of corporate governance and relevant developments (which will be taken up again later).

The homo oeconomicus as a basis for an understanding of participants in our economy is being criticised more and more. An understanding has emerged that the actions of human beings are always embedded in a social framework and are dependent on the personal characteristics of the actors. Therefore, the research area of behavioural finance has emerged and become more and more popular (Thaler 1993, 2005). One recent example is a popular book in which Akerlof & Shiller (2009) comment on behaviour in the stock market with the remark:

‘Investing in stocks is often like that: just as in the beauty contest, in the short run one does not win by picking the company most likely to succeed in the long run, but by picking the company most like to have high market value in the short run.’

There is various practical experience which supports the high influence of psychology on people acting in the financial markets. For example, one former investment banker (Kapoor, 2010) says in an interview:

‘During a boom the return is the highest where most people invest. Because earnings rise when returns increase, everybody buys the same, ignoring the risk. This herding behaviour is one of the central problems.’ ^[3]

To sum up, there are many more factors influencing economic developments than the laws and theories of economists have thus far provided. Therefore, to discover what influences a manager’s decisions, we need to make observations from different point of views. The following chapter gives an overview of the research done in the different areas.

2.5 Current state of research

A review of the contemporary literature shows that the discussion of the disadvantages of the US in comparison to overseas nations, such as Germany and Japan, is no longer the key element. One reason is probably globalization which leads to more and more interdependencies of companies, political systems, laws, regulations, and financial markets. Therefore, the focus has shifted to the influence of financial markets in general. Strongly connected are developments in the field of corporate governance. Many developments in this area have influenced companies and their managers, e.g. management bonuses. Also, as mentioned earlier, there is a wide range of other factors that have influenced the discussion.

For a better orientation, some kind of structure is necessary. As one of the first to look beyond the horizon of simple economic influences in the USA, Laverty (1996) has worked out three groups of influencing factors:

1. Economic
2. Organizational
3. Individual

This grouping makes sense as a starting point. Therefore, I will use this structure in the following section to give an overview of the main research findings since Laverty did this work.

2.5.1 Economic factors

‘Enduring great companies don't exist merely to deliver returns to shareholders. Indeed, in a truly great company, profits and cash flow become like blood and water to a healthy body: They are absolutely essential for life, but they are not the very point of life.’

(Collins, 2005, p.194)

[...]

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^[1] The United Nations Global Compact is a strategic policy initiative for businesses that are committed to aligning their operations and strategies with ten universally accepted principles in the areas of human rights, labour, environment and anti-corruption.

^[2] This ideal characterizes a merchant who is not only focused on profit but on the business relationship as well which has to be based on trust and fairness. For him the common welfare is also important together with a long-term relationship with his trading partners. In German: “ehrbarer Kaufmann”

^[3] Originally in German: „Im Boom steigen die Renditen dort am schnellsten, wo die meisten investieren. Weil die Erträge mit den Renditen steigen, kaufen plötzlich alle dasselbe, egal wie riskant es ist. Dieses Herdenverhalten ist eines der zentralen Probleme.