David R. Henderson  

Phelps on Short-Sightedness

Three Dispositions of (Modern)... Political Mood Cycles...

I'm less impressed with Phelps's piece than Arnold is, to put it mildly. Take the following line from Phelps:

Executives avoid farsighted projects, no matter how promising, out of a concern that lower short-term profits will cause share prices to drop.

If that were true, we could not explain the behavior of oil companies or drug companies. Both could raise their short-term profits by cutting their spending on discovery (oil) and R&D (drugs) to zero. They haven't done that. Why? Precisely because they care about share prices and share prices reflect the market's expectation of the present value of the future stream of net income.

HT to John Garen.

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COMMENTS (14 to date)
Les Cargill writes:

Oil and drug companies both rent-seek. It's as simple as that.

Phil writes:

But it's possible that oil companies and drug companies are different, because investors pay attention to their R&D pipeline. If they drop R&D, investors will know instantly (well, as of the next quarterly report), and the share price would drop.

Phelps could be referring to "non-standard" farsighted projects. If Wal-Mart created a weird but eventually profitable project to (say) put small stores in gas stations, it's quite plausible that the share price would drop.

Investors just wouldn't see the weird Walmart plan as necessary the way they see drug research spending as necessary.

If you read Phelps as saying "non-routine long-term projects" instead of just "long-term projects," it could very well be true.

Gene writes:

The two industries mentioned are secured by generous subsidies/tax breaks and probably fall under the category of "to big to fail" so they have a measure of comfort that most/all small businesses have when it comes to making an investment decision. Pundits need to stop asking CEO's and start asking the small entrepreneur his/her opinion--"Are you going to open that 2nd or 3rd or 20th restaurant/auto repair shop? Are you going to replace your heavy construction equipment or automate your assembly line. As a former small business owner, my decisions, "at the margins" are more costly and have to be considered more carefully than the decisions of a Fortune 500 CEO's. If I have my own capital or liquidity at stake, then I am going to be very careful and, yes, and going to have some degree of uncertainty given what is going on around me. While the self-employed are generally an optimistic bunch, they are careful stewards of their resources. If people really believe that job generation coming out of a recession starts with small business and upstarts, then they need to start asking not only the right questions, but ask them of the right people...Thank you for your time and attention...respectfully submitted.

Ted writes:

There is a problem with your two examples. There is no such thing as short-term profits in oil and drugs. All of their profits derive from long-term investment. Drugs being released today are based on R&D that started years, and even sometimes decades, ago. Oil being produced today are best on drill sites and R&D that was begun years ago.

But, in general, I don't agree with Phelps analysis anyway. I see no evidence that improving supply-side factors will do anything in the short-run, as this isn't a supply-side recession.

kebko writes:

It's another problem where price serves as its own signal. The market is completely using long-term future cash flows to value businesses. But, lacking other information, the most recent earnings trend & level are important signals to use to estimate future earnings.
So, the market isn't overweighting the most recent earnings in & of themselves. But, they are factored into the model to project future earnings.

Justin Rietz writes:

I would be interested to see the data Phelps has to back up his points. It also might be be interesting to look at the correlation between concentration of ownership and a business's willingness to invest in long term projects.

Anectdotaly, I think VC investment in Silicon Valley has actually picked up (based on my recent job hunt experience). The number of social networking / web 2.0 companies receiving funds far outweighs the market saturation point, IMHO.

Tom writes:

It's the accounting that drives behavior.

In oil, most exploration costs are capitalized - i.e. no immediate impact on earnings. DD&A expenses are influenced by subjective measures and estimates. So earnings can be managed without curtailing exploration activity.

In other industries, such as services and software, most investment costs must be expensed. This leads to the very short sighted behavior described.

As a management consultant for 30 years, I have witnessed both behaviors first hand.

Daniel Kuehn writes:

Let me get this straight David - because oil and drug companies haven't done the most extreme thing consistent with Phelps's thesis, then Phelps's thesis is wrong?

Hyena writes:

Whether the market's valuation depends on the long term valuation of the asset would depend heavily on how much the participants discount future earnings. In a market with a high demand for liquidity--which we've been in for about 10 years, it seems--the value of far future earnings approaches zero rapidly because few investors expect to be holding the asset then.

Likewise, the golden age of long-term investments was as the baby boomers were preparing to retire. They pushed the market further into the future, specifically, to their date of retirement.

Tracy W writes:

Daniel Kuehn - sounds like good logic to me. If a theory predicts that people should do something extreme (like "avoid farsighted projects, no matter how promising"), and we see people actually doing farsighted projects, then that theory's a bad one.

There's a lot of other evidence that Phelp's theory is wrong. For example, stock market returns rise when a company anounces a new strategic decision - see http://onlinelibrary.wiley.com/doi/10.1002/smj.4250110503/abstract, Woolridge, J. R. and Snow, C. C. (1990), Stock market reaction to strategic investment decisions. Strategic Management Journal, 11: 353–363. doi: 10.1002/smj.4250110503, or http://www.jstor.org/pss/3665583, or http://www.jstor.org/pss/3665906

Hyena - your argument misses out an important step. What do the participants plan to do with the asset once they no longer wish to hold it? If they intend to sell it, then logically the price that they can sell it at will depend on how valuable that asset is to future buyers. For example often when people sell a house, they invest time in tidying it up to make it look better to potential buyers (my parents once got a very good deal on a house where the owners didn't follow this principle, apart from all the weekends they spent working on it). Consequently even someone planning to sell an asset in a year has reason to care about its long-run return.

fundamentalist writes:

Phelps is right, but for the wrong reason. All companies take on the short term projects because they are the most profitable compared to long term projects. Hayek explains in his Ricardo Effect. When the Fed lowers interest rates, profits on short term projects rise much faster than profits in longer term projects.

Daniel Kuehn writes:

Tracy W -

RE: "Consequently even someone planning to sell an asset in a year has reason to care about its long-run return."

You seem to be making the same mistake as David. Neither I, nor Phelps, denied this point. Don't attach take the most extreme version of the statement and repudiate that when nobody is making that extreme sort of argument. Economic decisions are not scalar - reductio ad absurdum rhetorical strategies and economics generally don't mix very well.

Tracy W writes:

Daniel Kuhn, I don't follow you. On the one hand you quote something I said in a response to Hyena about someone planning to sell an asset in a year, on the other hand your text appears to be aimed at David and my data disproving Phelps' statement. Which statement are you disagreeing with me about?

You also say that David and I are taking the most extreme version of Phelps' statement. I've read the whole essay and as far as I can tell, I'm not taking the most extreme version of Phelps' statement, instead I'm just responding to what I read. Can you please explain what you think that Phelps actually did intend to say? Perhaps a way of clarifying what you think Phelps actually said about would be to say how you think that Phelp's statement could conceivably be disproved?

MernaMoose writes:

If that were true, we could not explain the behavior of oil companies or drug companies.

You haven't worked in Corporate America, have you?

Oil and drug companies are the exception to the rule. The rule is that you have to "sharpen your pencil" in order to determine what is and is not "profitable".

The final, ultimate end result is highly predictable: you will eventually realize that there is no need for anything except the department that receives incoming customer checks and deposits them in the corporate bank account. Who else in the company is actually "making money" for you?

If they aren't making money for you, then you should at minimum cut their budget some more.

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