In a famous editorial published in the Wall Street Journal, Warren Buffett and Jamie Dimon, the chairmen of Berkshire Hathaway and JP Morgan respectively, took the stock market to task for being too short-term oriented. The authors state that “This announcement today builds on the Commonsense Corporate Governance Principles that business leaders developed in 2016. These principles acknowledge that the financial markets have become too focused on the short term.” As a result, they suggested that companies dispense with quarterly earnings guidance which they said, “is a major driver of this trend and contributes to a shift away from long-term investments.” Their view was widely shared by many other corporate leaders who routinely wrung their hands over the market’s short-term orientation.
The problem with this view, and with the proposed solutions, is that they run counter to massive market evidence, particularly evidence from the last decade. There is no better place to start than with the automotive industry which I discussed in my previous post, Is Tesla a Tech Company. In that post, I noted that the market capitalization of Tesla was greater than the combined values of Ford and GM and had even surpassed the market cap of German giant Volkswagen. Tesla achieved this lofty valuation, furthermore, without every having earned a profit on an annual basis and while it was selling only about one-tenth the cars that GM, Ford and Volkswagen. When analyzed using any of the traditional valuation ratios such as price to revenue or enterprise value to EBITA, Tesla trades in another universe. Explaining the relative valuations of Tesla and established automakers is a real challenge. It is hard not to attribute part of it to irrational exuberance on the part of Tesla shareholders. But that is not the point of this post. The point is the whatever the explanation, it is not short-termism. All the traditional auto makers are profitable, Tesla’s profitability remains a question mark in the short-term, but the market has responded with a premium valuation based on its expectations of what will happen over the long term.
Compared to growth stocks, value stocks have greater current income, relative to market capitalization, but fewer future growth opportunities. If the market were becoming more short-term oriented the prices of value stocks should be rising relative to the prices of growth stocks. Over the period from January 2007 through December 2019, the Russell 1000 growth index outperformed the Russell 1000 value index by a massive 4.4% per year. Many companies like Spotify, Snap, Netflix, Beyond Meat and Shopify that have tiny earnings as a fraction of cash flow, or even negative earnings, saw their prices skyrocket while those of value stocks were stuck in the mud.
The phenomenon is not limited to smaller companies or recent startups. Internet giant Amazon, more than twenty years after its IPO, still trades at a P/E ratio of more than 83. Such a high ratio can be justified only if the market is anticipating, and baking into the market price of the stock, distant future growth. The case of Apple is even more amazing. In less than a year, Apple’s stock price has more than doubled, adding approximately $750 billion in market value while earnings hardly budged. The entire increase has ben due to changes in long-run expectations, not short-term earnings.
If there is such massive evidence that the market takes a long-run view, why then are do so many managers complain about short-termism? One possibility is the what is called short-termism is actually a dispute between company management and the market over the viability of a company’s long-term plan. If a company’s stock price fails to behave as management would like, it is easier to blame market short-termism than to countenance the fact that the market may be taking a dim view of the company’s long-term outlook. Another possibility is that the large price swings of growth companies makes it appear that prices are overly sensitive to short-term information. However, a better explanation for the volatility of growth stocks is that the prices are based on sentimental beliefs regarding a company’s long-term prospects. The attitudes of Tesla advocates regarding the manner in which the company will reinvent the auto business is an example. Such beliefs are subject to radical revisions if sentiment changes due in large part to their long-term nature. Rather than be based on current operating performance, they are based on projections of a future transformation. If confidence in that transformation is eroded, the price collapses.
Another phrase for short-termism is market myopia. In today’s market a better description would be hyperopia (farsightedness). In fact, a more relevant concern today is not that the market is short-sighted but that it is so hyperopic that prices may be running away from fundamentals. This has happened before in 2000 and again in 2007. In both cases, the runup was followed by a sharp drop in prices. This author’s fear is that there is a good chance it will happen again. Ironically, if it does, the drop could well be blamed on a myopic overreaction, ignoring the year of hyperopia the preceded it.