In the early 1970s American companies invested 15 times as much cash as they distributed to shareholders; in recent years the ratio has dropped back to below two (see chart). What has driven this change? In his new book, “The Road to Recovery: How and Why Economic Policy Must Change”, Andrew Smithers, an economist, argues that the main cause has been management incentives.
Executives are now paid largely in the form of bonuses rather than salary. These bonuses are often tied to the share price, which in turn depends on the ability of the company to meet its quarterly earnings-per-share target. Buy-backs tend to boost earnings per share; investment plans may dent them. Mr Smithers writes that “The result of the increased importance of bonuses and the use of these measures of performance is that managements are now less inclined to take short-term risks, such as cutting profit margins, and more inclined to take the longer-term risks involved in lower investment and the possible loss of market share that will result from higher margins.”
There is other evidence for his assertion. A 2004 academic survey found that the majority of managers questioned would not proceed with a profitable long-term project if it meant that the company would miss the consensus forecast of profits in the current quarter. A 2013 study found that publicly quoted companies where executive compensation is linked to the stockmarket invest considerably less than private firms and are less responsive to new investment opportunities. The authors state that “our results are most consistent with the view that public firms’ investment decisions are affected by managerial short-termism.”
Many executives are rewarded in the form of share options for meeting targets. Options are more valuable when they are linked to a volatile asset (the more the asset price moves, the more likely it is that the option will be exercised). Since share prices are affected by trends in profits, executives have an incentive to pursue strategies that make profits more volatile. Sure enough, Mr Smithers finds that profits of quoted companies have become much more volatile in recent years. Until 2000 profits in the national-accounts data had very similar volatility to the reported profits of S&P 500 companies; since then, the latter have been four times as volatile.