The Economics of Short-Term Performance Obsession

company’s value depends on its longterm ability to generate cash to fund value-creating growth and pay dividends to its shareholders. Even so, investment managers commonly base their stock selections on short-term earnings and portfolio tracking error rather than discounted cash flow (DCF)—the standard for valuing financial assets in well-functioning capital markets. Financial analysts fixate on quarterly earnings at the expense of fundamental research. Corporate executives, in turn, point to the behavior of the investment community to rationalize their own obsession with earnings. “Short-termism” is the disease; earnings and tracking error are the carriers. The gap between theory and practice prompts four basic questions: • Why do investment managers focus on quarterly earnings? • Can stock prices be allocatively efficient when short-term earnings and tracking error dominate investment decisions? • Can investment managers earn excess returns if they buy and sell stocks they believe the market has mispriced on a DCF basis? • Is corporate management’s focus on short-term earnings self-serving or also in the best interests of its shareholders? After addressing these questions, I present a three-pronged program—improving corporate performance reporting, incentives for corporate managers, and incentives for investment managers—for reducing short-term performance obsession.