February 2, 1998 ; Fortune Magazine. Geoffrey Colvin

You hear it everywhere: Ruthless short-term investors won't let today's managers execute brilliant long-term plans. Fact is, that's a lame excuse. Hear it? That high-pitched whine in the background of the business news? Hasn't been this loud since the late '80s, but you can't miss it now--and I'm convinced it's only going to get louder. It's managers across America complaining that nasty, unreasonable, hidebound shareholders are too short-term-oriented. These managers see companies ripe for acquiring, capital expenditures begging to be made, R&D that would pay off big, but if they follow through, they insist bitterly, the petty-minded beasts of Wall Street will hammer their stock. "I've tried to make decisions based on what's right for the company, not what's right for the stock price," writes Starbucks CEO Howard Schultz in his new book, Pour Your Heart Into It. Shocked by wild swings in his stock resulting from surprisingly bad or good quarterly news, he is now persuaded that the two types of decision-making are quite different. "Wall Street has a tendency to overemphasize short-term benefits at the expense of long-term benefits," Hyatt Hotels President Doug Geoga said last year. Warning readers of Hotel & Motel Management about the hazards of going public, he continued, "There is a reward given to pursue short-term actions that provide a short-term benefit at the expense of long-term value to your company." Putting this view more succinctly than anyone is Donald Trump. His Trump Hotels & Resorts has been a truly lousy performer, falling from $13 a share to $7 last year. Never fear, Trump told the Wall Street Journal; shareholders should look past the short term and focus on his long-term strategy. "I don't think that the great job that we've done has been appreciated," he said, in a rare understatement. Then, with one of those only-from-Trump quotes, he showed how profoundly he fails to get his role as chairman of a publicly traded corporation: "Other than the stock price, we're doing great."

Okay, is it true? Does the stock market shackle creative managers by systematically and unjustifiably overdiscounting returns from long-term projects, while obsessing on the next quarter? We can seek an answer in many different ways, but I'm telling you right now, they all lead to the same place. And the Wall Street bashers don't want to go there. To begin most basically, does the proposition make sense? To say that Wall Street gives excessive weight to short-term results is to say that investors as a group fail to take advantage of available information about a company's prospects: Evidence of a bright future is out there plain as day, yet investors refuse to bid up the stock in line with an appropriate discount rate. (Note that this theory applies in one direction only; no manager ever complains that Wall Street gives inadequate weight to long-term bad news.) In other words, it's to say that investors as a group are consistently passing up worthwhile opportunities, leaving money on the table every day, for illogical reasons, as can be seen by anyone with half a brain. Is it likely that people really act this way? Well, who knows, maybe they do. If 10% of Americans think Elvis is alive, if 2% of us believe we've been abducted by aliens, as we do, then maybe we also enjoy giving up substantial returns on our investments that are there for the taking. But I'm skeptical. Moving past the thought-experiment approach to the question, it's useful to see what reality tells us. It tells us loudly that Wall Street is anything but a den of heartless, visionless gnomes. On the contrary, the history of technology stocks suggests that America's most hopeless romantics, the dreamers who believe in sunny tomorrows only they can see, like nothing better than common equities. Open today's newspaper, and you'll find hundreds of companies in the stock tables with no price/earnings multiple because they have no earnings--but they do have prices, sometimes very high ones. Think of any new biotech stock, any Internet stock. Last year's hottest retailing success, Abercrombie & Fitch, has no earnings, but its stock tripled. Amazon.com, one of 1997's champion IPOs, has no earnings, but its stock went from 15 3/4 to 66. Another standout IPO, Star Telecommunications, went from 92 to 364 without earnings. Of course these stories don't all end happily. Can you say "Netscape"? Yet time and again Wall Street proves extraordinarily willing to take a flier on companies with no record. This is scant comfort to the determined whiner from an established company who believes Wall Street won't let him invest in R&D with a long-term payoff because doing so will reduce earnings and tank his stock. This scenario has practically become conventional wisdom, but broad-based evidence to support it is hard to find. Just the opposite, in fact: The evidence refutes it. A recent study by Baruch Lev (New York University) and Theodore Sougiannis (University of Illinois) finds that, on the whole, companies with higher R&D expenditures produce higher returns to shareholders.

A fascinating study by Lisa Muelbroek of the Harvard Business School investigates the common complaint that high R&D spending lowers a company's stock price and thus invites a takeover. She looked at companies that became takeover targets to see if they spent more than others in their industry on R&D. Nope. They actually spent less. As Muelbroek dryly notes, "One might argue that the low R&D by target firms in years well before takeover bids indicates that the causation flows from low R&D to takeovers rather than the reverse direction." Muelbroek then took an irresistible further step: If the threat of takeovers supposedly forces managers to stint on R&D, then adopting measures to prevent takeovers would enable them to spend on it as fully as they like. Does it? She examined hundreds of companies that adopted various anti-takeover measures and found that, after adoption, R&D (as a percent of sales) didn't change significantly. Indeed, since industrywide R&D spending tended to increase, companies with shark repellents actually reduced R&D, significantly relative to the industry. At this point the whiners' case against Wall Street is badly damaged below the water line and listing heavily. But diehards may cite the peculiar modern spectacle of investors savaging the stocks of companies that miss their earnings estimates for just one quarter, and sometimes not by much. Surely this is evidence of irrational short-termism? Not necessarily. In a market with often towering P/Es, each penny of earnings is supporting a skyscraper of price, so when earnings wobble, it follows that prices may tumble. More important, those so-called overreactions to earnings surprises aren't always overreactions. Consider the most spectacular earnings surprise of 1997, Oxford Health Plans' October announcement that it would report a quarterly loss instead of a profit. The stock dropped from $68 to $26 in one day, in percentage terms the largest one-day erasure of value by a major company in memory. But what's most astonishing is that this plunge wasn't enough. Far from overreacting, Wall Street didn't immediately grasp the extent of Oxford's trouble. The stock has since drifted down to around $15. The larger point is that while Wall Street obviously can't price every stock exactly right at every moment--this is real life--it goes wrong in both directions. Academic evidence suggests it underreacts about as often as it overreacts. All of which makes it hard to sympathize with managers who cry that they're grievously constrained by nearsighted investors. For such managers, the evidence presents a few thoughts worth pondering: * There's just no reason to believe that the capital markets are irrationally biased against long-term investments. If Wall Street doesn't like your long-term plan, it isn't because Wall Street generally despises projects with distant payoffs. It just despises your project. * The equity markets have been democratized. If you're frustrated because they don't rush to embrace the bright promise of your coffee bars, your hotels, your casinos as enthusiastically as you'd like, remember that nowadays you're asking people to bet their retirement and their kids' college education on your vision. Are they really being unreasonable? Face the fact that all those crazed short-termers are people pretty much like you. * If you see a winning investment for your company that Wall Street just doesn't get, that's worth money. The only logical move is for your company to make the investment--after all, you're sure it will pay off--and then get yourself more heavily into the company's irrationally low-priced stock and wait. Buy it, or take your pay less in cash and more in stock. In short, put your money where your mouth is. After removing the pacifier, of course.