Ideas for Leaders #713

Wrong Incentives Push CEO to Focus on the Short-term

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Key Concept

Researchers use unimpressed market reaction to new product and new client announcements to highlight the insidious damage of CEO incentives to focus on the short-term.

Idea Summary

A number of different incentives can potentially push leaders to make decisions that favour short-term returns over long-term value. To test whether such incentives actually have an impact on decision-making, a team of researchers used market reaction to new project announcements by CEOs. They compared differences in the market response to CEOs who had incentives to focus on the short term and CEOs who did not have such incentives. Market reaction to new project announcements is indicative of the perceived long-term value of those announcements. 

The researchers first identified four incentives that previous studies had shown lead to short-term thinking.

The first two incentives identified by the researchers were a shorter vesting period of CEO stock option grants, and for lower-level managers, a shorter expected life of employee stock options. The shorter windows on these options incentivize decision-makers to push for short-term profits for a simple reason: long-term rewards will come too late to impact the returns on their options. 

Another incentive was short CEO tenure. If a CEO has less of a track record, investors and directors are more likely to watch share price as an indication of the CEO’s performance more. Thus, a short tenure is often an incentive for CEOs to generate short-term results to establish a positive track record. 

Youth has the same effect: younger CEOs without a long track record will be pushing for short-term results. At the same, however, studies have shown that CEOs nearing retirement age also have an incentive to focus on the short-term. Thus, the fourth incentive studied by the researchers, CEO age, has a u-shaped effect on short-termism: high for younger and older CEOs, and lower for CEOs in the middle years of their careers.

The researchers used CIQ’s Key Development database to identify 141,079 new client and product announcement events between 2002 and 2009. They then pulled from a variety of other databases, including Compustat, Execucomp and SEC filings, to acquire data on executive incentives (based on the four items described above) and stock returns around the date of the announcements. 

With this data, they were able to correlate short-term incentives and market reaction to new project announcements. The results of their study showed that that announcements by CEOs who had incentives to focus on the short term did not elicit the same positive response from the markets as announcements by CEOs who did not have such incentives.

Additional analysis showed that this negative short-termism effect was more pronounced for new client announcements than new product announcements. One reason is that investors will have more information with which to judge the potential long-term value — or lack thereof — of new product announcements. It will be less clear to investors how new client partnerships might lead to short- or long-term value, which tempts leaders to hide their short-term ambitions in these partnerships. As a result, investors tend to view the long-term value of new client announcements even more skeptically.

Another interesting analysis, based on the study of the specific words used in the announcements, showed that CEOs with more incentive to focus on the short-term were more likely to use soft and vague ‘filler’ words when describing the new projects. The reason: since the new project, whether a new product or a new client relationship, has less actual long-term value, the CEOs have to ‘make stuff up’ (to use the vernacular). In other words, they fill the announcement space with vague and positive words that don’t say anything concrete.

Business Application

Most incentives for short-termism, such as CEO tenure and age, are visible to all. Investors, this study reveals, are aware of these incentives, and believe that such incentives will push CEOs to be less discriminatory in the projects that they choose — in other words, they will back projects that don’t have real long-term value. As a result, investors will view new project announcements from CEOs incentivized to focus on the short-term less positively. 

The best CEOs focus on the long-term value of all projects, even if they could be tempted by incentives to reach for short-term wins. In the long run, long-term thinking CEOs, especially if they are younger or have a shorter tenure, will reap the benefits of their long-term orientation — and so will their companies. For one lesson of this study is that investors are not easily fooled… even if you deliberately try to fool them.

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Authors

Institutions

Source

Idea conceived

  • March 2018

Idea posted

  • July 2018

DOI number

10.13007/713

Subject

Real Time Analytics