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Underinvestment Crisis Exaggerated

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Underinvestment Crisis Exaggerated

June 14, 2017

Although some think that companies are underinvesting in long-term research, a new working paper published by the National Bureau for Economic Research suggests that this concern is exaggerated.

The argument for underinvestment, also known as “short-termism,” goes as follows.  A fundamental shift in corporate decision-making has purportedly led companies to spend less on research and more short-term gains that deliver tangible returns to shareholders through mechanisms such as stock buybacks or dividends. This, supposedly, has reduced corporate innovation.

But Steve Kaplan of the University of Chicago Booth School of Business shows that even though scholars have been raising these concerns in some fashion since the 1970s, a careful analysis shows underinvestment has not occurred. If the short-termism identified in those articles were introducing significant distortions with harmful long-term effects, we should be seeing them now, some decades later.

Kaplan goes through the 40-year old history of these concerns.  In 1980 Harvard Business School’s Robert H. Hayes and William J. Abernathy wrote that American companies had “abdicated their strategic responsibilities” due to their “their devotion to short-term returns and management by the numbers.”

Kaplan looks at arguments related to the underinvestment hypothesis: trends in corporate profits, and changes in opportunities for alternative sources of investment. If U.S. companies have underinvested because they were too focused on short-term goals, over a longer time period corporate profits should have suffered. But they have not done so.

Corporate Profits as Percentage of GDP Since 1951

* Corporate profits are before tax with inventory valuation and capital consumption adjustments, as in Kaplan (2017).

Source: U.S. Bureau of Economic Analysis, Corporate Profits with Inventory Valuation Adjustment and Capital Consumption Adjustment, accessed via FRED Federal Reserve Bank of St. Louis.

In reality, no clear trend emerges in corporate profits. After a slight decline in corporate profits as a share of GDP in the 1970s, since 1990 they have recovered to almost reach those highs. This lack of deterioration is difficult to reconcile with the narrative of widespread short-termism in American companies that is sapping long-term growth prospects.

If American companies had habitually underinvested in research and development, alternative sources of capital, namely venture capital firms and private equity firms, would have been able to take advantage of these new opportunities for investment to fill that void.

Looking first at venture capital firms, Kaplan finds that the share of capital committed to venture capital funds relative to the total stock markets has not increased inexorably, as the theory would suggest. Instead, this share has generally fluctuated within a narrow band of one tenth to two tenths of a percentage point.

Another implication of possible dwindling investment by U.S. companies is that these alternative sources, such as venture capital firms, should be able to attain high returns. Using public market equivalent (PME) methodology to compare “investment in venture capital to an investment in public equities at the same amount and at the same time,” Kaplan fails to find any discernible trend in PMEs for venture capital from 1981 to 2013.

Unlike venture capital firms, the pattern of capital allocation to private equity firms suggest there may have been two periods with heightened opportunities due to the effects of short-termism. Kaplan rules out the first possibility of the 1980s as not likely being caused by short-termism because most of the companies funded by these private equity firms actually reduced investment. The mid-2000s may be an example of a brief period of opportunity for PE investments and returns, but after 2005 both have stabilized.

More broadly, the short-termism argument is hard to reconcile with developments in technology and other spheres. For years Amazon had a high valuation despite negative cash flow. The same dynamic extended more generally to companies in industries such as biotech stocks. One related study from Ritter found that of the 180 biotech companies that went public from 2013 to 2016, only 4 percent of these were profitable. High valuations for companies that have yet to turn a profit are based on expected cash flows far into the future, not short-term performance in the next quarter.

In energy, firms have invested substantial amounts in new fracking technology. Many of these investments required extended periods of negative cash flow, and multiple years for construction or navigating through the regulatory process. These investments would be unlikely in a world where companies were focused on the short-term to the detriment of making decisions on a longer time horizon.

Most of the adverse effects associated with persistent underinvestment by U.S. companies have not materialized in the ensuing decades. The underlying issue of creating a framework where companies compete in an open market to develop new products and innovations is vital to the American economy, but short-termism should not be the main source of worry.  

Charles Hughes is a policy analyst at the Manhattan Institute. Follow him on twitter @CharlesHHughes

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