UK: SHORT-TERMISM - INDUSTRY SHOOTS ITSELF IN THE FOOT. - The City is not alone in its shortsighted view.

Last Updated: 31 Aug 2010

The City is not alone in its shortsighted view.

Almost everything about the British economy is the subject of vigorous debate and disagreement. But one argument is supported from right and left, from businessmen and unionists, from economists and journalists: that the economy is plagued by short-termism, which leads to under-investment, lack of innovation and shortsighted strategies. Even the favoured culprit - the City of London - accepts the argument, though it is less keen about accepting the blame.

The Bank of England has introduced a new dimension into this issue. It believes that one financial obstacle doesn't lie in the City's demands for quick returns, but in those of industry itself. The majority of its surveyed companies set 20% nominal rates of return as their criterion for approving projects, and two-fifths looked for a three-year payback. This is confirmed by a separate CBI survey, which found that manufacturers wanted payback within two to three years.

The Bank comments that these high 'threshold rates of return are a critical hurdle when there are many competing claims on corporate resources'. Anyone who knows industry knows that's not the whole story. Managers don't naively present projects for approval without first ensuring that the numbers pass corporate criteria. When would-be borrowers provide a sensitivity analysis of their business plans, as a clearing banker observes, 'It's easy to get the results you want by sensitising down to your bottom line, whatever that may be.' The accepted minimum return on capital employed is a likely candidate.

Managers can safely cook their projections of return on investment because few companies ever check actuals against forecasts (which helps explain why high hurdle rates co-exist with much lower actual returns for businesses as a whole). The Bank is right, though, to locate short-termist pressure where it belongs - in companies themselves. It could be argued that high hurdle rates are a reflection of the City's hunger for short-term success, but their selection is still a voluntary choice by top management.

Far more insidious is a top management requirement that unit managers cook at their peril - the hitting of budgetary targets. The insistence of the Stock Exchange on more frequent reporting has coincided with the development of sophisticated forward budgeting techniques and with the adoption of reward-and-punishment systems linked to profit targets covering very short periods. With this kind of pressure, conflict with long-term programmes is inevitable.

Bernard Fournier, managing director of Rank Xerox, has found that such financial pressures make it 'very difficult to protect quality investments' - to which his company and its US parent are committed. In businesses with a weaker commitment to the long term, internally generated short-termism can only exercise a powerful, and baneful, influence. At many companies, December is spent hauling in profits from questionable, non-trading sources to 'make the numbers'. 'What this company needs', says a manager in one high-tech multinational, 'is twelve Decembers.' That's short-termism with a vengeance. In a minority of companies - such as National Westminster Life - the targeting has moved to a 'balanced scorecard' on which non-financials rank alongside the financials. If the majority of firms are serious in their complaints about short-termism, they will have to move their own internal reward and reporting systems in the same direction.

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