What's Wrong With Flat Corporate Profits? Beyond Short-Termism

Imagine a company that is among the most profitable in the world, with a long track record of making money hand over fist for years on end. Except there is only one problem: As big as the profits are, they are no longer getting bigger quarter after quarter. The company has reached a plateau, at least for the moment, where it is still making an unbelievable amount of money; just not more money all the time. 

Why should this be a problem? If I just described a privately-held business that any normal person owned, I'd be talking about a huge success. What's not to like about steady profits?

A lot, it turns out. At least for publicly-held companies -- even famously lucrative corporations like Apple. Apple's stock plunged 10 percent after the company revealed Wednesday that it's revenue growth is slowing. Mind you, we're talking about a company that expects to make between $41 million and $43 million in the first quarter of this year -- and a company that earned $54.5 billion in the last quarter of 2012, with an astounding $13.1 billion of that income pure profit. 

And yet investors are jumping ship as if the news just broke that iPhones cause cancer.

Of course, this is a familiar story. Companies that don't relentlessly grow their revenues and profits always get hammered by the stock market. And that creates enormous pressures on executives and the managers below them to improve the bottom line. 

Good things can certainly come out of this relentless drive for efficiency and innovation. But so can many bad things -- like, say, wages so low in entire industries, such as the retail sector (as Demos has documented), that large swaths of an industry's labor force needs to rely on public assistance just to survive. Or the cutting of corners when it comes to environmental regulations. Or, most commonly, chasing short-term sugar highs instead of making long-term investments in research and development. And, of course, let's not forget fraud: A common motive for cooking the books, and reporting inflated earnings and profits, is to avoid punishment by an unforgiving Wall Street. 

This is yet another example of how the U.S. financial system has lost its way. The stock market is supposed to mobilize capital for productive economic purposes; not hold a gun to the heads of executives and threaten to pull the trigger every three months.

Something must be done to ease the quarterly earnings pressures on public companies and there is no shortage of proposals. A comprehensive blueprint for reform was published last year in Great Britain -- the much discussed "Kay Report," written by economist John Kay. The report dissected the causes of short-termism, its pernicious effects, and made 17 recommendations to insulate companies from investor pressures and allow them to focus more on long term stewardship. 

Among the most intriguing recommendations is that the U.K. no longer require companies to report their quarterly earnings. Boy, that would be a big deal -- and a huge step forward -- if implemented here. Quite apart from tamping down the crazy feeding frenzy over quarterly earnings, and advanced projections of such earnings, it would save companies a lot of money if they didn't have to muck around with all those quarterly filings.

More familiarly, the Kay Report argued that executive pay needs to be better aligned with the long-term interests of companies and their shareholders. Amen to that. We've seen so many destructive examples of CEOs making a fortune through risky short-term strategies that end up gravely wounding, or killing, major companies. Think of Merrill Lynch and how Stanley O'Neal led that company to binge on mortgage-backed securities, making several hundred million dollars for himself. By the time a deeply indebted Merrill was sold for a pittance, devastating shareholders, O'Neal was gone. 

The Kay Report takes the compensation alignment argument a step further, with a proposal that should also be considered on this side of the Atlantic: 

Asset management firms should similarly structure managers’ remuneration so as to align the interests of asset managers with the interests and timescales of their clients. Pay should therefore not be related to short-term performance of the investment fund or asset management firm. Rather a long-term performance incentive should be provided in the form of an interest in the fund (either directly or via the firm) to be held at least until the manager is no longer responsible for that fund.

I know, it's hard to imagine what would happen to all the excess testosterone on Wall Street if money managers were no longer programmed to make a quick buck. 

One good idea that the Kay Report didn't mention is a financial speculation tax. Fast and easy trading encourages short-termism as money jumps in and out of stocks. While there is little deterrent to all this speculation right now -- and, in fact, trading has gotten much cheaper with computers -- a tax on financial transactions would serve to usefully slow everything down. 

Apple has been making great products for years. It is likely to continue doing so. We need a financial system where companies like that can more easily ignore Wall Street and focus on doing what they do best.