Does a long‐term orientation create value? Evidence from a regression discontinuity

• Date: 01 September 2017
• Published date: 01 September 2017
• DOI: http://doi.org/10.1002/smj.2629
• Author: Caroline Flammer,Pratima Bansal

Strategic Management Journal

Strat. Mgmt. J.,38: 1827–1847 (2017)

Published online EarlyView 7 February 2017 in WileyOnline Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2629

Received 1 July 2015;Final revisionreceived 10 October 2016

DOES A LONG-TERM ORIENTATION CREATE VALUE?

EVIDENCE FROM A REGRESSION DISCONTINUITY

CAROLINE FLAMMER1*and PRATIMA BANSAL2

1Questrom School of Business, Boston University, Boston, Massachusetts, U.S.A.

2Ivey Business School, Western University,London Ontario, Canada

Research summary: In this paper, we theorize and empirically investigate how a long-term

orientation impacts rm value. To study this relationship, we exploit exogenous changes in

executives’ long-term incentives. Specically, we examine shareholder proposals on long-term

executive compensation that pass or fail by a small margin of votes. The passage of such “close

call” proposals is akin to a random assignment of long-term incentives and hence provides a

clean causal estimate. We nd that the adoption of such proposals leads to (1) an increase in

rm value and operating performance—suggesting that a long-term orientation is benecial to

companies—and (2) an increase in rms’ investments in long-term strategies such as innovation

and stakeholder relationships. Overall, our results are consistent with a “time-based” agency

conict between shareholders and managers.

Managerial summary: This paper shows that corporate short-termism is hampering business

success. We show clear, causal evidence that imposing long-term incentives on executives—in the

form of long-term executive compensation—improves businessperformance. Long-term executive

compensation includes restricted stocks, restricted stock options, and long-term incentive plans.

Firms that adopted shareholder resolutionson long-term compensation experienced a signicant

increase in their stock price. This stock price increase foreshadowed an increase in operating

prots that materialized after twoyears. We unpack the reasons for these improvements in

performance, and nd that rms that adopted these shareholderresolutions made more investments

in R&D and stakeholder engagement, especially pertaining to employees and the natural

environment. Copyright © 2016 John Wiley & Sons, Ltd.

INTRODUCTION

Agency theory argues that managers’ preferences

are misaligned with those of the shareholders. As

a result, managers invest in projects that are not

the rst-best from the shareholders’ perspective,

leading to a decrease in rm value. Traditional

agency models focus on managers’ preference

Keywords: long-term orientation; nancial performance;

innovation; stakeholder relations; agency theory; regres-

sion discontinuity

*Correspondence to: Caroline Flammer, Questrom School of

Business, Boston University,595 Commonwealth Avenue, Ofce

634A, Boston, MA 02215, U.S.A. E-mail: cammer@bu.edu

Copyright © 2016 John Wiley & Sons, Ltd.

for, e.g., empire building (e.g., Jensen, 1986),

shirking (e.g., Bertrand and Mullainathan, 2003;

Holmstrom, 1979), or too little risk taking (e.g.,

Gormley and Matsa, 2016; Holmstrom, 1999).

In contrast, the question of whether companies

face a time-based agency problem— i.e., whether

managers’ time preferences are misaligned with

those of the shareholders— remains to be explored.

In this article, we aim to ll this void. Speci-

cally, we explore whether managers have a higher

discount rate— that is, a preference for the short

term— relative to shareholders. Anecdotal evidence

suggests that this might be the case. Indeed, a large

number of companies focus on meeting short-term

goals, even if doing so hinders the pursuit of

1828 C. Flammer and P. Bansal

superior long-term projects. Perhaps the most

striking evidence is provided in a survey by Gra-

ham, Harvey, and Rajgopal (2005), who nd that

78 percent of the surveyed executives would sacri-

ce projects with positive net present value (NPV)

if adopting them resulted in the rm missing quar-

terly earnings expectations. Overall, this evidence

is suggestive of a time-based agency problem.

If managers are myopic, we expect that the adop-

tion of a longer-term orientation (e.g., through the

provision of long-term incentives to the managers)

increases rm value. In other words, by adopting

longer time horizons, companies are able to coun-

teract managerial myopia and hence align man-

agers’ interests with long-term value creation.

From an empirical perspective, it is difcult to

examine the effect of a long-term orientation on

rm performance. There are two main obstacles.

First, temporal orientation is inherently unob-

servable. Second, temporal orientation is likely

endogenous with respect to nancial performance,

which makes it difcult to establish causality. For

example, nding a positive correlation between

empirical measures of long-term orientation and

performance may be driven by “deep pockets”:

companies that perform better need to worry less

about the short run and hence can more easily

afford to be long-term oriented. Similarly, the

relationship between a long-term orientation and

rm performance may be spurious if it is driven

by omitted variables. This concern is particu-

larly severe given that unobservable rm-level

attributes— such as managerial ability, investment

opportunities, etc.— are likely to drive both a

rm’s long-term orientation and performance.

In a nutshell, while empirically challenging,

exploiting a research design that provides a clean

causal estimate is essential to understanding the

impact of companies’ temporal orientation on

performance.

In this study, we attempt to overcome both obsta-

cles. Specically, we exploit a quasi-natural exper-

iment provided by exogenous changes in long-term

executivecompensation. The objective of long-term

executive compensation is to focus executives’

effort on creating long-term value, thus fostering

organizational long-term orientation (e.g., Cheng,

2004; Kole, 1997). Toobtain exogenous changes in

long-term compensation, we examine shareholder

proposals advocating the use of long-term execu-

tive compensation that pass or fail by a small mar-

gin of votes at shareholder meetings. Intuitively,

there should be no systematic difference between

companies that marginally pass long-term compen-

sation proposals with, say, 50.1percent of the votes

and companies that reject comparable proposals

with 49.9 percent of the votes. The passage of such

“close call” proposals is akin to a random assign-

ment of long-term incentives to companies and

therefore provides a quasi-experimental setting to

measure the causal effect of a long-term orientation

on rm performance. In the economics literature,

this approach of comparing outcomes just above

and below a discontinuous threshold is known as

“regression discontinuity design” (RDD). In this

article, the discontinuity arises because a minor dif-

ference in vote shares around the majority threshold

leads to a discrete change (that is, a discontinuity) in

the adoption of long-term compensation policies.1

Using this RDD approach, we nd that the pas-

sage of long-term compensation proposals leads to

a signicant increase in shareholder value. In par-

ticular, on the day of the shareholder meeting, a

proposal that marginally passes yields an abnor-

mal return of 1.14 percent compared to a proposal

that is marginally rejected. This evidence is con-

sistent with the view that a long-term orientation is

value-enhancing.

We further examine the effect of passing

long-term incentive proposals on operating perfor-

mance. Specically, we consider three measures

of operating performance (return on assets, net

prot margin, and sales growth). Regardless of the

measure, we consistently nd that operating per-

formance increases in the long run. Interestingly,

operating performance decreases slightly in the

short run (i.e., in the year following the vote), indi-

cating that an increased long-term orientation may

take some time to materialize into higher prots.

Arguably, this evidence suggests that managers

channel more resources toward long-term projects

that are costly in the short run, but pay off in the

long run.

To further explore this mechanism, we exam-

ine directly whether companies adopting long-term

compensation proposals are more likely to increase

their investments in long-term strategies such as

innovation and stakeholder relationships. We nd

1For a survey of RDD applications, see Lee and Lemieux (2010).

The RDD methodology is often seen as the sharpest tool of causal

inference since it approximates very closely the ideal setting of

randomized control experiments (see Lee and Lemieux, 2010:

282).

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J.,38: 1827–1847 (2017)

DOI: 10.1002/smj