12.18.2013

Compensate for long-term performance to fight short-termism

by Michael Roberge, MFS President and Chief Investment Officer

At any given time, there are dozens of financial analysts modeling earnings estimates on hundreds of companies for the next four, six or even eight quarters. That number falls once you get past 12 quarters to maybe a handful at best. When you get to 20 quarters — five years — the number of analysts writing earnings estimates on the world's leading companies drops to zero.

The average business cycle in the post-World War II period is approximately five years. Yet, many investors are focused on the next few quarters. The average holding period for a stock in the S&P 500 Index is now less than two years.


For a company to be judged and truly analyzed as an investment, shouldn't investors look at it over a full business cycle? Shouldn't they look at how that company does during the good times and bad, instead of making assumptions based on a short-term outlook?

The problem is that most research analysts are not being compensated to think about long-term earnings estimates. Their compensation structure is based on what they believe will happen over the next one or two years, or 20-40% of the business cycle.

We believe this fosters short-termism in the market, helping to drive down the average holding period of stocks. The result is stock trading — not stock investing — which increases the likelihood of volatility. That volatility rattles investors, especially individual investors, who need equity exposure to reach their long-term financial goals.

Based on industry flow data and our own surveys, we know that investors are hard-pressed to invest in equities and are turned off by market volatility and the fear of outsized losses. This fear trumps the business cycle and works against investors' long term interests.

For an active manager like MFS, our analysts are more focused on three- and five-year earnings estimates and trying to understand companies through the full business cycle.

Why? Because the true measure of how effective a company is — its strengths and weaknesses, the capability of its management team, its stewardship of capital — is best measured in the context of a full business cycle. In turn, we compensate our analysts on how well they are able to analyze companies over the long-term. In fact, our compensation structure puts a heavy emphasis on three- and five-year performance.

As an active manager, we look for opportunities to invest for the long-term. We look for companies with sustainable earnings that can grow over time, with high competitive barriers to entry and the ability to generate significant free cash flow. In order to do this, we must tune out the short-term noise and consider a company's long-term prospects. Otherwise, we are simply stock traders, not investors.

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