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Investing for Productivity and Prosperity system in Japan provides particularly favorable treatment to capital gains on corporate stock, thereby reducing the pre-tax return that investors demand on these securities relative to others. Finally, a variety of features of the Japanese economy, including the interlocking structure of corporate ownership and the supportive relationship between government and business, have reduced the riskiness of investment. Even if investors demand the same compensation for a given amount of risk in the United States and Japan, the required return on Japanese stocks may be lower because the overall level of risk has also been lower. To summarize, direct measurement of interest rates and the saving shortfall in the United States indicate that the cost of funds to corporations for investment in the United States has been and likely will remain higher than in Japan and probably in other competitor countries. At least in Japan, assessments of risk have been historically lower than in the United States, so that similar companies face higher costs of funds in the United States. In the following section, we consider certain features of the U.S. tax system, particularly the double taxation of corporate income flows, that result in a still higher cost of capital for U.S. corporations and we also consider characteristics of the U.S. capital allocation system that cause hurdle rates to be above the cost of capital. HURDLE RATES, TIME HORIZONS, AND CAPITAL ALLOCATION SYSTEMS IN THE INDUSTRIAL COUNTRIES Michael Porter’s work strongly suggests that the investment behavior of corporations is not determined exclusively by macroeconomic variables and policies operating on the costs of funds and the cost of capital, although the latter are important.14 Investment behavior is also determined by a complex set of institutional structures and policies that influence both the interactions of the corporation with its investors in its external capital market and the distribution of funds inside the corporation in its internal capital market. There is a widespread conviction among analysts and practitioners that forces at work in the U.S. public capital markets cause corporations to focus on the short run more than is ideal for greater long-term growth. The relatively high cost of equity capital is one such force. The pressure to focus on the short run is greater than that exerted by differences in the cost of capital alone and leads to hurdle rates in the United States that 14 Michael Porter in the forthcoming companion volume.
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Investing for Productivity and Prosperity significantly exceed the cost of capital. These high hurdle rates are reflected in the significantly higher current reported profitability of U.S. companies compared to those in Japan and Germany. The board concurs that there is a tendency to overemphasize the short-run return on investment in the U.S. capital allocation system, primarily in publicly held companies. The structural differences among industrial countries in their systems for allocating capital both among and within enterprises to different kinds of investment projects are one of the keys to understanding the pressures affecting time horizons. These capital allocation systems can be thought of as including the macroeconomic environment, the external capital market environment, and the internal capital market environment. Michael Porter’s research, which focused on the United States, Japan, and Germany (which have directly competing industries), indicates that the capital allocation systems in these advanced industrial economies are strikingly different. Each system has its strengths and weaknesses, and it is important to identify the principal features of each before reaching conclusions about changes that might be beneficial for investment and growth in the United States. All three countries have public markets for investments. The U.S. system is significantly more advanced than that of Germany or Japan in creating public markets that are accessible, liquid, and fair in that no class of investors is either advantaged or disadvantaged. Japanese and German public markets are more volatile and less efficient and provide investors with less information than their counterparts receive in the United States. Although the average holding period for all stocks in the United States declined substantially in the past decade as holdings by institutional investors and other investment managers increased, participants in the Japanese and German public markets hold their stocks for even shorter periods. If the only force at work on the matter of time horizons for investments were public trading, the investor pressure on management in all three countries to produce for the short term would not be substantially different. In contrast to the situation of U.S. companies, however, short-time horizons characteristic of public markets do not have a great deal of influence on the management decisions of most major Japanese and German companies. That is because the owners of controlling shares and debt have a vested interest in these companies’ long-term success, seek to sustain their relationships with the companies, and see their success as their own. Their perceptions and dominant postures lead them to
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Investing for Productivity and Prosperity buffer management from the volatility and short-term behavior of public markets. In Germany and Japan most of the equity and debt of many major companies is held by owners acting as principals who are and regard themselves as committed long-term investors. Many of these major owners of equity also hold debt and have other relationships with the corporation, serving as bankers, suppliers, customers, and so forth. These relationships align their goals with the long-term health of the corporation rather than its current share price. Given their significant stake in the corporation, such owners accumulate extensive information through direct, ongoing, and sometimes intimate contact with the company and use this information and contact to influence management. Accounting statements are only one of many information sources. Generally, major Japanese and German owners do not share this sensitive information publicly or use it to trade in the company’s shares. Such “inside” owners generally set the management goals of German and Japanese companies. The principal management goal is to secure the corporation ’s long-run position in the industries in which it competes globally. Executives with deep understanding of technology and production, often the top managers, are involved in investment decisions in some detail, ensuring that the capital allocation process is not based solely on rate-of-return financial information but also includes qualitative considerations such as competitive developments and technological trends. This insider phenomenon is not often found in major U.S. companies. In the U.S. system the dominant ownership is by institutional and other investment managers who manage portfolios of securities for others and whose performance is measured frequently. Capital is fluid and moves rapidly between firms on the basis of perceptions of near-term appreciation opportunities. Although their portfolios are often huge, the investment managers typically hold only a small percentage of any particular company’s capitalization and have relatively little influence on the management.15 The reasons for such small holdings include regulatory restrictions on equity holdings by mutual funds, banks, and other holders; fiduciary considerations; and the nature of a particular portfolio (e.g., indexed funds requiring proportionality). The prevalent view is that in an 15 Strict limits are placed on the holdings of banks and on the involvement that institutional investors can have on the board of directors. This has the effect of separating the principal investors from management decision making.
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Investing for Productivity and Prosperity uncertain macroeconomic environment, no long-term opportunity for participation in a big way as an insider is worth losing the flexibility to buy or sell at any time that comes with being an outside shareholder. The investment managers tend to hold shares for relatively short periods, partly because their own performance is measured quarterly or annually, and partly because as outsiders they are not privy to information that could build confidence in the longer-term prospects or the ability to influence them. Dissatisfaction with corporate performance is expressed either by investors selling their stock or, in a few cases, forcing a change in the direction or even membership of the board of directors to whom responsibility for overseeing strategy is delegated. The net result in the U.S. system is pressure from investors on corporate management and the directors to shift the emphasis toward the shorter run and toward results measurable in financial terms.16 Thus, in the internal capital allocation process in U.S. public companies, outside owners usually have little knowledge about the allocation choices available and no direct influence on the decisions. Choices are delegated to management and monitored largely via current financial results. Management compensation in the corporation is based principally on current financial performance or is in the form of stock options that usually are exercisable with little delay and therefore reinforce a sensitivity to current share price. Information flows within the corporation are comparatively hierarchical and limited. Top management that often is neither technically trained nor substantially involved in the details of the business relies heavily instead on financial reports. Too often, management’s goal is maximizing shareholder value, measured in terms of short-term share price. We do not mean to suggest that the short-run performance of the corporation is unimportant. The point is rather that in the U.S. capital market system, with its far greater reliance than elsewhere on institutions making investment decisions as fiduciaries for others, it is more difficult for publicly owned companies and financial investors to maintain an appropriate balance between short- and long-run investment. Exceptions exist to these general observations about each of the three countries, and in some cases the current trends may somewhat alter the picture. Generally, the differences among the three systems are substantial. The nature of the U.S. system also has another, seemingly unrelated, 16 Experienced members of the STEP board and others have observed that corporations that go public with an initial offering of stock exhibit a distinct shift in priorities.
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Investing for Productivity and Prosperity consequence. It has often been observed in recent years that some large, mature companies have wasted resources on investments with little prospect of success, maintained excessive overhead, hoarded cash, and misdirected resources to unwise diversification. These problems, which appear to have afflicted a number of companies in mature or declining industries, may have the same root cause: lack of effective monitoring of management because of fragmented ownership and limited owner information and influence in corporate decisions. This cause should be addressed directly rather than through costly proxy battles and takeovers, which take place only after performance has severely deteriorated. In short, there are tradeoffs with respect to corporate governance. In the Japanese and German systems, important classes of investors have inside information and a role in corporate governance. The near-permanent nature of their holding mitigates asymmetries in information available to them compared with other classes of investors. In the United States, fairness is maintained by preventing nearly all investors from having special access to information or influence on management. This extracts a cost, however, in terms of the balance between short- and long-term investment in established public companies and the ability to free up resources from companies with no profitable investment opportunities. In the United States there are some notable exceptions to these corporate biases against longer-term time horizons and investments. Indeed, the investment and capital allocation systems that support entrepreneurial ventures are remarkably similar in important respects to the capital allocation systems in Germany and Japan for larger, well-established enterprises.17 In the United States, venture capitaists own major stakes in companies, sit on corporate boards, are deeply informed about investment choices, are influential in corporate decisions, and expect to retain a substantial stake in the venture for a number of years. This does not violate principles of fairness because virtually all of the investors in companies in the start-up phase have access to what would be viewed as “inside information” in a publicly held company. The one significant contrast with the Japanese and German systems is that in these new U.S. ventures, managers and employees typically also own stock as a result of the compensation policies that senior management and venture capitalists adopt. This further aligns investment and employee interests around long-term performance. 17 Burton McMurtry in the forthcoming companion volume. For a more detailed treatment, see W. Sahlman (in press).
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