Do Investors Stifle Innovation? (Part I)

Note: This is the first of two related posts.

In his latest New York Times Magazine column, Adam Davidson writes, "from a C.E.O.'s perspective, long-term R. and D. is a lousy investment...the C.E.O. of DuPont who retired three years ago, told me that it's tough to get investors to think more than two years ahead — at most.'"

To continue the discussion, we asked two economists on different sides of the debate - Baruch Lev of New York University and Shivaram Rajgopal of Emory University - to answer the following question:

Are investors pressuring CEO's to cancel long-term R&D projects?

Baruch Lev's response is below. To read Shivaram Rajgopal's response, click here.

I fully agree that US competitiveness and economic growth will benefit from increased basic—paradigm changing—research. I take issue however with the argument that investors' short-termism (myopia) is a major obstacle to enhanced research. I would argue, based on solid evidence, that investor short-termism is a myth. Let me elaborate:

The alleged investor short-termism is generally attributed to those "trigger happy" investors (money managers, hedge funds, investment bankers) who report their investment results quarterly, and therefore, presumably, press CEO's to "sacrifice the long-term" (such as cutting basic research) to maximize quarterly earnings.

If the amount of corporate basic research had anything to do with investors' myopia, then basic research would have continuously declined as the dominance of institutional investors increased. Data from the National Science Foundation (NSF) clearly shows that this was not the case. Basic research was 3.4 percent of total corporate R&D in 1980, and—hard to believe—3.5 percent in 2007. During those three decades, institutional investors gradually gained a dominant role in capital markets.

The main reasons for the scant basic research are the high uncertainty of research outcomes and the difficulties of the producers to capture the benefits of this research. Massive intellectual property theft around the world and frivolous patent infringement lawsuits by opportunists (trolls) make basic research a highly risky proposition that many companies can't afford (unless they are monopolists,like AT&T until the early 1980s,whose famous Bell Labs engaged extensively in basic research).

The solution to this sorry state of affairs is clearly not in curing investors of their alleged myopia, rather in strengthening intellectual property protection worldwide, and alleviating the threat of frivolous and costly patent infringement lawsuits.

And now briefly to investors' myopia. This indeed is a widely-held misconception. While there are some short-term investors—and there is nothing wrong or unethical about that—capital markets are clearly dominated by long-term investors. How else to explain the relentless increase in intangible, long-term US investment (R&D, information technology, brands, human resources), growing from 4 percent of business output in 1947 to 14 percent in 2007 (while investment in physical assets decreased from12 to 10 percent)? In my recently published book, I present large-sample, rigorous studies corroborating the capital markets dominance of long-term, patient investors.

The belief in investor myopia is not just a benign misconception. It leads to harmful decisions by corporate managers and misplaced policy proposals. Hence the importance of thoroughly understanding investors' attitudes toward managerial decisions.



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