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Fallacy of Downsizing
Short term thinking and under investing
In a BBC interview in April, Elon Musk stated that he laid off more than 6,000 people at Twitter since taking over the company, shrinking the company from 8,000 employees to just 1,500. Over the past twelve months, Twitter was not the only tech company to conduct layoffs. According to Intellizence, there have been over 2,400 companies announcing layoffs since January 1st, 2023, including Amazon, Meta, and Microsoft. The impact of layoffs on these companies are still to be determined but for Twitter, Musk recently announced that revenue was down 50%. Is there a cause and effect here?
Let’s do a little literature review. A quick search for scholarly articles yields results such as this meta-analysis of 113 sources that showed “post-downsizing financial outcomes are generally negative…” and “...managers believe downsizing is effective, despite empirical evidence to the contrary.” You also can easily find articles such as this “Dumb and Dumber: The Impact of Downsizing on Firm Performance as Moderated by Industry Conditions.” While the paper’s title says it all, it does state in a more professional manner that, “After controlling for a set of industry and firm-level variables, including firms’ prior performance levels, our results indicate that downsizing is associated with decreases in subsequent firm profitability and that these negative effects are more pronounced in industries characterized by research and development (R&D) intensity, growth, and low capital intensity.” Researchers in The Journal of Business Research, using data from 4,710 publicly traded firms concluded that, “downsizing firms are significantly more likely to declare bankruptcy than firms that do not engage in downsizing and that intangible resources help to mitigate this likelihood.” Adam Grant, an American author and professor at the Wharton School of the University of Pennsylvania, tweeted this in Feb 2023:
So if years of research and data shows that layoffs are generally a bad idea, especially for companies that rely on R&D and knowledge workers, why do they continue to do so? Well, remember that list of companies that I mentioned had announced layoffs this year, Amazon, Meta, and Microsoft? Right after layoffs, shares of Microsoft (10,000 employees laid off) were up 6%. Amazon stock was up 19% and shares of Meta are up nearly 50%, all after layoff announcements. Data analyzed by Bloomberg showed that on average, large U.S. tech companies saw their stocks rise 5.6% in the month following their announcement of job cuts. I’m not going to claim that the large amount of stock-based compensation for executives is the sole influence on these decisions because there are a lot of other factors as well, including the pressure from the board and investors. Even if an executive is personally willing to take a hit to their own compensation in the short term for the benefit to the company and themselves in the long run, many investors are not.
There are lots of ways to look at how short term focused the stock markets are. One way is the average daily trading volume (ADTV), which is the average number of shares traded within a day in a given stock. The NASDAQ has an ADTV of over 5 billion shares worth over $250B which is about four percent of the entire market. Another way to view this is the Annualized Turnover Rate, which is a measure of the percentage of a portfolio's holdings that have been replaced over the course of a year. For the NYSE this has been as high as 158% in 2008 and as low as 54% in 2014. A third way to analyze the short term focus of the markets is the stock market turnover ratio which was reported at 68.43 % in 2019 for the US, according to the World Bank collection of development indicators. No matter what measurement you use to look at it, the stock markets are fairly short term focused, which by extension means that companies have a lot of pressure to maintain a short term focus as well. Now, there are, of course, lots of reasons that the market and traders like high volumes of trades including that it helps traders gauge the ease of buying or selling a security without causing significant price movements and it provides insights into the potential volatility of a security. But, the impact on businesses is more short term thinking and thus taking actions that reinforce this mindset.
So like most things in life, there is a necessary balance. The markets benefit from more of the short term thinking but most businesses benefit from more long term thinking. However, layoffs and their often negative impact on the company aren’t the only result of this pressure. What usually doesn’t make the headlines, like layoffs do, is underinvesting. Companies under pressure for short term results can often under invest in long term projects because they don’t produce results that are reportable that quarter. I’ve cast blame before in this newsletter on the SEC ruling in 1970 that mandated quarterly reporting as a factor in this. An article from the United Nations Global Compact states, “The short-term performance pressures on investors result in an excessive focus on quarterly earnings, with less attention paid to strategy, fundamentals and long-term value creation. Many companies respond to these pressures by reducing expenditures on research and development and foregoing investment opportunities with a positive long-term net present value.” Former Pepsi CEO Indra Nooyi, reflected that quarterly reporting regulations made her pay undue attention to producing short-term results.
Whether your company is taking radical actions such as layoffs or more muted responses such as under investing, both are potential signs that you are focusing too much on the short term. There are of course times when these actions are necessary, sometimes for the very viability of the company, but in many of these companies they were highly profitable before the layoffs (2022 EBITDA for MSFT $97.8B, META $37.6B, AMZN $54.2B). Twitter's annualized EBITDA for the quarter that ended in June 2022 was $-557M. Would Twitter have been better off working their way to profitability instead of cutting 80% of its staff? I would argue ‘yes’ but then again, I don’t think the purchase by Musk was really about turning the company around as much as it was a desire to own a media outlet. Billionaires have been acquiring media ownership for well over a century, with plenty of them still living large today, including the Bloomberg, Hearst, Newhouse, Murdoch, and Ochs-Sulzberger families. In more modern times we’ve seen Jeff Bezos: The Washington Post, John Henry: The Boston Globe, Glen Taylor: Star Tribune, and Marc Benioff: Time, just to name a few. So while Twitter is an interesting case study in almost real time of the impact of cutting staff, it’s likely not a case study that the rest of us can rely on because of so many other factors at play. But that still leaves plenty of data around the negative impacts of layoffs and the risk of under investing for the long term success of our businesses.