In the 1970s, the idea that companies exist for the main (or even sole) purpose to maximize shareholder value started to gain traction as it was propagated by economist like Milton Friedman and Michael Jensen. Now, there is a good deal to be said for this.
It's a simple goal and it's success is easily tracked. The idea gained traction in practice with high level early proponents like Jack Welch at GE (who has since renounced it). The upside is that it ruffled feathers in boardrooms that got too complacent in the 1980s (but so did increasing international competition).
But there is no legal requirement that companies should focus exclusively, or even mainly on creating returns for shareholders. Director's fiduciary duties are to the company, not to its shareholders. Historically, it's also a fairly new idea, certainly along the timeline of joint-stock companies, which have existed for centuries.
We will look at some of the consequences and try to answer whether it has actually been good for shareholders themselves.
In order to align the interests of management and shareholders, the former were incentivized by making a big part of their pay dependent upon the performance of the stock price.
This is the main way to ensure that the company is run in the interest of the owners and is supposed to eliminate (or at least greatly reduce) the agency problem (the possibility that management, the agency, pursues other goals than those of its principle, the owners).
The main instruments of this performance pay were directly tied to the stock price. First granting options, and after a change in accounting rule, this has shifted somewhat to (restricted) stock.
Shareholder capitalism is now supported by a host of institutional arrangements that have resulted in it being hardwired into the corporate DNA and even that of the wider economy:
- Academic underpinnings by stuff like the efficient market hypothesis and the principal-agent theorem. The first argues that the share price has discounted all relevant information available and therefore is the best metric of corporate success. The latter alerts us to a possible divergence of interests between principal (shareholders) and agents (management) and the need to overcome these.
- MBA teaching, where the concept dominates.
- The market for corporate take-overs and activist investors.
- "Ambulance chasing" lawyers threatening class action lawsuits in case the share price takes an unexpected dive leading to risk avoidance in the boardroom.
- The pressure of Wall Street and the quarterly earnings expectations.
- The aligned incentives for management.
While in no way complete, economists which are familiar with the consequences of institutional arrangements will be familiar with such embeddedness of a concept which often has the effect that individual organizations cannot really diverge from its logic, reinforcing the latter.
For instance, companies that would focus on the long-term outlook, or fail to fire people in a downturn, or fail to provide quarterly guidance to analysts, etc., could easily face negative consequences.
There is another and more pernicious way that the singular pursuit of shareholder value becomes ingrained in society. When companies, in the name of shareholder value, begin outsourcing, cutting cost, emphasize quarterly earnings, park earnings abroad through tax havens, etc., this creates negative externalities and others are forced to follow (or receive the wrath of their shareholders).
Speaking of negatives, we think there are a number of downsides.
In this, and a subsequent article we will argue that shareholder capitalism has produced negative effects that have done some damage to the economy:
- Performance: there is some evidence that companies with huge incentive pay package actually perform worse.
- Investment: we'll show how the singular pursuit of shareholder value has affected investment demand, away from longer-term projects with more uncertain returns towards shorter-term projects with more certain returns. Away from projects expanding the top-line towards means to increase the bottom line, like lay-offs, cost cutting, and more especially high payout ratios (share buybacks and dividends).
- Motivation: "let's create some value for shareholders today" is hardly a great motivator, especially where employees are more likely to be considered as a cost item. The principal-agency theorem is also prone to affect trust levels, and the dramatic rise in inequality even within firms might also affect motivation.
- Inequality: Executive incentive pay and a greater emphasis on shareholder value and cost cutting has greatly contributed to rising inequality. This has shifted income from low savers to high savers, leading to.
Risk aversion and short-termism
With the share price as the main metric of success and determinant of managerial compensation and Wall Street obsessed with the quarterly earnings cycle it's likely to affect the types of investment a company pursues, away from those with a longer horizon and a more uncertain pay-back, towards those projects with a shorter horizon and a more certain pay-back, here is Prospect:
A recent study by McKinsey & Company, the blue-chip consulting firm, and Canada's public pension board found alarming levels of short-termism in the corporate executive suite. According to the study, nearly 80 percent of top executives and directors reported feeling the most pressure to demonstrate a strong financial performance over a period of two years or less, with only 7 percent feeling considerable pressure to deliver strong performance over a period of five years or more. It also found that 55 percent of chief financial officers would forgo an attractive investment project today if it would cause the company to even marginally miss its quarterly-earnings target.
This is also creating a bias towards cost cutting, as the payoffs are often more certain (witness the jump in share price that often follows substantial lay-off announcements) and can be obtained relatively quickly even if there are studies showing that layoffs do not generally result in improved profits.
While in no way conclusive, but it's nevertheless notable that investment as a percentage of GDP has been on a generally downward path since the early 1980s, with the dot.com driven second half of the 1990s as exception.
Value extracting versus value creation
It might be surprising to some, but the stock market has ceased to be a net source of funds for decades:
It is simply the case that there has been a secular uptrend of the payout ratio, the amount companies spend on dividends and buybacks as a percentage of earnings (it sinks during recessions).
Payouts are considerably exceeding corporate cash flow, from Zerohedge:
In other words, companies will spend promptly send every single dollar in cash they create back to their shareholders, and then use up an additional $115 billion from cash on the balance sheet, sell equity or issue new debt, to fund the difference.
Economist William Lazonick argues in Profits without Prosperity that we have moved from a retain-and-reinvest model that run until the late 1970s where companies:
retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth-what I call "sustainable prosperity."
This has given way to what he calls a downsize-and-distribute regime which emphasized cost cutting and the distributing the freed-up cash to financial interests. Despite a big increase in the profit share:
Corporate profitability is not translating into widespread economic prosperity. The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings-a total of $2.4 trillion-to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.
Indeed, the shift in this model is likely to have contributed substantially to a change in the economy at large. Here is the Washington Post (our emphasis):
Over the past decade, more than 90 percent of Fortune 500 corporations' net earnings have been funneled to investors. The great shareholder shift has affected more than employees' incomes. As Luke A. Stewart and Robert D. Atkinson noted in a 2013 report for the Information Technology and Innovation Foundation, business investment in equipment, software and buildings increased by just 0.5 percent per year between 2000 and 2011 - "less than a fifth that of the 1980s and less than one-tenth that of the 1990s."
This isn't a surprise. Lazonick again (or emphasis):
In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company's shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (NYSEARCA:EPS) targets. As a result, the very people we rely on to make investments in the productive capabilities that will increase our shared prosperity are instead devoting most of their companies' profits to uses that will increase their own prosperity-with unsurprising results.
There are some self re-inforcing mechanisms at work which could slow economic growth, creating a feedback loop:
- Low investment ultimately erodes the quality and quantity of the capital stock, leading to a decrease of productivity growth and a decrease of the growth rate at which the economy can grow without creating inflation.
- The distributional effects (which we'll discuss in more detail in a follow-up article) transfer money from low savers to high savers, eroding the growth of demand and reinforcing the tendency of firms to focus on cost cutting and the bottom line, rather than invest to expand capacity, reinforcing the cycle.
There is some justification for those that fear that the singularity of creating shareholder value might loosen some constraints on selfish impulses and moral constraints, here is Michael Lind in Salon:
According to a 2007 article in the Journal of Business Ethics, 31 of 34 corporate directors, each of whom served on an average of six boards of Fortune 200 corporations, agreed that their duty to shareholders would require them to cut down a mature forest or allow a dangerous, unregulated toxin into the environment, if that increased shareholder value.
This isn't so hypothetical, as the accounting scandals of the early 2000s testify or the work of journalist Joris Luyendijk on how many people working in financial institutions have managed to reduce or eliminate moral considerations during their office hours. From the FT book review:
Bankers are ever more vulnerable to "the call" from HR summoning them for the sack. Such a nerve-racking regime cannot but affect their behaviour. "If you can be out of the door in five minutes, your horizon becomes five minutes," says one. Meanwhile, the dreary imperatives of shareholder value mean that little matters to management other than the achievement of revenue targets. The best way to bring in money is still to design complex financial products or trading strategies - the risk of which sits principally on the shoulders of distant and unknowing investors. The reliance on so-called "quants" and their sophisticated algorithmic computer models means these are not only incomprehensible to outsiders but to many managers as well.
So in the name of creating shareholder value, the best way is to create products that can evade scrutiny by clients and superiors alike. If the former get shafted, too bad.
- Contrast this with the world in which elites were still morally bound and publicly spirited as described by Fareed Zakaria in his 'The Future of Freedom,' describing one sector and profession after another where the invasion of the profit motive eroded professional and civic spirit.
- Gaming the system, stock buybacks at certain times, accounting stock based compensation
No employee gets out of bed with the thought that today he/she is going to create a whole lot of value for shareholders. It's basically the antithesis of employee motivation, especially where they feel that the company they're working for doesn't have any loyalty towards them and are considered mostly as a cost to be minimized.
The same might even hold for the main beneficiaries, the executives who, whilst enjoying substantial pay packages, might be here today, gone tomorrow. Here is Jeroen van der Veer, former CEO of Shell, summing it up:
If I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse.
Do shareholders benefit?
While one can make a considerable case arguing that shareholder capitalism has not benefited the economy, and might as well have done substantial damage, what about its supposed main beneficiaries, the shareholders themselves?
The emphasis on shareholder value and would make sense if it led to better performance of companies. However, there is a various amount of research that fails to show aligning incentives between owners and managers improves their performance. Here is Robert Reich:
Professors Michael J. Cooper of the University of Utah, Huseyin Gulen of Purdue University, and P. Raghavendra Rau of the University of Cambridge, recently found that companies with the highest-paid CEOs returned about 10 percent less to their shareholders than do their industry peers.
And here is Bryce Covert citing another one:
Equilar, an executive compensation consultancy, compared the salaries of 200 highly paid CEOs to their companies' performance based on things like profitability, revenue, and stock return. Rather than showing a clear trend line linking pay and performance, the data is scattered. In fact, chief executive pay is only 1 percent based on stock performance, with 99 percent based on other things entirely.
Even shareholder value itself doesn't necessarily improve and the main beneficiaries are actually the executives, they have done extraordinarily well (from Prospect):
from 1933 until 1976-roughly speaking, the era of "managerial capitalism" in which managers sought to balance the interest of shareholders with those of employees, customers, and society at large-the total real compound annual return on the stocks of the S&P 500 was 7.5 percent. From 1976 until 2011-roughly the period of "shareholder capitalism"-the comparable return has been 6.5 percent. Meanwhile, according to Martin's calculation, the ratio of chief-executive compensation to corporate profits increased eightfold between 1980 and 2000, almost all of it coming in the form of stock-based compensation
This is highly ironic as the executives where the ones whose sloppiness and leeway shareholder capitalism was supposed to remedy.
But there is actually more to it. Even if all those options and shares issued for executive incentive pay don't show up in the profit and loss account, so they don't affect company earnings, they still come out of the pocket of shareholders in the form of dilution.
And a study by Wintergreen Advisers, a money management firm, argues (from the New York Times):
buybacks are aimed not necessarily at benefiting shareholders, but rather at offsetting the dilution that results from awarding stock to executives. That observation is reinforced by the fact that corporate buyback activity increases when stock prices are high - exactly the opposite of what prudent investing would dictate. In all, the study estimates that the shareholder costs of the dilutions, and the buybacks to reduce that dilution, at companies in the S.&P. 500 index amounted to 4.1 percent of each company's shares outstanding and 10.2 percent at companies with the highest combination of awards and buybacks.
Buybacks when stock prices are high (above intrinsic value) was compared by Warren Buffett to buying dollar bills for $1.10.
Shareholder capitalism isn't likely to create more shareholder value compared to alternatives. And there are some detrimental side-effects to the workings of the economy. It tends to boost inequality and through various means have a dampening effect on investment, motivation and might even erode morality. All of this is likely have some effect on economic growth.
These things are widely discussed in the economic literature, what's perhaps less well known is that shareholder capitalism isn't a guarantee for better shareholder returns. In fact, the big winners are the executives that shareholder capitalism were supposed to discipline.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.