The belief that companies exist solely to make their owners rich has changed the world, but done so by failing on its own terms.
Called shareholder value maximisation (SVM), this is the credo finding its origins in the thinking of economist Milton Friedman, which reduces the complex competing interests and objectives of companies to one: a rising stock price.
“The world’s dumbest idea,” investor James Montier of GMO labelled it in a talk at a CFA Institute event. “As shareholders, be clear: shareholder value maximisation has failed you. We have to consider the wider impact on society.”
This debate is at the heart of several disputes raging in financial markets and is perhaps best exemplified by the fallout around IBM’s disappointing earnings, which serve as an excellent illustration of the pitfalls of prioritising the return of capital, via share buy-backs, over longer-term investment.
The central problem with SVM is that it hasn’t demonstrably achieved its own aim, though it has led to a massive increase in the share of company resources paid out in compensation to top executives. That may be in part because a single-minded obsession with making quarterly earnings targets leads to systematic underinvestment in new opportunities, something we see in the marked trend towards a lower rate of capital expenditure and investment in the economy.
That’s because SVM is that terrible and dangerous thing: a human institution designed by economists who truly believe that people respond principally and reliably to incentives. Part of the back story, Montier argues, is a naive belief during the 1970s in the efficient market hypothesis, the idea that the market perfectly reflects the underlying reality of the stocks and bonds it trades.
Taking as its basis the idea that a rising stock was by definition the best indicator of the successful creation of value, it then went one step further and married this to the idea that providing lavish stock — and option-based incentives to executives would lead to the best decisions and outcomes.
There is only one problem with the whole SVM experiment: the results.
As Montier points out, the value created by companies since 1990, the era of shareholder value maximisation, is actually worse than during the 1940-90 managerial era, during which executives were paid in ways true-believing economists said was ‘like bureaucrats’. While both periods produced real returns of about 7 per cent a year, the bureaucratic age actually outperformed by about two percentage points a year when you isolate yield and growth.
More to the point, SVM has had a malign impact on how managers in big companies behave, almost certainly because under this system they are paid to make quarterly numbers in order to drive up their own takings as much as possible.
While the corporate investment drought post-2008 is one of the mysteries of the post-crash world, it is actually part of a long-term trend of lower private investment in the economy.
This is no surprise when you look at a study from Duke University, which found that CFOs of listed companies are willing to forgo projects which will produce positive net present value outcomes in order to make quarterly earnings. In other words, they feel they are obliged to play the earnings game even when it means passing on, well, maximising shareholder value.
A separate study found that publicly traded firms make far lower investments in response to opportunities than privately held ones. Public firms in some situations invest only about half as much.
That neatly dispels the idea that companies aren’t investing because they don’t see opportunities. It does suggest that public companies are setting themselves up, à la IBM, for a comeuppance. This is closely tied to how executives are paid, and to the shortened time horizons they feel they have to get their ‘share’.
This also implies a less dynamic and slower-growing economy.
And while equality of outcome is not the responsibility of investors, you can also argue that SVM, by pouring resources on top executives, makes an important contribution to the growing inequality in wealth and income in the US. This in turn leads to less growth, as lower-income people spend a higher proportion of the money they do get.
Remember too, that shareholders, who were supposed to be the prime beneficiaries of SVM, simply aren’t. Instead it is insiders who make out, while investors and the economy and society as a whole suffer.
All of this is actually not an economic problem but a cultural one, and cultural problems require cultural solutions.
It is time for a return to a managerial culture, with lower rewards and more longer-term thinking.
