Search This Blog

Saturday, January 03, 2015

Maximizing Shareholder Value: the Dumbest Idea of All

James Montier of GMO may have hit on the reason why our economy remains in the dumps despite many trillions of central bank stimulus. The problem is that the idea of maximizing shareholder value is the dumbest idea ever.

Montier writes in The World's Dumbest Idea that Shareholder Value Maximization (SVM) has been a complete failure and has contributed to some worrisome economic outcomes. In fact, it was not Montier who came up with that “dumbest idea” moniker, it was Jack Welch, the revered former CEO of GE who first said it in March 2009. Montier shows that SVM is a very bad idea indeed.

He illustrates some of the problems with the bad performance in IBM. “In many ways that bluest of blue chips, IBM, represents a perfect microcosm of the general pattern of obsession with SVM.” In 1973, IBM's goals were:

  1. respect for individual employees;
  2. a commitment to customer service; and
  3. achieving excellence.

By 2010, IBM had narrowed their goal down to just one: doubling earnings in five years. To do that, they went on a tear buying back their stock to shrink the float and spread their earnings over fewer and fewer shares. This propped up earnings per share, but meant that capital investments languished—IBM was like the locomotive running down the tracks with the railroad engineer ordering train cars to be stripped of their wood and thrown into the fire to speed the train up! It's not a sustainable strategy at all.

It's no coincidence that IBM was the worst performing Dow stock last year, losing 20% of its value. Montier contrasts IBM's dismal performance with another Dow stock, Johnson & Johnson, which has stuck with an enduring set of goals:

We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products… We are responsible to our employees… We are responsible to the communities in which we live and to the world community as well… Our final responsibility is to our stockholders...When we operate according to these principles, the stockholders should realize a fair return.
Montier says:
The contrast between the two firms couldn’t be much greater. Whilst IBM targeted SVM, Johnson & Johnson thought shareholders should get a “fair return.” Yet, Johnson & Johnson has delivered considerably more return to shareholders than IBM has managed over the same time period.
The real problem comes from aligning managerial pay to stock performance. This is something we've been saying for some time now. When managerial pay comes from stock performance, managers will focus on the very short term and abandon strategies which bolster long term performance and hurt short term profits. The stock market is the sole focus for managers when this happens. Investments in plant and equipment, as well as research and development are avoided in order to buy back shares and distribute dividends to investors. Given this “pay me a lot now” attitude, the length of time corporate management sticks around the executive suite is dropping—”take the money and run” becomes the ongoing mantra.

Montier argues that SVM shares responsibility for the following negative trends:

  • declining and low rates of business investment;
  • rising inequality; and
  • a low labour share of GDP.

The fact that private firms invest twice as much as public firms simply confirms the pernicious trends in public companies. Public company management is returning capital to shareholders at a rate more than twice the historical average (50% versus 10-20% before the Global Financial Crisis). That returned capital is foreclosing the future for public companies. Capital returned to shareholders isn't going into the kinds of investments we need for a better future. In a very profound way, SVM is setting our economy up for long term failure.

If shares were undervalued, buybacks would make sense. But Montier writes:

Now, if one were feeling charitable, one might choose to suggest that there just weren’t many new investment opportunities, and thus this return of capital was a perfectly reasonable thing to do. If this were the case, one might hope that the buybacks were done at prices that were below intrinsic value (since this would have genuinely improved the lot of shareholders). However, as Exhibit 14 shows, this hasn’t been the case. When market valuations were high (prior to the financial crisis) a record number of buybacks were conducted. Conversely, at the market lows, firms were hardly doing any buybacks at all. As Warren Buffett said in his letter to shareholders back in 1999, “Buying dollar bills for $1.10 is not a good business for those who stick around.”
Income inequality is one of the biggest long term problems. Montier demonstrates that SVM is a primary contributor to the problem:
We can see this has been a driving force behind the rise of the 1% thanks to a study by Bakija, Cole, and Heim (2012). The rise in incomes of the top 1% has been driven largely by executives and those in finance. In fact, executives and those in finance accounted for some 58% of the expansion of the income for the top 1%, and 67% of the increase in incomes for the top 0.1% between 1979 and 2005. Thus, there can be little doubt that SVM has played a major role in the increased inequality that we have witnessed.
Montier comes to the following conclusions:
Shareholder’s Lesson

Firstly, SVM has failed its namesakes: it has not delivered increased returns to shareholders in any meaningful way, and may actually have led to poorer corporate performance!

Corporate’s Lesson

Secondly, it suggests that management guru Peter Drucker was right back in 1973 when he suggested “The only valid purpose of a firm is to create a customer.” Only by focusing on being a good business are you likely to end up delivering decent returns to shareholders. Focusing on the latter as an objective can easily undermine the former. Concentrate on the former, and the latter will take care of itself. As Keynes once put it, “Achieve immortality by accident, if at all.”

Everyone’s Lesson

Thirdly, we need to think about the broader impact of policies like SVM on the economy overall. Shareholders are but one very narrow group of our broader economic landscape. Yet by allowing companies to focus on them alone, we have potentially unleashed a number of ills upon ourselves. A broader perspective is called for. Customers, employees, and taxpayers should all be considered. Raising any one group to the exclusion of others is likely a path to disaster. Anyone for stakeholder capitalism?