This is the continuation of the article published in last week’s edition which among other things looked at why the shareholder value theory has no legal foundation.
The article posited that legally, no statutes require that companies be run to maximise profits or share prices. In most states, corporations can be formed for any lawful purpose.
The shareholder value theory has proven to be a bust in practice. Here are some of the reasons:
It produces short-termism, underinvestment, and a preoccupation with image management. We wrote in 2005 for the Conference Board Review about how the pre-occupation with quarterly earnings led companies to underinvest on a widespread basis. Richard Davies and Andrew Haldane of the Bank of England demonstrated that companies were using unduly high discount rates, which punished long-term investment. Pearlstein provides more confirmation:
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 per cent 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 seven per cent feeling considerable pressure to deliver strong performance over a period of five years or more. It also found that 55 per cent 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.
As we have stated before, we’ve been hearing this sort of thing from McKinsey contacts for more than a decade. And the “55 per cent” figure likely understates the amount of short-termism. First, even in a presumably anonymous survey, some CFOs might be loath to admit that. Second, for any project big enough to impact quarterly earnings, the CFO is almost certain not to have the final say. So even if his team approves it, it could be nixed by the CEO out of concern for earnings impact.
It empirically produces worse results. We have written from time-to-time about the concept of obliquity, that in a complex system that is affected by interactions with it, it is impossible to map out a simple path to a goal. As a result, other approaches are typically more successful. From a 2007 Financial Times article by John Kay who later wrote a book about the concept:
Obliquity gives rise to the profit-seeking paradox: the most profitable companies are not the most profit oriented. ICI and Boeing illustrate how a greater focus on shareholder returns was self-defeating in its own narrow terms. Comparisons of the same companies over time are mirrored in contrasts between different companies in the same industries. In their 2002 book, Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras compared outstanding companies with adequate but less remarkable companies with similar operations.
Merck and Pfizer was one such comparison. Collins and Porras compared the philosophy of George Merck (“We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear. The better we have remembered it, the larger they have been”) with that of John McKeen of Pfizer (“So far as humanly possible, we aim to get profit out of everything we do”).
Collins and Porras also paired Hewlett Packard with Texas Instruments, Procter & Gamble with Colgate, Marriott with Howard Johnson, and found the same result in each case: the company that put more emphasis on profit in its declaration of objectives was the less profitable in its financial statements.
Some more commonly cited reasons for why a focus on shareholder value hurts performance is that it dampens innovation. Pearlstein describes another, how it demotivates workers:
Perhaps the most ridiculous aspect of shareholder–über-alles is how at odds it is with every modern theory about managing people. David Langstaff, then–chief executive of TASC, a Virginia–based government-contracting firm, put it this way in a recent speech at a conference hosted by the Aspen Institute and the business school at Northwestern University: “If you are the sole proprietor of a business, do you think that you can motivate your employees for maximum performance by encouraging them simply to make more money for you?” Langstaff asked rhetorically. “That is effectively what an enterprise is saying when it states that its purpose is to maximise profit for its investors.”
And on a societal level, it erodes social capital and trust, which are the foundations for commerce:
It is our social capital that is now badly depleted. This erosion manifests in the weakened norms of behaviour that once restrained the most selfish impulses of economic actors and provided an ethical basis for modern capitalism. A capitalism in which Wall Street bankers and traders think peddling dangerous loans or worthless securities to unsuspecting customers is just “part of the game,” a capitalism in which top executives believe it is economically necessary that they earn 350 times what their front line workers do, a capitalism that thinks of employees as expendable inputs, a capitalism in which corporations perceive it as both their fiduciary duty to evade taxes and their constitutional right to use unlimited amounts of corporate funds to purchase control of the political system—that is a capitalism whose trust deficit is every bit as corrosive as budget and trade deficits.
Many elite professionals are deeply upset with Trump’s win. Yet the ideology that he represents is very much in line with the logic of corporate raiders, many of whom, like him, went to Wharton Business School. And many elite professionals, in particular lawyers and consultants, profited handsomely from the adoption of the buccaneer capitalist view of the world and actively enabled much of its questionable thinking and conduct. As CEO pay rose, so did the pay of top advisers. They couldn’t be all that good, after all, if they were in a wildy different income strata.
So as Lambert has warned, unless we hear a different economic and social vision from The Resistance, which looks troubling to have more failed Democratic party influence behind it than either of us like, the best we are likely to get is a restoration. And if you remember the French Revolution, strongman Napoleon was succeeded by the Bourbon Restoration, which then led to the Second Empire under his nephew. So if we want better outcomes, status quo ante is not good enough. —