The idea that a company's primary purpose is to enrich its shareholders is the "dumbest idea in the world", according to high-profile GMO strategist James Montier, who warns that the so-called shareholder value model is "creating and storing up economic problems that simply won't go away".
Speaking at the recent CFA Institute European Investment Conference in London, Montier suggested the corporate world’s obsession with rising stock prices encourages underinvestment and chronic short-termism, to the detriment of shareholders and the wider economy.
Attitudinal change
The idea of shareholder value maximisation is typically traced back to 1970, when economist
Milton Friedman
famously argued the “one and only responsibility of business” is to “use its resources and engage in activities designed to increase its profits”.
Any act of corporate social responsibility, he added, does a disservice to company investors and is “an example of taxation without representation”.
Other academics and commentators built on Friedman’s thesis in subsequent years, arguing that chief executives were being paid like bureaucrats rather than “value-maximising entrepreneurs”.
Companies and their shareholders would continue to suffer from poor performance, the thesis went, unless chief executives were properly incentivised and rewarded for performance via generous stock option packages.
Over time, these academic ideas percolated into the wider business environment. Montier notes that in 1981, the Business Roundtable – a group of chief executives of major US corporations – asserted that corporations “have a responsibility to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment”.
By 1997, however, the same group said companies’ principal objective must be “to generate economic returns to its owners . . . if the CEO and the directors are not focused on shareholder value, it may be less likely that the corporation will realise that value”.
The evolution in attitudes certainly benefited chief executives. The old salary/bonus model was gradually abandoned: around two-thirds of compensation for chief executives now comes from options and stocks. Chief executives now earn more than 300 times the pay of the average worker, compared to a ratio of 46:1 in 1983.
Investors have done less well. Between 1940 and 1990, investors earned real returns of about 7 per cent, Montier estimates, roughly the same as the post-1990 world. However, adjusted for valuation changes, real returns have actually fallen to about 5 per cent over the last 25 years, he says. That points to investors actually being better off in the old managerial era.
Failures
There are many reasons for this, says Montier. For one, incentives do not work the way economists often think they will, he says. He cites experiments conducted by behavioural finance expert
Dan Ariely
, who found that higher bonuses can actually “discourage executives from working to the best of their ability”.
More crucially, the emphasis on share prices and on meeting quarterly earnings expectations has led to destructive short-term behaviour, as exemplified by a revealing Duke University survey of chief financial officers of listed companies.
The officers were asked if they would give the go-ahead to a great long-term project that comes along just before the end of quarter. In a scenario where the company would still beat earnings per share (EPS) by 10 US cents, 80 per cent would accept the project. That drops to just 60 per cent if the project resulted in missing EPS by 10 cents. If it led to a one-off EPS miss of 50 cents, only half would give the thumbs up to the no-risk long-term project.
In a short-term world, Montier argues, companies and executives have inevitably moved from a value-creation approach to one of value extraction. Today, the average S&P 500 company has a tenure of 15 years, compared to 27 years in the 1970s and about 76 years back in the 1930s.
The average chief executive sticks around for six years, compared to 10 years in the 1970s. He also points to falling rates of business investment over the last three decades, and the “enormous differences” between private and public companies – the former invest almost twice as much as listed companies. This parsimony among listed companies is especially evident in industries where stock prices are “particularly sensitive to current earnings”, according to one study, indicating decisions are motivated by “managerial short-termism”.
Buybacks
This reluctance to invest is contrasted with the explosion in share buybacks. Between 2003 and 2012, S&P 500 companies spent $2.4 trillion – more than half their profits – buying back their own stock, according to
William Lazonick
of the University of Massachusetts. Another 37 per cent of earnings went on dividends.
The old “retain-and-reinvest” approach, says Lazonick, has been replaced by one of “downsize and distribute”.
Montier agrees with Warren Buffett, who once opined that stock buybacks are usually done to "pump up or support the stock price". It may do so in the short term, said Buffett, but "buying dollar bills for $1.10 is not good business for those who stick around".
Lehman Brothers famously wasted some $1 billion buying back shares in early 2008, not long before it went bankrupt. Other banks were just as profligate, with America’s financial sector spending more than $200 billion on share buybacks between 2006 and 2008.
Share buybacks have hit record levels in 2014, to the extent that even institutional investors have become concerned.
Larry Fink of Blackrock, the world's largest money manager, wrote an open letter to corporate America in March, warning that "too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks". In July, the monthly Merrill Lynch fund manager survey found more investors than ever before believe companies are under-investing and few want more cash returns.
Defence
Others, like valuation expert and New York University finance professor
Aswath Damodaran
, caution against blind opposition to share buybacks.
“How many of you wish that Microsoft had not bought back $100 billion worth of shares over the last decade and instead pumped that money into more Zunes and Surfaces?” he asks.
“Or that Hewlett Packard, instead of paying out $60 billion to stockholders had bought three more companies like Autonomy (and written them off soon after)?”
Similarly, many see condemnation of the shareholder value model as simplistic.
Chief executives with a short-term focus are not doing their job properly, they say, as they are not maximising long-term shareholder value.
Nor are chief executives obliged to be slaves to the quarterly earnings game.
Aswath Damodaran notes that Amazon’s long-term bets on growth have been largely welcomed by markets over the years, with investors willing to look past disappointing earnings reports, while the same could be said of firms like Facebook, Apple and Google.
Still, while advocates suggest that the shareholder value thesis is distinct from short-term stock price maximisation, Montier argues that the rise in short-termism indicates the model has failed – a victim, perhaps, of the law of unintended consequences.
"Shareholder value maximisation has failed shareholders," he says; companies must return to the days when a rising share price "was a by-product, not an objective". CEO fireworks: 'I don't consider the bloody ROI' Sometimes, demands to maximise shareholder value can lead to fireworks. In February, questions regarding the cost and benefits of Apple's sustainability programmes were put to chief executive Tim Cook, followed by a request that the company commit only to doing things that are profitable.
“When we work on making our devices accessible by the blind, I don’t consider the bloody ROI [return on investment],” Cook replied, adding that the same was true about certain environmental issues and worker safety. “If you want me to do things only for ROI reasons, you should get out of this stock.”
