Taking the long view

Last week’s Schumpeter column in The Economist discussed the pursuit of shareholder value as the leading ideology for corporate governance in the west, and the criticism it has been receiving lately.

The article concludes with the question whether there is really an alternative to running corporations first and foremost in the interest of shareholders. There isn’t, in spite of the perverse side-effects the implementation of this governance model shows (a false alibi for short termism, executive pay out of sync with productivity). Take a step back and ask why we consider shareholder value as the preferred principle of corporate governance. This is a relatively recent phenomenon that has risen to prominence in the 1980s in the US and UK. Until the 1970s, corporations had been governed using the principle of retaining and reinvesting earnings into corporate growth. Corporations accumulated capabilities, resources, employees, business units and grew into giants (some of them highly leveraged conglomerates that were viable only in the low-interest rate environment of the 1960s). During the 1970s, it became increasingly clear that the business units of these giant and diversified corporations performed less well than their more focused peers. One well-known example is the success of new Japanese competitors that challenged the US manufacturing industries. That lack of performance of industry giants was partly because of added complexity and bureaucracy. The benefits from diversification that resulted from the consistent retain-and-invest policy proved elusive, while the opportunity costs were very real [1]. Agency theory (a 1970s academic development) argued for the need for a takeover market, a market for corporate control that could discipline managers when their companies performed poorly. This (hostile) takeover market would blossom in the first half of the 1980s, with the junk bond as its central instrument, and the new institutional investor and the old US savings-and-loans institutions as prime participants.

Oil-induced high inflation levels of the early 1970s prevented US financial institutions to generate positive real returns for households. In 1974, this triggered a deregulation of pension funds and life insurance companies. From then on, significant parts of their portfolios could be invested in higher yield and riskier corporate equities, junk bonds and venture equity. As corporate shareholdings were transferred from individuals and households to mutual funds, pension funds and life insurance companies, the collective power of the shareholder to influence the return on equity on the assets they held increased. Subsequently, retail banks and savings-and-loans institutions were deregulated as of 1978 to allow them to compete with money-market funds for household deposits by allowing them to invest in riskier assets such as junk bonds. Meanwhile, the business model of investment banks changed from supporting corporations’ long-term investment activities (bond issues) to underwriting M&A deals and trading in government and corporate securities. Advances in IT allowed for the handling of larger trading volumes. A liquid takeover market was born.

Thus the focus on shareholder return increased. Giant corporations downsized, shed jobs and focused on their most profitable businesses. That doesn’t mean that today retain-and-reinvest is a thing of the past. Retained earnings still provide the bulk of corporate capital needs. Shareholders are happy for companies to plow back earnings into the firm, so long as it goes to positive NPV investments. Every positive NPV investment generates a capital gain for their shares. On the other hand, shareholders of mature companies with plenty of free cash flow but few profitable investment opportunities (e.g. telco’s) don’t always trust managers to spend retained earnings wisely and fear that the money will be plowed back into building a larger empire rather than a more profitable one. In such cases investors may insist on generous dividends. Not because dividends are valuable in themselves, but because they stand for a more careful, value-oriented investment policy that allows the investor to reinvest capital to its most productive use.

Shareholder value creation is a long term strategy (even if the future is discounted today) that satisfies all stakeholders. The shareholder is the entrepreneur, the specialist in taking on risk. The shareholder “insures” workers by buying their products (or their labor services) for resale before consumers have indicated how much they are willing to pay for them. The workers receive an assured income (in the short run at least), while the shareholder bears the risk caused by price fluctuations in consumer markets. The shareholder is legally the last in line to claim the company’s revenues. Only after all factor providers (employees for labor, suppliers for raw materials, banks and bondholders for debt) have received competitive compensation for the value they deliver to the firm, can the shareholder claim ownership of the remaining earnings and is shareholder value created.

Have the forces that created this focus on shareholder value creation changed today? They have not. Capital is more mobile and global than ever before. Any other governance model is an illusion, and that isn’t even a problem.

Economist (2012) Schumpeter: Taking the long view. The Economist November 24, 2012

Lazonick W., O’Sullivan M. (2000) Maximizing shareholder value: a new ideology for corporate governance. Economy and Society 29(1) (2000) 13-35

[1] Investors can diversify their portfolios more easily than companies because they only have to buy and sell stocks, something they can do easily and relatively cheaply many times a year. But for a corporation to substantially change a portfolio of real businesses involves considerable transaction costs and disruption, and typically takes many years.

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