Back in March the FT reported that Jack Welch, the former chief of General Electric and champion of shareholder value since the 1980s, had declared the idea that company managers should concentrate on it to be ‘dumb’. His apparent conversion prompts one to ask how different interpretations of shareholder value might influence business behaviour, and what might be the economic, social and political implications of that.
Peter Johnson, trained as an accountant, is head of finance at technology company Artihmatica . He has spent his career in various finance roles in the City of London.
Now, ‘value’ can mean several different things. It may refer to an absolute quantity, or a difference between two quantities, or a ratio of two quantities. Examples might be, respectively, a utility, a profit, and a rate of return. An enterprise may therefore aim to pursue a number of non-financial utilities, to achieve revenue or gross margin or profit targets, to produce a given rate of return on investment (“ROI”), and perhaps also to control risk. It may seek a blend of these, perhaps through a process to reach agreement between many stakeholders. Notions of value are held by many people and we cannot assume that they all think about it in the same way, or even that they agree about the nature of the thing being valued. And one could think of kinds of value that cannot be maximised or set off against others because they don’t vary along any kind of scale. Establishing exactly who your constituencies are and what they think and want may turn out to be rather complicated.
It is worth making these distinctions, because different value objectives are often spoken of interchangeably and precisely when in fact they may be incompatible and incalculable. Business managers’ actions will therefore depend on the relative importance to them of a range of alternative values that they might pursue and on how those values are arrived at. The purpose of this article is to consider particularly the interrelationship of shareholder objectives and business practice.
Many ‘traditional’ shareholders – for example, owner-managers or states – may take a long-term view of the capital value of their stake or may not think about it at all. Broadly speaking, the predominant interest of these parties is in running the business and developing products and services. They will of course pay attention to finance, and be very focused on the profits or cash produced by the enterprise. These are the rewards of past success and also the resources it can re-invest to generate profits or cash in the future, and so indicate both the sustainability of the business and its total value.
Capital markets liberalisation, however, brought a different constituency to the fore: professional financial investors such as fund managers, insurance companies, venture capitalists, and private stock market players. These investors have their own business – making decisions every day about where to put their or their clients’ money. The separation of ownership and management means investors are likely to be indifferent to what the companies they invest in make and how they make it. Their purpose is not to build an enterprise to make goods or services, but to back one in order to make money: that is the sole basis of their decision to invest. Capital markets are now overwhelmingly places where investors trade with each other. What one might think is their essential function – the provision of capital to business for investment in production – has become secondary to portfolio management activity.
Large investors may use very sophisticated analysis tools, and others don’t need to use any. The common thread is an assessment of the expected rate of return on capital and the risk profile of the securities held. Holdings are switched if doing so would increase the rate of return or reduce risk within the desired risk-return framework. The rate of return most often used is the profit arising from the investment in a given time divided by the sum invested – a ratio. The fact that the profit ratio is measured over time is key: the rate of return is a measure of the efficiency of capital allocation, something qualitatively different from the long-run or aggregate profit that might be earned.
These key elements apply to un-traded, private company shares as well as to publicly traded securities. Anyone who has tried to raise capital from venture capital funds, for example, will know that after a quick description of the business idea, the questions are, How big can it get? and What’s the exit? The investors want high returns and are more concerned about getting out than about getting in. Though what follows is expressed in terms of public markets, it is mutatis mutandis applicable to private capital too.
In an open capital market companies want to hold on to investors. Even if today’s shareholders do not directly provide capital, investor confidence is a signal of the overall health of the company and its withdrawal can lead to the company’s operational collapse and make it impossible for the company to raise cash from any sources. So if your investors want to maximise their returns and you want to keep them, you will very likely allow return maximisation to become a business objective and adopt strategies to deliver it.
Now we know that equity markets do not always accurately reflect future long-run profit expectations or a business’s sustainability, and one reason for this may indeed be that expected outcomes from business managers’ actions do not entirely meet investors’ demands, which in turn drive market prices. Conversely, it wouldn’t be surprising if a business that was well aligned with meeting stock market demands didn’t also compromise some things that don’t directly lead to a strong share price but are nevertheless of value to other people.
The issue is one of priorities. Market and internal pressures to keep the share price – and also inevitably option plans – ‘performing’ lead business managers to prefer operational strategies to further that end. What might these be?
1. Since sales prices for non-monopolies are hard to manipulate and investment in long-term research and development is expensive and uncertain (and often involves government help), the emphasis will be on either reducing costs and capital employed or compressing the timeframe within which the company allocates funds to business areas, builds them up, and then takes profits.
2. The drive to increase the efficiency with which capital generates returns is likely to include outsourcing, franchising, or the use of overseas or unregulated production facilities, all of which employ someone else’s capital.
3. Where possible, companies will try to acquire market power that will allow them to increase returns and so be rewarded by investors. Examples of sources of market power are the legal monopolies granted over intellectual property or land use rights, dominance of a customer market (think Microsoft or Intel) or of suppliers (think supermarkets), or sometimes cartels, corruption, and so on. Companies with strong stock prices will tend to have established one or more areas in which to exert market power.
4. Questions of product quality, working conditions, and environmental sustainability will drift down the agenda, certainly insofar as they do not contribute to near-term financial results. Progress in all these areas takes time to yield benefits for anyone, let alone the company.
5. Mergers and acquisitions are a good way to keep the investors’ plates spinning on the promise of increased returns. In reality, M&A activity is rarely stimulated by a desire to make a better locomotive or happier customers, and is conventionally justified to the market in terms of market share, ‘efficiencies,’ and higher returns.
6. Financial engineering is another important way to increase shareholder returns without actually making anything. The huge growth, especially in a financial sector whose purpose is to make financial returns, of complex international corporate structures, off-balance-sheet finance, synthetic or structured investment products, and derivative instruments was largely driven by this need.
7. Excessive risk taking may also arise, especially if companies are oversupplied with capital and scrambling for returns. A recent example is AIG’s suicidal purchase of mortgage-backed securities using billions of dollars received as collateral from a stock lending programme that was itself only a means for speculators to make a turn short selling quoted shares owned by AIG. More generally, increasing debt or ‘leverage’ as the experts say, is a good way of screwing up shareholder returns...
8. Companies may also resort to tax avoidance and sundry disingenuous reporting from greenwash to edgy interpretations of accounting or disclosure standards. At the extremes, they may engage in illegal tax evasion or false accounting.
All the above are instances of operational strategies that are wasteful or positively harmful for society but may be adopted to produce returns for today’s investors. In that sense, they can all appropriately be called short term.
Short termism may therefore be less a disease of managers than a consequence of investor mobility and competition for financial returns. The end result is that capital is not allocated in a socially efficient way. Unless we believe that investor returns are the only measure of an enterprise’s contribution to human welfare over any term, we cannot escape the need to make choices.
Who needs returns?
The ROI is a significant consideration for many businesses and the driving principle of some, especially in the financial sector where ‘return on capital’ is the operational objective. But maximising the ROI can be incompatible with optimum social utility. Does it follow that the rate of return should be eliminated from business decision processes? Well, possibly.
ROI is often used in business to compare alternative uses of the same amount of capital. Consider for example a choice between two projects each requiring an input of 100, say in manufacturing machinery with a given production capacity and life. Project / machine A returns 115 in one year, and project / machine B returns 60 a year for two years, or 120 in total. Which to choose? We can’t say that it depends on your cost of capital, since that is only another way of saying your required rate of return. The question is whether the rate of return is the right measure, and that cannot be answered by referring to the time value of money.
ROI gives suspect results in comparing unequal capital outlays. Suppose a company is considering two alternative investments to start a new business area. Option A requires input of 100 and offers a profit of 10 and option B requires input of 30 and offers a profit 6. A company with 100 of capital available would maximise profit by choosing A, but maximise ROI (20% vs 10%) by choosing B and returning or not raising 70 of capital. This is especially clear if the whole company currently ‘yields’ more than 10%, since project A would ‘dilute earnings,’ as the jargon goes: it would reduce earnings per pound invested even though total earnings increased. In fact, if the company’s current yield is over 20%, it may do neither project and instead hand out the whole 100 in dividends or share buy-backs. This is not self-evidently the best outcome for either the company or society as a whole, even though it is what efficient capital markets are meant to encourage. Many businesses recently bailed out by governments were under-capitalised, partly, we might suspect, because of the urge to keep shareholder returns as high as possible.
Finally, consider the replacement of a broken IT system that an organisation, say a regulator, needs to keep working. It is meaningless to bother with ROI since the ‘return’ is (a) a non-financial utility that can’t be computed, and (b) the utility is binary and can’t be compared with alternatives on any continuous scale. Yet even here ROIs are routinely called for and debated.
Where now?
We need to change the language of the discussion. It is time to address the objectives of investors, business, and the rest of society and how those objectives are pursued. This process goes far deeper than regulatory reform: it asks us all to think about what the economic system is for and about what balance of utility, profit, and risk we want to reach.
Markets are often said to be value-free and consequently the things done there acquire an odour of natural law or inevitability. But this is an incorrect view of markets. They are not value-free externally given structures. Markets are places where social exchange happens and embody political, moral, and psychological values through the participation of the people who use them and in doing so give the markets their particular forms. There is nothing special about markets.
Choices are necessary, and many are present in the system already: rules about safety, environmental pollution, product quality, treatment of employees, financial disclosure and so on pursue social utility objectives at the expense of profit and return. But public discourse still tends to focus on ‘red tape’ and ‘imposing costs on business’ as if the unbridled market was a norm which was being interfered with, and as if businesses were somehow not really part of society. It is no surprise that compliance with regulations is often grudging or dishonest.
Whilst politicians, media, and the general public may decry greed and preach responsibility, public policy often contradicts the fine words. For example, in the UK privatisation is routinely stated to be a means of providing public services at lower cost to the taxpayer. But if ‘low cost’ or ‘value for money’ is all we’re interested in, are we not perpetuating the mistake, thinking the financial outcome is all that matters? We should not be surprised that the quality and quantity of what is provided suffer. Or in the US, the Treasury helps out the banks by marketising worthless junk bonds, providing an ‘investment opportunity’ to the people who issued the junk in the first place.
In the short term...
Short termism, bonus ‘cultures’, business irresponsibility and so on are serious problems. But tough talk about executive pay misses the point that corporate executives are often only working out the logic of a portfolio-manager-oriented financial system. Of course, they have a huge interest in maintaining the status quo, and must we not excuse wrong-doing or swallow the story that clever bankers were ‘bound’ to play a bad system to the limit – what on earth does such an exculpation add up to? But the fact remains that we are all, if not directly then through insurance policies, pension savings, investment products, or bank deposits, participants in this system. We cannot stand outside and point the finger in.
So what might encourage longer term decisions? Ultimately, it means restraining the return-driven investor and changing how we think about economic performance. To repeat the point, by proxy if not directly, we are all return-driven investors. It is an immense project.
More immediately, alongside the search for a new consensus on what we want for our societies, we might make a practical start with incentives to hold shares for longer, a different kind of reporting and accounting, and by testing some new legal and governance structures.
To have and to hold
In the context of shareholder incentives, the FT’s Lex column has proposed reducing the tax on dividends for long term shareholdings, ultimately to zero. This is partly motivated by the complaint that dividend income – at least in the UK – is taxed twice, once in the company on its profits, and then again when received by the shareholder. Alternatively, one could tax gains from long term holdings much less than gains from short term holdings, or increase share transactions taxes.
It is hard to judge what unintended consequences might flow from such moves, and the trouble is that even if they are not susceptible to avoidance schemes (and we should assume the best commercial lawyers will think of some), we end up trying to influence behaviour by changing the numbers, when the real task is to change the objectives. It is, in essence, an accountant’s proposal.
What kind of beans should we count?
Backward-looking financial statements are prepared by accountants and audited by auditors who are also accountants. They deal in financial quantities for which many complex and sometimes contentious valuation and disclosure rules exist – written and often only understood by accountants. Broadly speaking, historical financial statements (for example, of banks and insurance companies), containing all manner of unreal financial numbers are in disrepute.
The accountancy profession has shown few signs of self-criticism about its role in the financial chaos. Only in June’s Accountancy (the UK profession’s official reading), Lord Mandelson told auditors: “We must be particularly careful that going concern disclosures do not cause an unnecessary loss of confidence in healthy companies.” Which is very nice, but it might have been more pertinent to ask why they said nothing about companies that were unhealthy.
But finance directors and auditors and regulators had no idea. The people who currently do the corporate accounting, verifying, and regulating inhabited a system that failed the investor community and everyone else, not because of a few shortcomings that can be fixed, but because the whole system was designed to support investor markets and the kind of operational manoeuvres I’ve described above. From the inside they could not have seen where it was going, let alone have changed course. Is there any hope of restoring confidence in corporate reporting? What should be reported in what way, and to whom, and who should decide this? How can we tell that the people reporting know what they’re talking about and are not conflicted? What is the social value of commercial confidentiality? Can change come without throwing everything away and starting again? How could one throw everything away? How much do we need accountants to do the accounting, just as we apparently need ex-bankers to do the banking?
I propose no answer to these questions here, but they do, in my view, call for a non-specialist public and political engagement. Government cannot impose a system by itself, but it can take a lead in developing, together with all interested parties, a better framework for the provision of socially useful information about what companies do and propose to do.
Just how dumb is the shareholder?
“On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy... Your main constituencies are your employees, your customers and your products,” said Jack Welch.
Literally, perhaps he’s right. But the short list of constituencies and the the simplistic formulation of value suggest that he doesn’t really mean it: at root, Welch still thinks the shareholder is the only person to whom the result matters. We could, do, and should make other assumptions.
Taxpayer support shows that society has an interest in the soundness of important industries. And society has a broader concern that corporate activity be as useful as possible in terms of employment, growth, quality of life, sustainability, development, and so on. Some of this concern is reflected in regulation. The shareholder’s interest can neither in principle nor in practice be supposed to be identical with society’s interest and shareholders are only one group in a line of stakeholders who are served by corporate activity. Given that vastly more of a company’s revenues are paid to its suppliers, employees, and taxing authorities than are returned to capital providers, it is not obvious where investors should stand in the queue.
Shareholders occupy the strangely asymmetrical position of owning a business and yet, when things go wrong, having the last claim over its assets. The legal construct of the company is responsible for its debts, but its shareholders are not: their risk of loss is limited to their investment but their profit is unlimited. This protection is said to be a pre-requisite of entrepreneurial investment i.e. risk taking. It is possible that the formal structure of shareholding encourages just that: a gambler’s mentality at variance with the concerns of other stakeholders. And of course, executive share option schemes do this doubly since no stake is required until the gamble pays off. Could we design something better?
This goes to the heart of corporate organisation, entrepreneur incentive, and governance. Attempts have been made to create forums and structures to embody broader notions of accountability that might encircle the shareholders’ fortress. But they are nowhere near mainstream, and no serious public attempt has been made to re-think the limited liability shareholder model.
The financial crisis prompts us to question the doctrine of the supremacy of investor demands, especially in developed markets where the investors are now mainly financial. The moment to do this is here: once everything is ‘back to normal’ the impetus will have gone. The FT offers the view that “there is no intellectually coherent alternative” to shareholder value. But this is lazy, dogmatic thinking. It is entirely reasonable to ask (a) whether the current system is coherent, (b) whether intellectual coherence of a system makes it a good system, (c) whether the pursuit of shareholder value in fact causes periodic losses of value, and therefore finally, (d) why the search should be limited merely to other ways of doing what the current system does.
Not invented (or made) here
We might learn something about structure and governance from the German experience. Whilst Britain was becoming a ‘knowledge society,’ Germany became the world’s largest industrial exporter. It is not a low cost economy. Taxes are higher than in the UK. There is plenty of knowledge in Germany too, as it happens. German companies are often concerned about the environmental impact of their products. They do not try to make everything cheaper: instead they manufacture high quality, expensive goods well.
The Mittelstand of owner-managed medium-sized industrial concerns is a recognised stabilising factor in Germany. Insulated from the demands of professional investors, it has generally remained able to reinvest for long-term technological gain and profit. Also encouraging stability and good governance is the requirement that all companies with more than 500 staff must have a supervisory board, one third of whom must be employees. The board also contains representatives of shareholders and management. Even if the process can be cumbersome, the message that employees and shareholders should understand the business and participate in policy and monitoring could not be clearer.
What could we take from this model? A supervisory board – or even the executive board, why not? – might also include representatives of the local community, suppliers, overseas partners, relevant environmental interests, or any other identified stakeholders. They need not be defined in advance. Provided the structures were effective and encouraged constructive co-operation, this must help keep company policy focused on a wide spectrum of long-term aims and ensure that the policy remains acceptable.
Alongside a requirement for stakeholder representation, I believe there is a case to examine the legal concept of the shareholder, which in an environment dominated by professional investors may encourage gambling behaviour and be at odds with the interests of other stakeholders. If the obverse of limited liability is irresponsibility, then perhaps there is an argument to increase the risks for shareholders by making them at least partially liable for the company’s obligations, financial and non-financial. Naturally, measures of this nature might dampen the entrepreneurism of business managers and capital providers, but isn’t that precisely the point? Thinking about these issues seriously means challenging the assumption – not only intellectually but in practice and law – that making as much money as possible for shareholders is what business is for and the source of the benefit it brings to society. Wherever the discussion leads, if today’s model of investor-traded shares does not align investor or company behaviour with the needs of other stakeholders, and if we believe that it should – that those needs are important – then the model must be changed.