The Wrongologist

What’s
Wrong Today:

The Wrongologist has
written here
and here
about the problems with CEOs chasing short-term shareholder value, which remains
pervasive in large organizations.

His thesis
is that today’s version of capitalism no longer functions in a manner that
makes all stakeholders better off. Let’s remember that a firm’s stakeholders include
the shareholders, employees, customers, suppliers and the communities in which
the firm operates.

Take a
look at the ratio of corporate profits (after taxes) to GDP since 1950:

Without
the inconvenient interruption of the Great Recession, corporate profits have
headed almost straight up since 2000. Let’s also remember that we still have
more than 11.5 million Americans unemployed and that we have 3 million fewer
jobs today than in 2008.

Now the Financial Times reports that the theory
of maximizing short-term shareholder value has a new feather in its cap: it is
responsible for killing the economic recovery that should have occurred after
the financial meltdown of 2008.

Robin Harding, in his
article entitled “Corporate investment:
A mysterious divergence”
[gated @FT.com] pinpoints the role of shareholder value theory in undermining the US economic
recovery. He asks a question that
has puzzled the world’s top economists: why
is net investment at 4% of output when pre-tax corporate profits are now at
record highs – more than 11% of GDP?

In
standard economic theory, this makes no sense. When profits go up, companies
should find new investment opportunities to lay the groundwork for even more
profits in future. In turn, that investment should create jobs, generate more
capital goods and lead to higher wages. That’s how capitalism is meant to work.

So
why isn’t it happening? Mr. Harding explores the leading scapegoats for what’s
gone wrong—regulations, Obamacare, tax policy, fear of another financial crisis
and so on—and shows why they don’t add up. Ever since the financial crisis,
corporations have hoarded an increasing amount. The pile reached $2.2 trillion
at the end of last year, up from $1.5 trillion at the end of 2007, according to
data from the Federal Reserve. The phenomenon of firms sitting on mountains of
cash and unable to find anything useful to do with them reflects management
processes constrained either by fear, or lack of imagination.

Harding
references a study by economists from the Stern School of Business and Harvard
Business School, Alexander Ljungqvist, Joan Farre-Mensa, and John Asker,
entitled “Corporate Investment and Stock Market Listing: A Puzzle?” that
compares the investment patterns of publicly traded companies and privately
held firms. It turns out that the lag in investment is a phenomenon of the
public companies more than the privately held firms.

From the
Article’s Abstract:

Ljungqvist,
Farre-Mensa and Asker found that, keeping company size and industry constant, private US companies invest nearly twice
as much as those listed on the stock market: 6.8% of total assets versus just
3.7%.

They also found
that private firms’ investment decisions are
more than four times more responsive to changes in investment opportunities
than are those of public firms.

Finally, they
found that firms that recently had an Initial Public Offering (IPO) are significantly more sensitive to
investment opportunities in the five years before they go public than they are afterwards.

Harding
concludes:

The
argument offered by executives that “the stock market made us do it” has the
same legitimacy as “the dog ate my homework”. The Wrongologist has two words
for them: Warren Buffett.
There are many ways to play the investment game. It is becoming increasingly
difficult to win at the game when the average investor is working against
computer algorithms and split second trading.

A
year ago in Big,
Bad and Wrong Ideas, the Wrongologist argued that the idea that the mandate
that companies must maximize return to shareholders needs to be reassessed. He
cited the following:

• Today’s shareholders are
  the most mobile of corporate stakeholders: High frequency trading
  represents 70+% of today’s stock trading by volume. High frequency
  shareholders hold their positions for fractions of a second, so they are
  only interested in corporate strategies that maximize short-term profits
  and dividends.

• Professional funds managers own
  large chunks of equity in public firms. They have a free hand to get
  wealthy because they earn management fees tied to the fund’s size, without
  real responsibility for the longer term performance of the corporations whose
  equity they hold.

• Some companies even ignore
  votes by shareholders that turn directors out of office. So the power of
  small shareholders has diminished over time.

But public
companies like Amazon [AMZN], Whole Foods [WFM] and Costco [COST] have
successfully pursued customer value, despite the pressures of Wall Street. Isn’t
it about time we stop compensating corporate leaders for meeting their
quarterly numbers and instead shift the focus of business to its true goal of
adding value to all stakeholders of their firms?

Instead,
the short-term focused CEOs:

• Focus
  their R&D on current cash cow products without creating a transition to new
  products or technologies

• Change
  their company’s benefits plans to the detriment of the workforce, to get higher profits now, but high turnover and low morale later.

• Acquire
  companies that have good public image and cash flow but are poor fits with the
  greater organization

So, Corporations’ short-term
earnings mentality has produced a series of “accomplishments”:

• It
  has led to “profits” based on cutting corners with customer loyalty

• It
  is responsible for offshoring of manufacturing, thereby destroying a major
  segment of the US
  Economy

• It
  has even undermined US
  capacity to compete
  globally

Capital is
entirely triumphant in the United States from a political perspective. There is
no one in Congress with the political will to even raise this issue in a
serious way, much less address it substantially. In decades past, labor unions,
farmers, and small businesses had sufficient political strength to
force congress to pass laws limiting the power of big
business. That is all long gone.

When
everyone thinks the long term future is someone else’s problem, there will be
no long term future.