Aug 31, 2020
Everyone loses with shareholder value, including shareholders
Shareholder value fails to deliver the goods for shareholders, even as it tramples on the interests of everyone else. It’s ideology, not economics
For decades we have been taught that the purpose of a company in a free market economy is to deliver returns to shareholders, period. But the reality is that “shareholder value” damages the interests of everyone the company touches — the workers, the community, the environment, and the owners as well. It’s a lose-lose game.
To be fair, there is no conclusive evidence — yet — of better performance for the opposing concept — variously called stakeholder value, socially responsible investing, impact investing or ESG investing (for Environment, Social and Governance).
But ESG is still an evolving practice — its uncertainty doesn’t excuse the fallacy of shareholder value. If a theory is true, the evidence should support it, especially one tested by time. However, when you look at shareholder value carefully, the economics falls apart and only the ideology remains.
To understand how shareholder value became the reigning paradigm, you have to go back to its beginnings.
As a finance guy myself, I hold great respect for Milton Friedman, the Nobel prize-winning economist and social philosopher whose libertarian precepts reigned supreme from the 1970s to the early 2000s, and are still cherished by many conservatives today.
Friedman ardently argued that free markets are the foundation of both prosperity and democracy, in such seminal works as Capitalism and Freedom, first published in 1962 and still in print, and Free to Choose: A Personal Statement, published in 1980 with his wife, Rose, which was so popular that it became a 10-part television series on PBS.
Friedman famously made the case for shareholder value in an article in The New York Times in 1970 whose title says it all: “The Social Responsibility of Business is to Increase its Profits.” Re-reading it recently, I was shocked at its shallowness.
Friedman’s thesis is simple: corporate executives are agents for owners and investors, and their sole duty is to make financial returns for their principals.
When companies engage in social activity, says Friedman, they are helping some but inflicting pain on others — on their customers, in the form of higher prices; on their employees, in the form of lower wages; and on their shareholders, in the form of reduced returns. This puts managers in an untenable position as it conflicts with their obligation to maximize profits for shareholders.
Friedman recognizes that a company with a sole proprietor may support social causes — it is the owner’s money, after all. But it never occurs to him that a company with a large group of shareholders might also consider social good as a valid objective. He simply assumes that in a big corporation the owners invariably give CEOs one instruction: make us money.
Amazingly, Friedman even concedes that it may be in the long-term interest of a company to support social causes in its community. “That may make it easier to attract desirable employees … or have other worthwhile effects.”
But then he immediately dismisses his own counter-argument to shareholder value, calling most social activity “hypocritical window-dressing.” It’s just corporate public relations, even when the cost may be “entirely justified on its own self-interest.” Apparently, for Friedman, hypocrisy outweighs profits when social issues are at stake.
Friedman quickly skips over this hole in his thesis to get to the main point. The hidden cost imposed by social activity is a form of taxation, which is the function of government, not business. The corporate executive who spends on social causes is, in effect, an unelected civil servant, taxing and spending without accountability to taxpayers and voters. This is not free enterprise, it is … socialism, which Friedman hates with a passion.
For Friedman, “the doctrine of ‘social responsibility’ “ is “fundamentally subversive” to our American way of life. Maximizing profits without regard to social consequences is the best way to defend our free enterprise economy and our political freedom.
Friedman’s argument has a seductive appeal, combining patriotism and greed. But the real question is: Does it work?
If you ask mainstream academics, they will probably point to the second “ur”-text in the history of shareholder value: “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” published in 1976 by Michael Jensen and William Meckling and still treated with reverence.
It’s complicated, but in essence, this paper defines the company as a “legal fiction which serves as a nexus for contracting relationships. ” A company is a mini-market where owners, lenders and managers continuously negotiate with each other to gain the highest financial return for themselves.
Whereas Friedman philosophizes, Jensen and Meckling use math. But neither paper relies on real-world data to prove their points. And — more importantly — each simply assumes the key “truth” they are trying to reveal.
In the case of Jensen and Meckling, one of their core assumptions is that, “No outside owner gains utility in a firm in any way other than through its effects on his wealth or cash flows.” In other words, all a shareholder cares about is financial return.
If you assume that shareholders create companies solely to earn money, it is not hard to conclude that the purpose of a company is to maximize shareholder value. QED.
Shareholder value had a good run in corporate boardrooms and popular culture for several decades. It fit neatly with the Cold War’s horror of socialism and the Ronald Reagan era’s embrace of small government, a frayed safety net, and personal selfishness — the “Me Decade.”
But the economic results were a bust. Not in the case of CEOs, whose compensation during 1978–2013 increased by 937%, more than double the increase in the S&P 500 or Dow Jones stock indexes. But employees were massively shortchanged. Labor productivity grew 90% during that same period while typical worker compensation only inched upwards by 10%.
The ultimate irony is that shareholders, who were supposed to be the beneficiaries of the theory, got hammered. From 1965 to 2015, the aggregate return on assets of US firms across the economy fell from 4.7% to 1.3%, a cut in the profitability rate of more than two-thirds.
We can’t know, of course, that shareholder value caused the profitability decline across the economy. But there is evidence that aggressively adopting shareholder value techniques — such as higher levels of mergers and acquisitions, anti-union activity, staff reduction, and investment in technology — offered no significant help in the case of troubled industries.
By 2009, even Jack Welch, whom many consider the paragon of the shareholder value movement during his stint as chairman and CEO of General Electric from 1981 to 2001, had thrown in the towel.
“On the face of it, shareholder value is the dumbest idea in the world,” he said. “Shareholder value is a result, not a strategy . . . Your main constituencies are your employees, your customers and your products.”
The legal argument for shareholder value also falls flat. Contrary to what many non-lawyers assume, boards of directors are not required to prioritize shareholder returns above all else. In fact, under the “business judgment rule,” their authority to exercise discretion over the affairs of the company is almost unlimited, in the absence of a conflict of interest — even if their actions decrease shareholder value.
Of course, shareholders can remove directors if they are not happy with their performance, but so long as they are on the board, a director’s duty is to act on behalf of the company, not the shareholders. In doing this, they may take into account the role of the company in the community and in the environment, the long-term vs. short-term objectives of the company, the interests of other stakeholders, and many other factors besides financial returns.
Today, business has to step up as we deal with such deep-rooted crises as climate change, income inequality, and systemic racism. With the ideological blinders of shareholder value removed, we can see clearly that companies are members of their community. Like any other community member, they bear some responsibility for the well-being of all.
