Nothing will be better received by the economic elites than a theory that rationalizes and promotes their self interest, and few theories have done so as well as the myth of “Shareholder Value.” Harold Meyerson summed the theory up succinctly:
“The idea that corporations exist to reward their shareholders arose not in a body of law but from the work of ideologically driven economists. In 1970,Milton Friedman wrote that business properly had but one goal: to maximize profits. The same year, Friedman’s University of Chicago colleague Eugene Fama argued that a corporation’s share price was always the accurate reflection of the enterprise’s worth, an idea that trickled down into the belief that the proper goal of a corporation was to boost its share value — particularly after most CEO salaries and bonuses became linked to that value.” [WaPo]
The musings (or rationalizations if you will) of Friedman and Fama were expanded by Michael Jensen and William Meckling in a 1976 Journal of Financial Economics article “Theory of the Firm: Managerial Behavior, Agency Cost, and Ownership Structure,” a long title for a short idea: Shareholder Value. [DSE]
Yesterday’s post took a few swings at the Shareholder Value mythology, but the subject deserves a closer look.
First, there is no requirement in law which requires the management of an enterprise to direct its focus toward Shareholder Value. None, zip, zero. [HarvardLawF] So, why is the theory now treated as dogmatically as received wisdom?
Let’s try one notion on for size – the theory is arithmetically convenient. As a nation, we do love to count things. We’ll even count the number of times we’ve counted things. A posted price for a share of common stock is easy to recognize and count. It is what the stock market for the day says it is. Arena Pharmaceuticals is selling for $5.12 today [YahooF] There are some sticky questions we might ask, such as will the study of its autoimmune drug yield an effective and profitable product? If the price of ARNA today is $5.12 per share does that describe the value of the company? The Friedman/Fama profit motif combined with the Shareholder Value Theory assumes that the price of the share x number of shares = the value of the company. And, here’s where things break down.
According to the vaunted “efficient market” theory the answer is Yes! The share price is a measure of value — except when it isn’t. On July 23, 2008 the closing price for Lehman Brothers was $16.05 for 33,685 in share volume. Did that describe the value of the corporation? Or, should we look at the stock price in September 22, 2008 when Lehman Brothers was closing at $0.23? [NASDAQ] Apparently, one of the flaws in the arithmetically convenient adoption of stock price as a measure of corporate value is that if the corporation can’t properly value its holdings then the price and the value aren’t coterminous. In English that would be: If the company can’t value its assets properly then why on God’s Green Earth should we believe the stock price is anything other than guesswork on the part of some investors?
Since the Shareholder Value Theory, although flawed, might be convenient it also appeals to another notion worth exploring – the theory holds appeal for those who have short term interest in market trading. Under all the fancy mathematics and all but impenetrable jargon, the proponents of the Shareholder Value myth were alleging that since the price equated to the value of the firm, then using the stock price as a measuring tool meant one could evaluate the short term success of a company. Lovely, but that misses a few marks.
Secondly, under the older “retain and reinvest” or the “stakeholders” models of corporate performance there were niches for thinking about long term corporate viability. Was the company doing enough in terms of research and development? Was it investing in new plants and equipment? Was it retaining and retraining its labor force? If “Engulf & Devour” acquired some firms using leveraged buyouts and hostile takeovers in the heat of the 20th century M&A boom, then what was to prevent the management from treating the newly acquired companies as little more than paper in the portfolio? Share price moved the M&A, and share price would be the convenient measure of the “value” of the company. What shareholder value was produced by, say, the Quaker Oats takeover of Snapple? Or America Online with Time Warner? Or Sprint and Nextel? [Investopedia]
Instead of “stakeholders,” management, labor, customers, etc. involved in the interests of the corporation, the financial engineers became the model for corporate management. Thence, the financial engineers became beholden to the financial Auspex. Roger Martin’s book, Fixing the Game, proposes two categories – the “real market,” and the “expectations market.” The ‘real’ market includes the world in which factories are built and staffed, goods and services are bought and sold, and revenue is earned and the bills are paid. The Expectations Market is another world. In it the stock market via the analysts and rating services assess the real market activities of the firm and based on that analysis makes prognostications about how the company will perform in the future. Why would an executive go to all the trouble to improve real market performance in the long run when simply raising short term expectations will do nicely? Who loves this short term market perspective?
If you guessed Hedge Funds, take your seat at the head of the class. And, do the hedge fund and private equity firms deliver on Shareholder Value? Not quite:
“…the most generous conclusion one may reach from these empirical studies has to be that “activist” hedge funds create some short-term wealth for some shareholders as a result of investors who believe hedge fund propaganda (and some academic studies), jumping in the stock of targeted companies. In a minority of cases, activist hedge funds may bring some lasting value for shareholders but largely at the expense of workers and bond holders; thus, the impact of activist hedge funds seems to take the form of wealth transfer rather than wealth creation.” [IOGPP pdf]
Note the last part? “Take the form of wealth transfer rather than wealth creation.” What have some of the more critical articles of the current economic situation been saying all along? That in the matrix of Shareholder Value and Financialism, intensified by corporate compensation schemes, and further abetted by hedge fund activism – we have transfers of wealth without the actual creation of a better economy for everyone.
Finally, about all that can be said of the Shareholder Value Scam is that it serves the purposes of those who have vested interests in stock market short-termism and volatility, who have an interest in transferring rather than creating wealth, and who have a predilection for espousing those theories which will make them feel better about the whole thing.
References and Recommended Reading: R. Straub, “Shareholder Value – A Theory that changed the course of history – for the better or the worse,” Drucker Society Europe, June, 2012. Jensen and Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics, October 1976. (pdf) Lynn Stout, “The Shareholder Value Myth,” Harvard Law School Forum, June 2012. Yves Smith, “Maximize Shareholder Value” Myth, Naked Capitalism, May 2014. Diane E. Davis, “Political Power and Social Theory,” MIT Cambridge, 2005. (pdf) Steve Denning, “The Origin of the World’s Dumbest Idea: Milton Friedman,” Forbes, June 2013. Steve Denning, The Dumbest Idea in the World, Forbes, Novmber 2011. Yvan Allaire, “Activist Hedge Funds: Creators of lasting wealth, What do the empirical studies really say? Institute for Governance of Private and Public Organizations, July 2014.