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Monday, January 9, 2017

Resisting The Lure Of Short-Termism: Kill 'The World's Dumbest Idea' 01-09

There is only one valid definition of a business purpose: to create a customer.

– Peter Drucker, The Practice of Management (1954)

When pressures are mounting to deliver short-term results, how do successful CEOs resist those pressures and achieve long-term growth? The issue is pressing: low global economic growth is putting stress on the political and social fabric in Europe and the Americas and populist leaders are mobilizing widespread unrest. “By succumbing to false solutions, born of disillusion and rage,” writes Martin Wolf in the Financial Times this week, “the west might even destroy the intellectual and institutional pillars on which the postwar global economic and political order has rested.”

The first step in resisting the pressures of short-termism is to correctly identify their source. The root cause is remarkably simple—the view, which is widely held both inside and outside the firm, that the very purpose of a corporation is to maximize shareholder value as reflected in the current stock price (MSV). This notion, which even Jack Welch has called “the dumbest idea in the world,” got going in the 1980s, particularly in the U.S., and is now regarded in much of the business world, the stock market and government as an almost-immutable truth of the universe. As The Economist even declared in March 2016, MSV is now “the biggest idea in business.”

The Birth Of A Bad Idea

Why did the idea arise? MSV was a well-intended effort by firms to survive in a “VUCA” world, namely, a world that is increasingly volatile, uncertain, complex and ambiguous. In this more difficult context, in which power in the marketplace has steadily shifted from firms to customers, firms focused more sharply on what is immediately profitable. This was presented as a better approach than the then-prevailing view that a firm should seek to meet the needs of an array of stakeholders—customers, employees, shareholders and society. The misguided hope, articulated by Milton Friedman in September 1970, was that if a firm focused on solely on shareholders, everyone would be better off through the supposed “magic of the marketplace.”

The result has been the opposite. MSV led to a vicious cycle of value extraction and economic decline.

To be sure, companies often said that their goal is long-term shareholder value. Indeed, esteemed business school professors defend shareholder value in this way, as in an article in Harvard Business Review in August 2016. The professors seek to reclaim MSV by suggesting that shareholder value has been “hijacked by those who incorrectly believe that the goal is to maximize short-term earnings to boost today’s stock price. Properly understood, maximizing shareholder value means allocating resources so as to maximize long-term cash flow.”

But since calculating the long-term cash flow of any particular action is an impractical guide for day-to-day decision-making in a firm, once shareholder value of any kind becomes the firm’s goal, it’s the impact on the current stock price that in practice becomes the basis for day-to-day decision-making. This in turn leads inexorably to a focus on the short-term.

Short-term Incentives Are Larger Than Previously Understood

Inside the firm, enhancing short-term shareholder value is what most CEOs are currently paid to do. Stock-based compensation is the main reason why the “hijacked version” of MSV—that the goal of a firm is shareholder value as reflected in the current stock price—has become so pervasive. By focusing CEO attention on the current stock price, stock-based compensation is often at odds with long-term growth.

CEO stock-based compensation is even more massive than previously understood. Research published in 2016 in The Atlantic and Harvard Business Review by Professor William Lazonick, shows that the CEO–to-median-worker pay ratio is not, as commonly estimated, in the order of 300:1, with average CEO compensation in the order of $10-15 million, which is already shocking.
Lazonick’s new research shows that the actual CEO–to-median-worker-pay ratio of the 500 highest paid executives is almost 1000:1 or $33 million, with 82% from stock-based pay. Over several decades, executive compensation has increased more than 1000%. 

Creating long-term sustainable value through investment in market-creating innovation can have huge payoffs both for the shareholders and for the economy. But it usually takes years of hard work and is full of risk, with possibly no payoff during the tenure of the current chief executive. There are two much easier avenues available to the CEO to boost the stock price. One is cutting costs. The other is boosting the share price through share buybacks. Both are relatively easy and the results in terms of an enhanced share price are immediate, with practically no short-term risk. It is done in private with the stroke of a pen. Is it any wonder that CEOs give more attention to cost-cutting and share buybacks than to investment in risky slow-gestating innovation?

Massive share buybacks are a relatively recent phenomenon. Prior to 1982, large stock buybacks were illegal because they constituted obvious stock price manipulation. But the SEC in the Reagan administration introduced a new rule—Rule 10b-18—which creates “a safe harbor” for firms to buy back as many shares as they like. This effectively opened the floodgates. The Economist has called the practice “a resort to corporate cocaine”. Reuters has called it “corporate self-cannibalization.”

The SEC seems to consider itself powerless to do anything about the ensuing stock price manipulation. Thus in July 2015, when Senator Tammy Baldwin (D-WI) directly asked the SEC head in the Obama administration, Mary Jo White, to look into the issue of stock price manipulation resulting from share buybacks, White replied in effect that the SEC could not consider the issue because the protection offered by Rule 10b-18 was absolute. The prospects of changing that ruling in the investor-friendly Trump administration seem even more remote.

Lazonick’s recent research also shows how SEC rules currently enable executives to time the granting and vesting of their own shares so as to maximize their own compensation, despite the blatant conflict of interest.

As a result, CEOs have pursued lavish share buybacks with abandon, despite disastrous financial, economic and social consequences. As Upton Sinclair pointed out long ago, “it is difficult to get a man to understand something when his salary depends on not understanding it.”

Share Buybacks Are Gargantuan In Scale

The current scale of share buybacks is breath-taking. Over the years 2006-2015, Lazonick’s latest research shows that the 459 companies in the S&P 500 Index that were publicly listed over the ten-year period expended $3.9 trillion on stock buybacks, representing 54% of net income, plus another 37% of net income on dividends. Much of the remaining 10% of profits was held abroad, sheltered from U.S. taxes.

The total of share buybacks for all US, Canadian, and European firms, for the decade 2004-2013 was $6.9 trillion. The total share buybacks for all public companies in just the U.S. for that decade was around $5 trillion.

Buybacks might make some sense when a stock is undervalued, but Lazonick’s research shows that most buybacks occur when the stock is overvalued, thus enabling firms to mask other business problems. Contrary to the stated goal of enhancing shareholder value, the net result of share buybacks executed at the top of the market is to systematically destroy real shareholder value.

As Robin Harding in the Financial Times concludes, it is “time to stop thinking about corporate governance and executive pay as matters of equity and to regard them instead as a macroeconomic problem of the first rank.”

‘The Stock Market Made Us Do It’

Outside the firm, it is the stock market that acts as the enforcer of the MSV religion. As Dennis Berman in the Wall Street Journal points out, decisions are often driven by the C-suite’s perception that they are under “the threat from shareholder activists, who now patrol the market like prison guards with billy clubs. Overspend and get whacked.”

These perceptions are not far from reality. Take the case of Timken Steel, a company in Canton Ohio which has been making steel and bearings for almost a hundred years. It’s the kind of firm where “making things still matters.” Unlike other companies in the region, like Goodyear Tire & Rubber or the Hoover Company, Timken has not tried to cut costs by moving production to other countries where labor is cheaper. Instead Timken has made huge capital and social investments in Canton Ohio. Over the last decade, its share price had kept pace with the stock market, but that was no protection against “activist shareholders,” formerly known more accurately as “corporate raiders.”

In 2013, Timken was attacked by Relational Investors, in partnership with the California State Teachers’ Retirement System, (CalSTRS), which represents some 236,000 teachers and other retirees in California. Relational applied its usual modus operandi: acquiring stakes in the company, pressuring it to make changes to “unlock value”, insisting that the firm load itself up with debt, buy back their own shares, return assets to shareholders and drive their share prices higher. Relational then cashes in its profits with no thought for the financially fragile state in which it leaves the company it has attacked or the jobs that it might have destroyed.

Using CalSTRS as a PR shield to deflect criticism, Relational was successful in its raid on Timken. All told, Relational acquired its stake at about $40 a share and sold it at around $70, reaping a 75% gain — $188 million — in just over two years. Relational sold all its shares after the quick profit and moved on to the next victim.

Since then, the results for Timken have been less happy. Loaded with debt and split into two firms, its share price has declined by more than 60% and its long-term viability is uncertain.

In making its profit, Relational created no jobs and generated no products or services for any real people. It simply extracted money that had been created over years by the hard work of Timken’s management and workers and left Timken in a weakened state.

Timken is just one example of the noxious effects of the doctrine of MSV by which activist shareholders extract value and disturb the creation of long-term value. The Timken case is part of a broader pattern of attacks by activist shareholders on public firms that depress investment in innovation.

In fact, it looks like another record breaking year for shareholder activism activity, “both in the number of campaigns (more than 230 campaigns in the United States alone in 2015) to the size and iconic nature of the companies targeted (e.g., AIG, DuPont, General Electric and General Motors).” While some long-term investors are having second thoughts about shareholder activism, since “it cannot be the case that 'divest and distribute' is the right strategy for shareholder value as often as is advocated by activist funds relative to other ideas,” nevertheless the raids continue to increase with ever bigger and bolder campaigns. 2016 is also on track to be a record year for activism outside the United States.

The Cost Of Shareholder Activism

What is the cost of shareholder activism? The impact of the stock market on investment has been quantified in a brilliant 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.“ The study compared the investment patterns of public companies and privately held firms.

The study 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 per cent of total assets versus just 3.7 per cent.”

In other words, public firms invest roughly half as much as those private firms that are relatively free from the pressures of MSV. As Matthew Yglesias at Slate concluded: “We are reaping the bitter fruits of the ‘shareholder value’ revolution.”

Double Whammy: The Link To Bureaucracy

But wait, it’s not just shareholder value alone. MSV is a double whammy. Shareholder value forms a sinister partnership with top-down bureaucracy—a devastating constraint in a world in which a motivated workforce producing continuous innovation is a necessity for survival.

Thus when a firm embraces the goal of making money for the shareholders and its executives, it can’t inspire its staff to pursue that goal with any commitment or passion. Making money for the boss at the expense of the customer doesn’t put a spring in anyone’s step or excite anyone to give his or her very best. The goal is inherently dispiriting.

So once a firm commits to MSV, it has little choice but to manage itself with strict command-and-control to force employees to pursue a goal that they don’t really believe in. So MSV and top-down bureaucracy fit together in a perfect interlocking relationship, like a hand and a glove. If a firm tries to move away from bureaucracy, for instance by introducing Agile team practices, then the goals, prescriptions and metrics of MSV kick in to undermine the change and force a reversion to bureaucracy. So once firms embrace MSV, they are doomed to a state of suboptimal equilibrium with lackluster bureaucratic management.

The sorry current state of the work force has been measured by Gallup. It found that only 33% of U.S. corporate employees are engaged in their work, while 17% are disengaged and actively involved disrupting the firm. Deloitte’s studies show that only 11% of the workforce is passionate about what they do. The result is a workforce that is ill-adapted to producing the market-creating innovation that is urgently needed, thus making cost-cutting and share buybacks ever more attractive to the CEO.

Macroeconomic Impact

The impact of these management practices are now everywhere apparent. For instance, as shown in Deloitte’s Shift Index the rates of return on assets of U.S. firms continue their half-century decline that has been independent of political parties, recessions, bubbles, and major world events.

 Work done by the Kauffman Foundation and the Institute for Competitiveness & Prosperity shows that over the last twenty five years, companies more than five years old were net destroyers of jobs, not job creators.

Meanwhile workers wages have stagnated for decades. Since the advent of MSV in the 1980s, the benefits of productivity gains have flowed to shareholders, including the executives, not to workers who created those gains.

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The stock-price manipulation involved in massive buybacks—and the resulting exorbitant executive pay—are thus not just moral or legal problems. The consequences of MSV and share buybacks are a macro-economic and social disaster: net disinvestment, loss of shareholder value, diminished investment in innovation, destruction of jobs, exploitation of workers, windfall gains for activist insiders, rapidly increasing inequality and sustained economic stagnation. Stock buybacks are thus a financial bonanza for stockholders and senior managers, but they destroy economic value for society.

Meanwhile, since the U.S. presidential election in November 2016, the stock market has been on a tear. Investors seem to believe that by releasing resources that are currently “bottled up” by bad tax policy, business will get an automatic stimulus for investment. The case is plausible to the extent that the stash of cash overseas is massive. U.S. firms are currently holding almost $2 trillion in assets overseas, pending some kind of tax reform. But what will happen if the cash is repatriated? But where will it go?

The answer was unhappily apparent in an interview with Cisco Systems CEO, Chuck Robbins, on CNBC’s Squawkbox in December 2016. He was asked what Cisco would do if it could repatriate overseas capital. Cisco has more than $60 billion abroad, and it stands to gain a great deal if the repatriation measures currently being considered are implemented.

Robbins’ answer was frank. As he had outlined in an earlier call with Cisco's investors, Cisco would, he said, use the money for “a combination of dividends, share buybacks and M&A activity.” In other words, If this pattern is replicated, there will be more of the short-term financial engineering that has kept the U.S. economy in a seemingly endless state of secular economic stagnation.

There Is Another Way

There is of course another way to run a corporation. Firms pursuing this way start from the opposite premise from MSV. Instead of the firm being focused on extracting value for shareholders, the firm aims primarily at creating value for customers. The aspiration isn’t new. It’s Peter Drucker’s foundational insight of 1954: “There is only one valid purpose of a firm is to create a customer.” It’s through providing value to customers that firms justify their existence. Profits and share price increases are the result, not the goal of a firm’s activities.

The most prominent example is Amazon. Amazon never focused on short-term shareholder value. At Amazon, shareholder value is the result, not the operational goal. Amazon’s operational goal is market leadership. Although short-term profits have been very variable, the stock market has handsomely rewarded Amazon’s long term strategy.

“We first measure ourselves,” says CEO Jeff Bezos, “in terms of the metrics most indicative of our market leadership: customer and revenue growth, the degree to which our customers continue to purchase from us on a repeat basis, and the strength of our brand. We have invested and will continue to invest aggressively to expand and leverage our customer base, brand, and infrastructure as we move to establish an enduring franchise.”

Amazon obsesses over customers, not shareholders. “From the beginning, our focus has been on offering our customers compelling value."  Long-term shareholder value, says Bezos, “will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.”

Amazon Is Not Alone

Amazon is not alone in rejecting the doctine of MSV .

Thus Vinci Group Chairman and CEO Xavier Huillard has called MSV “totally
Alibaba CEO Jack Ma has declared that “customers are number one; employees are number two and shareholders are number three.”

Paul Polman, CEO of Unilever has denounced “the cult of shareholder value.”

John Mackey at Whole Foods has condemned businesses that “view their purpose as profit maximization and treat all participants in the system as means to that end.”

Marc Benioff, Chairman and CEO of Salesforce declared that MSV is “wrong. The business of business isn't just about creating profits for shareholders -- it's also about improving the state of the world and driving stakeholder value.”

In a 2014 report from the Aspen Institute, which convened a cross-section of business thought leaders, including both executives and academics, the most important finding is that a majority of the thought leaders who participated in the study, particularly corporate executives, agreed that “the primary purpose of the corporation is to serve customers’ interests.” In effect, the best way to serve shareholders’ interests is to deliver value to customers.

Len Sherman’s new book, If You're in a Dogfight, Become a Cat! (January 2017) offers many further examples, including Costco and JetBlue.

The report of the SD Learning Consortium (November 2016) also gives examples, including Barclays, Cerner, C.H.Robinson, Ericsson, Microsoft, Riot Games and Spotify.

The management journal, Strategy & Leadership, has courageously championed and elaborated the principles of this better way over a number of years.

Firms pursuing this different approach include young firms and old firms, big firms and small firms, US and non-US firms, those in software and those outside software. In effect, the discussion isn’t about a type of firm, but rather a different set of leadership and managerial practices.

The argument offered by executives that “Wall Street made us do it” thus has the same legitimacy as “the dog ate my homework.” A significant set of public companies have already been successfully pursuing customer value, with broad applause from Wall Street and strong support from discerning thought leaders.

The result is a virtuous circle of value creation.

A Wider Set Of Issues For Society

Thus we know how to resist the lure of short-termism. The question is: when will firms get on and do it?

It is of course theoretically possible that CEOs and their boards of directors will awaken tomorrow morning and commit themselves to creating value for customers rather than extracting value for shareholders.

It’s theoretically possible that investors will awaken tomorrow and refocus their attentions on firms that create real long-term value.

It is theoretically possible that the new head of the SEC will remove Rule 10b-18 which enables massive stock price manipulation.

Realistically though, these things won’t happen unless and until there is a sea change in the wider political, social and organizational context. Thus the current situation is one of fundamental institutional failure across the whole of society. The behavioral breakdown is mutually reinforcing.

CEOs are extracting value from their firms, rather than creating it. CFOs are systematically enforcing earnings-per-share thinking in decisions throughout their organizations. Business schools are teaching their students how to do it. Hedge funds and activist shareholders are gambling risk-free with other people’s money to take advantage of it. Institutional shareholders are complicit in what the CEOs and CFOs are doing.

Regulators remain indifferent to systemic failure. Rating agencies reward malfeasance. Financial analysts applaud short-term gains and ignore obvious long-term rot. Politicians stand by and watch. In a great betrayal, the very leaders who should be fixing the system are complicit in its continuance. Unless our society as a whole reverses course, it is heading for a cataclysm.

Thus change in behavior is needed in a whole set of institutions and actors: CEOs, CFOs, investors, legislators, regulators, rating agencies, analysts, management journals, thought leaders, business schools and politicians—all need to think and act differently.

A Moment Of Truth Has Arrived

We are thus at a critical point in a vast societal drama. We have reached that key moment, which Aristotle famously called “anagnorisis” or “recognition.” This is the theatrical moment in a drama when ignorance shifts to knowledge. Just as King Lear in Shakespeare’s play eventually recognized that his apparently virtuous daughters, Goneril and Regan, were a really bad lot, and that his apparently disrespectful daughter, Cordelia, truly loved him, so society is learning that much of ‘the talent’ it thought were adding value have in fact been extracting value for themselves.

As usual with anagnorisis and the shock of recognition at a disturbing, previously-hidden truth, there is a disquieting sense that the accepted coordinates of knowledge have somehow gone awry and the universe has come out of whack. This can lead to denial and a delay in action, even though the facts are staring us in the face.

If the recognition of our error comes too late, as in Shakespeare’s Lear, the result will be terrible tragedy. If the recognition comes soon enough, the drama can still have a happy ending. We are about to find out in our case which it is to be.

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