A savvy portfolio manager wants to buy shares of companies focused like a laser beam on maximizing shareholder value, right?
Not so, says James Montier, a member of Jeremy Grantham’s asset allocation team at Grantham Mayo Van Otterloo (GMO), whose new whitepaper, echoing former GE CEO Jack Welch, calls shareholder value “the dumbest idea in the world.”
That is because, paradoxically, it leads to poor corporate performance and can be traced as the source of social ills including declining rates of business investment, rising inequality and an atrophying middle class that ultimately redound to the disadvantage of business.
Montier traces the history and widespread adoption of this “dumb idea” as part of an effort by corporate governance types to adopt compensation systems linking pay and performance so that managers’ and shareholders’ interests would be aligned.
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Fearing that salaried executives would not share the same level of care as an owner, it was thought that bulking up CEO pay with stock and stock options would boost shareholder return.
But Montier marshals a variety of different kinds of evidence to show that CEO pay is part of the problem rather than the solution.
He acknowledges that IBM, a leader in the shareholder value movement (SVM) that kicked in in the 1990s, did initially experience a corporate revival with then CEO Lou Gerstner’s focus on shareholder value and his successor Samuel Palmisano’s narrow focus on earnings per share.
But he contrasts IBM’s experience with that of Johnson & Johnson, which long term has created far more shareholder value, but which has never deviated from its stated mission to focus on doctors and nurses, mothers and fathers, employees and communities, only lastly acknowledging that “when we operate according to these [priorities], the stockholders should realize a fair return.”
From that particular example, Montier compares the aggregate performance of S&P 500 companies in the era of salaried CEOs and the modern shareholder value maximizing period from 1990 to the present.
He finds a close to 200 basis point return advantage in the earlier era after adjusting the data to examine underlying performance. (Though Montier calls this result a “prima facie case against SVM,” the GMO exec regrettably does not detail precisely how he adjusts the data to achieve this result.)
So why did the shareholder value movement that prevails in today’s corporate environment not live up to its promise?
Montier advances CEO pay as a primary cause. Stock and options now account for some two-thirds of CEO compensation, and Montier reserves most of his ire for the latter, which he says gives executives “all of the upside and none of the downside of equity ownership; Effectively [options] create a heads I win, tails you lose situation.”
The GMO exec cites a fascinating experiment by Dan Ariely, who tested the effect of incentives in rural India (where it would be cheaper to offer cash rewards that are meaningful to the recipients).
The behavioral economist offered 4 rupees to participants who reached the “very good” level in a series of six games; 40 rupees to participants who achieved that level in a medium incentive version of the game; and 400 rupees to a high-incentive version of the game.
Since 400 rupees represents the average monthly per capita consumption, country wide, in India, a participant in the high-incentive group had the chance to earn an entire half year’s consumption over the course of the six games.
Surprisingly, 35% of the low-incentive group achieved the maximum, just under the 37% of the medium-incentive group, but the high-incentive group achieved a relatively paltry 19.5% of the maximum.
“From the collective evidence on the psychology of incentives, it appears that when incentives get too high people tend to obsess about them directly, rather than on the task in hand that leads to the payout. Effectively, high incentives divert attention away from where it should be,” Montier writes.
While CEO pay has gone up, CEO tenure has gone way down (to about an average of six years from an average of about 12 years in the salaried era). The lifespan of the company has similarly plummeted, from an average of 75 years in the S&P 500 during the 1920s to 27 years during the salaried 1970s to just 15 years in today’s shareholder value era.