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.
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.
“It is little wonder that CEOs may be incentivized to extract maximum rent in the minimum time possible given the shrinkage of their time horizons,” Montier writes.
The tendency to in effect plunder a corporation’s wealth for short-term profit maximization (not just for CEOs but for shareholders whose own time horizons have shrunk) may also be responsible for a plague of social ills.
Montier cites an experiment in which CFOs were asked: Given a 12% cost of capital and a 16% internal rate of return, would they take advantage of an investment opportunity under four scenarios, each with disparate impacts on quarterly earnings per share (EPS).
Most CFOs, naturally, would accept the investment opportunity under a scenario in which that opportunity would likely improve quarterly EPS. (Why not all would do so remains a mystery.)
But progressively fewer CFOs would accept the opportunity under scenarios in which the company’s EPS might fall 10 cents below, 20 cents below or 60 cents below a $1.90 consensus estimate of EPS. Only half would take advantage of the high-rate-of-return investment opportunity if EPS fell 60 cents below estimates in the coming quarter.
Moreover, Montier, comparing listed and unlisted firms, finds that private firms invest at nearly twice the rate of public firms. And stock distributions have risen to about 50% of cash flow compared to between 10 and 20% in the previous salaried manager era.
Indeed, firms overwhelmingly finance their investments internally rather than through equity or bond issuance, implying that stock markets do not provide vital capital to the corporate sector but rather extract it from corporations.
A case in point is stock buybacks, which the data show are conducted overwhelmingly when market valuations are high, though one would think corporations would buy back their stock when it falls below its intrinsic value.
In all the above cases, Montier concludes that today’s corporate executives are short-term oriented compared to a prevailing mentality in the previous era towards long-term investment. He quotes Warren Buffett, who said “buying dollar bills for $1.10 is not a good business for those who stick around.”
The GMO exec next looks at rising inequality, citing data that the top 1% own nearly 40% of the stock market and the top 10% own 80% of the stock market.
While Americans surveyed on CEO pay think the average CEO earns 30 times the average worker and that a multiple of 7 would be fair, the ratio of CEO-to-worker compensation is actually just short of 300x today (down from a high of 383x in 2000 and up from 20x in the salaried CEO era circa 1965.
Montier blames the shareholder value movement for this trend, citing other data showing that executives accounted for 58% of the expansion of income of the top 1%, or 67% of the income expansion when including finance-related occupations.
Now looking at the bottom 90%, Montier brings data showing their share of GDP declined from 42% in the 1940s to about 27% today, and that income gains in the past two expansions have gone entirely to the top 10%.
“The problem with this (apart from being an affront to any sense of fairness) is that the 90% have a much higher propensity to consume than the top 10%. Thus as income (and wealth) is concentrated in the hands of fewer and fewer, growth is likely to slow significantly,” writes Montier, who further cites data showing the bottom 90% have a savings rate of effectively 0% versus 40% for the top 1%.
To Montier, the shareholder value movement is once again a primary cause.
“If firms are trying to maximize profits, they will be squeezing labor at every turn (ultimately … undermining demand for their own products by destroying income).”
The GMO exec concludes that corporations and society alike benefit when they focus on providing value to the customer and letting the rest (i.e., shareholder value) take care of itself.
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