Mar 02 2014
In arguments over business and the economy, you often hear that the job of corporations is to “maximize shareholder value.”
People use this phrase to justify all kinds of things that are ethically ambiguous (e.g. polluting as much as possible up to the legal limit), or seen as distasteful to some (e.g. layoffs).
But, is that the right goal of a corporation? Is it even a good benchmark of a successful corporation? And, does it even work anymore?
In order to understand if “maximizing shareholder value” makes sense as a primary business objective, it’s important to understand the historical forces that led to this goal for corporations being broadly adopted. This concept has not been fixed as the sole, or even primary, goal of corporations, but instead was created in response to a specific set of circumstances.
Basically, U.S. corporations performed relatively poorly in the 1970s because of their huge size and inefficiencies (it’s difficult for lumbering giants to find and invest in good ideas). This, combined with increased competition from smaller (and therefore more efficient) Japanese firms caused U.S. firms to profit even less.
The primary operating mantra for U.S. corporations was “reinvest and retain,” meaning that corporations should use their profits to 1) reinvest in new, productive inventions, and 2) retain both their earnings and their talent to build capacity to take advantage of those productive inventions.
To our modern business eyes, this might seem foolish, but you should remember that this strategy had worked basically since the start of the industrial revolution.
So, in the 1980s, the ~100 year objective of “reinvest and retain” wasn’t working anymore. Smaller, more nimble firms were eating away at larger, slower competitors.
In addition, the 1980s saw the rise of large institutional investors – basically guys who just aggregated capital and pushed it around. These started out being guys who aggregated retirement savings for hundreds of thousands of workers, and therefore had big dollars to push into productive companies.
Large institutional investors did not care about ongoing R&D, or about retaining quality talent. And, this model was not working very well at the time. So, “maximize shareholder return” was born out of this primordial business ooze. It aligned big capital with big business in order to produce stellar returns for both.
Of course, this begs the question: does “maximize shareholder value” work as a business objective today?
I would argue that it doesn’t because:
1. Large organizations are much leaner now (after 30 years of rightsizing and justifying every head against a P&L), and feedback loops on productivity of R&D and internal investments are much more equal across all sizes of companies
2. The large institutional investors have gotten so large as to overwhelm any (and every) capital market, and therefore, every company within the market. Currency traders can crash economies. Banks control both commodities traders and commodities storage and transport facilities, allowing them to manipulate commodities markets. And 70+% of market trades are made by algorithm, introducing manipulation through HFT (yes, yes, as well as liquidity, because when you want to sell a stock, you HAVE to do it RIGHT THIS SECOND so very often).
3. We have learned to manipulate stock prices (the most common and simplest proxy for shareholder value) with a host of tricks that have nothing to do with value creation. I’m talking about things like splits and buybacks; special dividends; shifting borrowing costs and bond holdings; offshoring tax liabilities with no way of repatriation of profits sans tax (unless – or until? – large companies strongarm the federal government into a repatriation tax holiday); the creation of shell corporations; etc. These things do not add to the productive economy, but do line the wallets of bettors and financial manipulators.
I would posit that a return to “retain and reinvest” as a main objective of corporations would be good for the companies, their employees, tax rolls, the broader business climate, and society at large.
In fact, the smartest businesses that I know of are using this model to grow very, very profitable companies (albeit, probably without saying it in this way).
Look at the organizing structure and operating model of these very, very innovative, and very, very profitable companies:
Google: Two classes of shares, with minimal voting rights of money investors. No dividends. Basically, the board cannot be controlled and the huge profitability of search ads can’t escape Google’s walls to be frittered away by dumb Wall Street people. Instead, it’s tightly held by the business leaders, who reinvest in a whole host of productive innovations.
Facebook: Two classes of shares, and 57% of the voting interest held in one person – Mark Zuckerberg. He gets to take risks with money from big institutional investors without being beholden to anyone for the performance of the company. Hence, you get huge moves like the $19B acquisition of WhatsApp, even when P/E is over 100.
Berkshire Hathaway: Has never split stock. Has never paid a dividend due to tax inefficiencies of doing so. Added a second class of stock to be more affordable to newer investors, but with reduced voting rights. Buys to hold literally forever, with no plans to ever sell a company. Keeps management in place to continue growing their business units. Takes FCF from business units into a BDC structure to mount the next acquisition. This is the definition of “retain and reinvest.”
If this is interesting, you should check out a deeper overview of the history of “maximize shareholder value” (warning: PDF).