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Saturday 12 June 2010

Greed’s Not Good For Shareholders

Don't Aim to Maximise Shareholder Value

When we look at the genuinely successful business people of our time, that happy band of folks who’ve created true shareholder value, enriching themselves and their followers to an astonishing degree, we find an extraordinary thing. The vast majority of these people are not particularly interested in money and their companies are generally not dedicated to some New Age declaration of shareholder value maximisation.

Greed is not a quality that seems to drive the world’s greatest creators of shareholder value and creating shareholder value is not the aim of the companies that are best at it. In fact we can pretty much guarantee the alternative: wherever you find over-rewarded executives presiding over companies whose main aim is to increase their market capitalisation we should pick up our skirts and get the hell out of it. Corporate greed is bad for ordinary shareholders.

Buffett's Army

If you read Warren Buffett’s shareholder letters, for instance, you can’t help but notice that the people whose companies he takes over all, by and large, continue to work for him despite being made rich beyond the dreams of our avarice. They tap-dance to the workplace everyday and lead their companies through a set of values far removed from the value enhancing conceits of management consultants.

What seems to set aside great business people and their businesses from the pond life that mainly occupies executive positions is that they focus on things other than making money. These generally involve doing stuff that people actually want to pay good cash for, rather than an obsession with growth. Indeed, the last thing we should want is running our companies is people who are greedy for money, since the opportunities for unscrupulous executives to cheat us shareholders are huge.

Welch on Shareholder Value

The dangers of the concept of shareholder value are outlined by Jacques Reland who quotes Jack Welch with approval:
“On the face of it Shareholder Value is the dumbest idea in the world. Shareholder Value is a result, not a strategy. Your main constituencies are your employees, your customers and your products”
Welch, of course, was the man behind the elevation of shareholder value to cult status in his time as CEO of General Electric, so this looks like something of a sea change. Appearances may be deceptive, however: Welch was a man on a mission and it’s doubtful if share price increases were anything like his main driver. Unfortunately where trailblazers go with intelligence and subtlety their followers tend to go with dumb adherence of a set of rules – and then usually fail the first time these are challenged.

To the CEO's the Spoils

As Reland points out, by 2000, half of the rewards for CEO’s in the US were based on bonuses and stock options – all triggered by short-term rises in share prices. And, in general, these perversely incentivised executives were responsible only to institutional investors, incentivised to see the valuations of their portfolios increase quarter on quarter. There was always going to be a price to pay.

The price is income inequalities on a grand scale – a winner takes all casino in which the few achieve rewards out of all proportion to their skills and achievements. The outcome of this lottery is inevitable failure because as more and more of the available money is concentrated into fewer and fewer hands the consequence is that the poorer masses aren’t able to sustain the spending needed to maintain the vast incomes of the rich. This can be overcome for a while through the use of borrowing but the end, when it comes, is never going to be pleasant.

At root, though, the greed is good culture cannot be self-sustaining. Eventually all the wells of finance run dry and only those corporations who are capable of creating real value for their shareholders by developing businesses founded on ideas beyond the short-term accumulation of riches will thrive. Finding these organisations is the fundamental task of the long-term investor, because it’s these types of companies that permit a minimal trading, long-term buy and hold strategy that will outperform.

True Capitalism

A true capitalist has no concerns with people becoming rich through the sweat of their own labour but a system in which an executive with no interest in the long-term future of their corporation can obtain rewards in a few years that ensure a life of ease and comfort is a perversion of the whole idea. Capitalism is about rewarding those people who put in the hard yards and get a few breaks – not about offering huge windfalls to greedy executives who happen to ascend the greasy pole.

Examples of what happens when corporations lose sight of their true objectives and start targeting purely financial returns abound. Yet true shareholder value comes from a relentless focus on the true business. Here’s Bill George of Medtronic from 1991:
"The best path to long-term growth in shareholder value comes from having a well articulated mission that inspires employee commitment. Companies that pursue that mission in a consistent and unrelenting manner will create greater shareholder value than anyone believes possible. There are simply no shortcuts to creating long-term shareholder value. Sustainable growth cannot be achieved by a series of short-term actions. Real value can only be created by the hard work of dedicated, motivated employees that develop innovative products and services, establish intimate customer relationships, and build organizations over an extended period of time".
Medtronic's mission statement is still worth reading (and, no, I don't own stock). And Bill George is still making smart points on the same subject:
"The root cause of Citigroup´s and GM´s problems- and of our current economic crisis - is the mantra of "maximizing shareholder value," which led to an incessant focus on short-term gains. Any company that focuses primarily on short-term shareholder value will eventually destroy itself. When entire industries do so - as we have witnessed with financial service institutions and U.S. auto makers - they can drag the entire country into a deep recession".
Faustian Economics

Woe betide a customer focused company that gets taken over by one focused on financial returns – shareholders need to get out before the employees do. However, to implement this approach properly managements need to understand how to genuinely create value and, in the case of quoted companies, how to stand up to analysts who don’t like actually having to think for a living.

At the root of the desire to maximise shareholder value is a Faustian pact between the financial community and corporations. The desire of the former to be led by the nose to generate earnings forecasts and the wish of the latter's executive to boost share prices can lead to an escalating process of earnings management and manipulation that has little to do with running a company properly. As Fuller and Jensen record, in Just Say No to Wall Street:
"Many will say, “So what? If overly aggressive analysts drove executives to create more shareholder value faster, what’s the harm?” What they fail to recognize is that this vicious cycle can impose real, lasting costs on companies when analyst expectations become unhinged from what is possible for firms to accomplish."
Maximising short-term earnings - which is an imaginary number anyway - at the expense of the long-term stability of a business is exactly the wrong way to go about maximising shareholder value. Even more than this a corporation that doesn’t have good industrial relations is the walking dead. A company which is genuinely maximising shareholder value has a set of values which are communicated to its staff and which don’t shy away from the economic realities of the world. Companies which don’t manage these things don’t deserve the support of shareholders and, by and large, won’t get it.

Greed Ain't Good

Greed, by individuals or by corporations, is never, ever good for shareholders. It may offer some short-term gains to share prices but inevitably will end in disaster. Here’s an easy tip: most companies these days have some mission statement declaring what they stand for. If this talks about excellence, about providing benefits to society and a culture that’s supportive of staff then the corporation may be worth investigating further. If it speaks only of financial targets and maximising shareholder value then don’t waste any more time.

Maybe we can’t stop perversely incentivised corporations and executives but we can sure as hell avoid them.

Related Articles: CEO Pay - Because They're Worth It?, Peverse Incentives Are Daylight Robbery, Moral Corporations: An Oxymoron?


  1. Money is part of life. But it is not the only part.

    Become too focused on it and you lose the benefits of balance. And that means you end up making less money!


  2. Shareholder "value" does not equal shareholder price. Maybe the CEO should focus on the former but not the latter.

  3. John Kay's "Obliquity" is centred on exactly this argument, and is a good read (if a little slow going at times).

  4. The sad fact is that most investors are so wrapped up in newsflow and short-term stock price moves that they themselves create the incentive for CEOs to have the wrong focus.

  5. John Kay's "Obliquity" is centred on exactly this argument, and is a good read (if a little slow going at times).

    Hi Lemondy

    I know what you mean but I think that the book goes far beyond the single idea that maximising shareholder value can be achieved by inflating share prices (which is quite an old chestnut, beloved of Buffett and rehashed here). The core concept of Obliquity - that complex solutions can't be achieved by direct approaches because of the uncertainty associated with, well, everything - is pretty original in its breadth, I think, even if many of the individual examples are well known. And there are a couple of very interesting twists for anyone interested in behavioral finance ...

    Anyway, I've just finished writing an article about the book, so people can make up their own minds in a few weeks. Or better still, buy it :)

  6. Confused argument.

    Buffet often speaks of companies run for the shareholders. That means preserving and increasing value for the shareholders. Which means making money by selling stuff at the highest price the market will bear to you and me. Which is exactly what he's done.

    He also insists that the managers of any company he buys continue to run it, or he won't buy it. Which begs the question: why sell if you're the owner, are in charge and have a good long term business? Answer: to get the cash now. You see, selling means getting cash. How exactly are they not interested in money?

    Most companies start out serving a need, selling something customers want to buy. It's just that not all lines of business have staying power. Medtronic's CEO doesn't even know why his company is successful. Hint: it has more to do with patent protection keeping competitors out and less with "excellence" talk(whether communicated to the workforce or not).

    Here's Charlie Munger's explanation of good businesses who definitely are out there to increase shareholder value.

    Btw. greed does not fluctuate all that much, it's more or less constant.
    We all want more or better(in our own judgment) for us and our children. If you think you don't, cancel your internet and go and work the land with a horse and plow.