James Montier has a good post over at GMO, The World’s Dumbest Idea, in which he tries to diagnose what has gone wrong with American capitalism. This is now a popular debate. Montier is a superb market analyst, and he adds to the debate by showing, quantitatively, what has happened to American companies over the past forty years. Jeremiah’s readers will recall that America started going to hell in the 1970s.
Before 1976, professional managers were in charge of performance in the real market and were paid for performance in that real market.
Montier lays the blame on Milton Friedman and a management fad called shareholder value maximization (SVM). He makes observations about corporate short termism, executive compensation, and social responsibility. Montier distinguishes the SVM period from an earlier (and better) “era of managerialism.” Here is his chart showing how SVM has shortened the lives of successful American companies.
To some extent, this is a semantic argument about the meaning of “shareholder value.” Obviously, if myopic (and overpaid) executives are destroying big companies, that is no one’s idea of value.
Writing in 1970, Friedman had probably the same idea of value as did most professional managers, i.e., “if we take care of the customer, then the profits will take care of themselves.” Those were the days of investing for the long term, for retirement. The leading newsletter was called Value Line. Montier, himself, is a “value” investor. The idea that executives could use leverage to juice their options hadn’t been invented yet.
If [a sole proprietor] acts to reduce the returns of his enterprise in order to exercise his “social responsibility,” he is spending his own money, not someone else’s.
Friedman’s point was that executives are not hired to spend the shareholders’ money on social projects. They should focus on making a profit, and then the shareholders can – individually – support social projects as they desire.
A confirmed free marketer, Friedman believed that a company serves society best by creating products that people want to buy, and jobs that people want to hold. This is not too different from the oft cited mission statements of companies like P&G and J&J.
Friedman never actually said “shareholder value maximization.” He talked about increasing profits, which – in the old days – was understood to depend on those other values.
We will provide branded products and services of superior quality and value that improve the lives of the world’s consumers, now and for generations to come.
In the old days, people didn’t expect to get rich quick on their investments. In a market based on value, that is not realistic. The way to get rich quick is to pillage the value built up by more responsible managers.
Montier cites the case of IBM, and their plan to double EPS in five years. Seriously, double EPS in five years? Any cogent director would have to ask how the new CEO plans to do that. Is there a magic elixir to double our sales? Or, is he planning to slash R&D, cut staff, and load up on debt? You would hope that someone whose family name is on the building defenestrates him at that point – Montier supplies a comparison with privately held firms.
The real problem is not Friedman and not, strictly speaking, SVM. The real problem is that mechanisms have been invented whereby executives can pump their share prices, and their compensation, while actually destroying value. Studies and samples vary, but corporate debt in America has gone from something like two times earnings, in the old days, to four times earnings today.
For the last 35 years, stock-based compensation has been tried. It had the opposite effect of what was intended.
Montier’s article is filled with facts about the perverse consequences of stock based compensation, but he doesn’t make any serious recommendations for public policy. He leaves us hanging with a vague notion of “stakeholder capitalism,” and an apology for sounding socialist. Of course, this is where a socialist would say that government should run all the companies, because “the government doesn’t have to make a profit.”
That is actually the world’s dumbest idea. It would merely exchange one set of rapacious managers for another, probably worse. It is also a case of freeze-frame economics. Socialists always want to take over the existing companies, with no provision for entrepreneurial new ones.
So, what about policy? The Forbes article quoted here contains specific legal reforms, like getting rid of forward guidance. Another obvious reform would be to hike interest rates. The Fed is ostensibly “independent” so that they can choke off asset price inflation, financialization, and structural traps. It doesn’t take independence to be the stooge of Wall Street.