How the pursuit of shareholder value weakened the economy

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During the 1980s we started to think that the best way to run a company was simply to run it for the benefit of the owners, that is, creating shareholder value became the overriding, if not the single objective.

In order to get management on board, we had to get rid of the agency problem, that is, financial incentives were used to align the interests of management and owners. 

In the past, management had too much leeway, it was argued. Pursuing objectives like growth for its own sake (as management pay and prestige were more dependent on the size of the company).

Focusing on creating shareholder value was simpler, no conflicting goals, a clear measure of success is visible for all. 

The consequences of this shift in corporate governance have not been good, we'll describe the main consequences in this thread.

1. Executive pay exploded
   
2. Companies aren't run any better
   
3. It hasn't produced an investment boom
   
4. Gaming the system
   
5. Value extraction, rather than value creation
   
6. It has contributed to wage stagnation
   
7. There has been considerable amount of gaming the system
   
8. It is a main factor behind rising inequality, which is damaging the economy
   
9. A vicious cycle is likely
   

1) Executive pay exploded

Consider that in 1965, CEOs of America’s largest corporations were paid, on average, 20 times the pay of average workers. Now, the ratio is over 300 to 1. Not only has CEO pay exploded, so has the pay of top executives just below them. The share of corporate income devoted to compensating the five highest-paid executives of large corporations ballooned from an average of 5 percent in 1993 to more than 15 percent by 2005 (the latest data available)...

Robert Reich

This is mostly a consequence of dealing with what economist call an agency problem, that is, the problem to align the interests of management (the agents) with the owners (the principals).

In the past, management was deemed to deviate too much from the interests of the owners (shareholders), for instance by wasting money on lavish management perks and emphasizing growth of the company over its profitability, as the size of a company confers status, power and higher salaries to management.

In order to align the interests of management and shareholders, executive pay became more performance related, with shareholder value the main metric. This introduced incentive pay in the form of stock options and share based compensation, which has greatly ballooned over the past decades.

But the single-minded pursuit of shareholder value, while giving more clarity to company objectives, has produced a series of side effects that have had negative consequences for the functioning of the economy at large, which we'll try to set out in this thread. 

One of these consequences is the explosion of executive pay. In and by itself this wouldn't necessarily be a problem, if it led to better run companies which invested more. But there is evidence that it actually has done the opposite. 

[fsilk]

Republicans don't want you to know..

The Securities and Exchange Commission on Wednesday made waves in approving 3-2 a rule that will require most public companies to regularly disclose the ratio of chief executive pay to that of the average employee. The rule came at the urging of Democrats like Senator Elizabeth Warren and worker groups like the AFL-CIO. And it was approved despite opposition from the business community and Republicans.

The Chamber of Commerce is expected to sue over the rule. The head of its Center for Capital Markets Competitiveness David Hirschmann said that the rule “is more harmful than hurtful” and that the Chamber will seek to “clean up the mess. “To steal a line from Justice Scalia, this is pure applesauce,” SEC Republican Commissioner Daniel Gallagher said to Reuters.

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2) Companies are not run better
There seems to be little link between performance and pay, Robert Reich cites a study:

Professors Michael J. Cooper of the University of Utah, Huseyin Gulen of Purdue University, and P. Raghavendra Rau of the University of Cambridge, recently found that companies with the highest-paid CEOs returned about 10 percent less to their shareholders than do their industry peers.

Bryce Covert cites another one:

Equilar, an executive compensation consultancy, compared the salaries of 200 highly paid CEOs to their companies’ performance based on things like profitability, revenue, and stock return. Rather than showing a clear trend line linking pay and performance, the data is scattered. In fact, chief executive pay is only 1 percent based on stock performance, with 99 percent based on other things entirely.

They got a graph looking like this:

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3) It hasn't produced an investment boom

In fact quite the contrary:

Since 1980, U.S. investment as a percentage of GDP was sliced in half, from nearly 24 percent to 12 percent, leaving the United States 174th in the world. The result was a dearth of real value added products and productivity.

While there is no definite evidence that the change in corporate governance is the main culprit here, nevertheless there are a few indications:

• Companies care more about meeting the quarterly earnings reports, as the effect on share prices directly influences executive pay.
  
• Investment decisions have a tendency to shift towards projects with a shorter term horizon and more certain pay-off.
  
• For the same reason, this tends to put more emphasis on cost cutting, rather than expansion, as the returns on that are more certain and more short-term.
  
• For that reason, it has probably also contributed to the stagnation of real wages.
  

According to William Lazonick we have moved from a retain-and-reinvest model that run until the late 1970s where companies

retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what I call “sustainable prosperity.”

But this has given way to a downsize-and-distribute regime which emphasized cost cutting and the distributing the freed-up cash to financial interests. Despite a big increase in the profit share:

Corporate profitability is not translating into widespread economic prosperity. The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.

Even people like Stanley Druckenmiller are getting concerned:

Capital spending is the lowest it's been relative to sales in many, many years. That's the reason productivity is down. We've got to get out of this financial engineering stuff and get more into investing in the real economy."

Or, from the Washington Post

Over the past decade, more than 90 percent of Fortune 500 corporations’ net earnings have been funneled to investors. The great shareholder shift has affected more than employees’ incomes. As Luke A. Stewart and Robert D. Atkinson noted in a 2013 report for the Information Technology and Innovation Foundation, business investment in equipment, software and buildings increased by just 0.5 percent per year between 2000 and 2011 — “less than a fifth that of the 1980s and less than one-tenth that of the 1990s.”

And

The power of major shareholders to appropriate corporate revenue has grown as the power of workers to win raise increases has dwindled — even though the actual commitment of shareholders to any one corporation has diminished. (In 1960, the average length of time an investor held a stock was eight years; today, it’s four months, and when computerized high-frequency trading is factored in, it’s 22 seconds.) The decimation of private-sector unions has flatly eliminated the ability of large numbers of U.S. workers to bargain collectively for better pay or working conditions. But the ability of financiers to threaten the jobs of corporate managers unless they fork over more cash to shareholders has greatly increased.

And Laurence Fink, CEO of BlackRock:

Laurence Fink, the chairman and CEO of BlackRock, the world’s largest asset manager, wrote in an open letter to corporate America in March. “Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”

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4) Gaming the system
Putting all emphasis on creating shareholder value as the single measure of success, and tying executive compensation to it via stock options and share based compensation, this opened the way for gaming the system:

• A series of accounting scandals emerged in the late 1990s (Enron, Worldcom, etc.) in which complex accounting tricks were deployed, often with tacit agreement from accounting firms, to keep the share price up.
  
• Companies became enthusiastic buyers of their own shares, this is one way that management can use to boost it share price and hence it's own compensation.
  

There is a pretty good relationship between the share price and the level of buybacks and dividends:



Lazonick again:

Why are such massive resources being devoted to stock repurchases? Corporate executives give several reasons, which I will discuss later. But none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay, and in the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards.

You'll notice another problem in the graph above, companies tend to buy back their shares when they are expensive. It is often argued that companies buy back their own shares as a signal that they think the shares are undervalued. Reality seems pretty much the opposite..

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5) Value extraction, rather than value creation

Look at the figure below:



For the past two decades, companies haven't raised capital, in fact they have withdrawn huge sums, and these sums really are huge:

In 2014, S&P 500 companies bought back $553 billion in shares, in addition to paying shareholders $350 billion in dividends. Total returns to shareholders equaled $904 billion, a bit shy of reported earnings of $909 billion.

That is, almost all reported profits went to buybacks and dividends..

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6) Focusing on shareholder value as the sole purpose has contributed to wage stagnation

There is no doubt that since the shareholder value revolution, the benefits of the company have gone overwhelmingly to  and shareholders and top management (much of it through stock and option based compensation). Tthe top CEO to worker pay ratio increased from 20:1 to over 300:1 today.

Stock and option based compensation simply shifts the incentives towards maximizing the short-term stock price as this is related to most of executive compensation. William Lazonick:

Stock-based instruments make up the majority of their pay, and in the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.

We have already seen above that share prices indeed correlate with buybacks. It's a main driver of executive pay: Lazonick:

As documented by the economists Thomas Piketty and Emmanuel Saez, the richest 0.1% of U.S. households collected a record 12.3% of all U.S. income in 2007, surpassing their 11.5% share in 1928, on the eve of the Great Depression. In the financial crisis of 2008–2009, their share fell sharply, but it has since rebounded, hitting 11.3% in 2012.

Since the late 1980s, the largest component of the income of the top 0.1% has been compensation, driven by stock-based pay. Meanwhile, the growth of workers’ wages has been slow and sporadic, except during the internet boom of 1998–2000, the only time in the past 46 years when real wages rose by 2% or more for three years running. Since the late 1970s, average growth in real wages has increasingly lagged productivity growth. 

While company earnings are not a zero sum game, what is notable is that median wages have started to lag the growth of productivity in a meaningful way, and while this effect has played out in other countries, none of them to the extent of what happened in the US. As we wrote elsewhere, this really is almost exclusively a US problem.



While there are other reasons for the wage stagnation, the shift to shareholder value as the exclusive goal of the company is, in all likelihood contributing significantly:

• Proportionally much more of the company's spoils go to shareholders and executives
  
• It changes the incentives of management to short-term cost cutting and away from making long-term investments in capabilities with more uncertain returns. We have already seen above the shareholder revolution hasn't been followed by an investment boom, quite the contrary. This is hurting wages in two ways, with less investment, companies grow less fast, hurting future employment opportunities. Declining investment also lead to a faster aging capital stock and a slower introduction of newer, more productive capacity. While this is beneficial for employment levels in the short run, it hurts productivity growth and the possibility for real wage rises.
  

[stpioc]

Even on Wall street doubts emerge..

More than that, though, is that investors are tiring of companies devoting so much money toward buybacks and dividends and comparatively small levels to capital spending. Dividends and buybacks combined in 2015 for a record $954.6 billion, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. In its latest Global Fund Manager Survey, Bank of America Merrill Lynch found that the level of market professionals who believe companies are spending too much on payouts — "fatigue with financial engineering," as the survey put it — has reached its highest level since the bull market began in March 2009.

Buyback fuel for the bull market is losing steam

But there seem to be other reasons than the effect on the economy..

Buybacks are becoming an increasingly inefficient way to boost share prices, with individual companies that devote a large share of buybacks underperforming their peers over the past year.Caterpillar, for instance, has been a company aggressively buying back shares but with little to show performance-wise. The company has spent more than $8 billion buying back shares over the past three years, a time during which its stock has declined more than 12 percent. More broadly, an exchange-traded fund that tracks the companies that commit the most to buybacks has performed poorly. The SPDR S&P 500 Buyback fund has lost about 9 percent over the past year, a time during which the S&P 500 index has been down about 1.2 percent.

Buyback fuel for the bull market is losing steam

[stpioc]

BP has defended a huge increase in the amount it paid CEO Bob Dudley in the face of anger among many investors. Shareholders voting at BP's annual meeting Thursday are angry that Dudley took home $19.6 million in pay and benefits in 2015, up 20% over the previous year. The bumper payout came despite an annual loss of $5.2 billion, a collapse in the group's share price, and plans to shed 7,000 jobs by the end of 2017.

BP defends massive pay hike for CEO - Apr. 14, 2016

[stpioc]

Time was, layoffs were seen as an emergency strategy, the last resort in a downturn or crisis. Today, however, layoffs are a standard tool for doing business. As the economy continues to heal and job indicators improve, a number of firms have announced a fresh wave of layoffs — Nordstrom, Sprint and American Express among them — citing the need to improve profitability. Studies have shown that layoffs do not generally result in improved profits. And yet, firms continue to keep the pink slips at the ready. Why? It’s about the triumph of short-termism, says Wharton management professor Adam Cobb. “For most firms, labor represents a fairly significant cost. So, if you think profit is not where you want it to be, you say, ‘I can pull this lever and the costs will go down.’

How Layoffs Hurt Companies - Knowledge@Wharton