Friday, June 17, 2016

Shareholder value

In the last few decades there has been a shift in the purpose of a corporation. Now the mantra is a corporation must maximize shareholder value. Everything else is secondary. The radio program Marketplace has now concluded a week long series discussing how we got to this point and what are the consequences. The audio for the series is about 35 minutes. If my summary sometimes seems repetitive it is because ideas were mentioned as part of segments aired on different days.

Back in February I had written about why increasing shareholder value is a bad idea.

When candidates for president talk about bringing back jobs, keep out immigrants, drop out of trade agreements, reduce the power of Wall Street, reform campaign finance laws, retrain American workers, and cut taxes on job creators, they're talking about a time before shareholder value was king.

IBM used to take very good care of its employees. The company even owned golf courses. Good care of employees, according to Thomas Watson Senior and Junior, meant good productivity. An insecure employee didn't perform so well. So make them to feel secure. Yes, profits were good, but so was support of employees.

There were three sources of power: corporation leaders, government, and labor unions. The society was better when all three worked together. But in the 1970s corporations stagnated because of inflation and the cost of the Vietnam war. Corporations rethought their strategy – and decided that the bottom line was all.

In the 1980s IBM didn't see the popularity of the PC and defended the mainframe market. That didn't go well. An outsider was brought in to lead the company. And he repudiated all of Watson's employee protections.

In the 1970s Milton Friedman stated a corporation has only one responsibility, to increase its profits. He said this because the old corporate model was crumbling from inflation and weak growth. Corporations were taking on too many social responsibilities, such as full employment, pollution (!), and ending discrimination. Corporations became bloated. And a claim was made that the shareholder suffered because of the excessive executive perks. The idea of business for shareholder profits caught on and stuck.

Yes, shareholders were happy – stock prices shot up 12-fold in the '80s and '90s. For each dollar in profits, 80 cents went to shareholders.

Executives found the fastest way to boost profits was to cut employees. The corporate social contract was shredded. Along with it went generous employee benefits.

About this same time activist investors would buy shares to force corporations to shift to the shareholder first structure. This was easily done by threatening the senior leadership. If you won't do it we'll get someone who will.

However, there is no law that says the shareholder comes first. Even Justice Alito affirmed that idea just a few years ago. Though it wasn't actual law, it was acted upon as if it was law.

The emphasis on shareholder value has led to disasters, such as Enron and the BP oil spill.

Back to those 1970s pronouncements. The actual text was to "act in the best interest of the shareholders," which doesn't always mean maximize profit. It might, for instance, mean investing in the future of the company, so that its profits can continue for a longer time. In addition, those who made the pronouncements are having second thoughts.

The pharma industry is an example of what happened. In the first half of the 1900s George Merck, head of Merck & Co. said that profits would follow from how well their product benefited people. And the corporation did well.

But now the big pharma companies don't create the drugs, they buy them from elsewhere. That saves on development costs. Then they try to find new uses for the drugs. A second component of profit is taxes. A move to Ireland will help that along. And third is prices. It's no longer what is appropriate for the patient. It's how high to price the drug to boost income. The drive isn't to help patients, it's to help investors.

Those "activist investors" mentioned before are now usually hedge fund managers. Many times these guys will force a corporation to make some changes (see those threats mentioned above). Then once the stock prices has risen, they cash out. But the changes they forced on the corporation usually lead to big long-term problems.

Alas, one of the big sources of hedge fund money is us – in particular, public pension plans in our names. That's because the plans were set up with the expectation of high returns. Failure to meet those returns mean the plans are underfunded (and that usually implies the gov't entity that created the plan underfunded it at the start). These funds must pursue high returns to meet oblications. The other big source of money now in stocks is our 401(K) accounts and the mutual funds we invest in. But we're usually silent investors – do you know all the corporations in your accounts? And that allows the activist investors to speak with a louder voice.

Recently, many corporations have done stock buy-back programs. Yes, they are spending money to buy themselves. The reason is simple. It increases the value of the company in the eyes of the shareholder. But that value is only gained when the stock is sold.

A side effect of a buy-back is that it attracts shareholders who are in it for the short term. Those activist investors look for corporations with lots of cash on hand. They buy stock, raise hell, the management does a stock buy-back, and the investors cash out. That's essentially a wealth transfer from the corporation to the investor. Alas, that means the corporation no longer has that money for useful things like investing in their future – including stabilizing their workforce with higher wages and better benefits and also withstanding economic slumps. It also means the decisions are driven by the people who matter least – shareholders in it for a short time.

I know you would have never guessed this one... When the focus is on shareholder value, who loses? Yes, of course. Workers. The big way to make shareholder value go up is to reduce assets. And workers are assets. But the work still needs to get done. The result is the temp worker.

I remember when I worked for the auto industry (gosh, I left 9 years ago!) many of my colleagues were temp workers – even though many of them stayed for years and held important institutional knowledge. The reason is simple – it was a lot easier to reduce the number of workers by canceling temp contracts.

But it also means lower wages and skimpier benefits. And no permanence. Just try to buy a house when you list a temp company as your employer.

We've been hearing the GOP bellow for years that tax breaks should be given to the "job creators." But modern corporations see no value in creating jobs. Adding jobs reduces shareholder value.

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