Steve Denning
“There is a rare type
of organism that eats itself alive,” writes Dennis Berman in the Wall Street Journal.
The short-tailed cricket, for instance, eats its own wings. The sea squirt
digests its own brain after attaching itself to a rock. And the North American
rat snake has been known to consume two-thirds of its entire body.
Another organism that
is currently practicing self-cannibalism, Mr. Berman writes, is Corporate
America.
The 100 largest
companies in the S&P, writes Mr. Berman, have spent around $1 trillion on
share buybacks since 2008. And the pace is increasing. “In the 12 months ending
in September,” writes David Hall also in the Wall Street Journal, “the total
dollar amount of all corporate buybacks increased by 15 percent from a year
earlier.” (Mr. Berman cites one major firm that has, over the last twenty
years, bought back more than half its own shares. If it were to continue at
this pace, by the year 2034, it would have no publicly traded shares at all.)
The practice of share
buybacks, which is facilitated by cheap money from the Fed, is worrying for
several reasons:
“Those buybacks have
been substituting for substantive future investment, be it software engineers,
new products, or extra marketing. This has two effects: It stymies the economic
growth originally intended by the Fed. And it could eventually leave businesses
ill-equipped to adapt to changes in their industries.”
If only one or two
firms were doing this, it might not matter much. But when most large firms are
spending massive amounts on buying back their own shares, the implications are
macro-economic. The national economy remains stagnant, even as share prices are
soaring. The rising stock market reflects financial gadgetry more than growth
of the real economy.
Shying away from
investment
- · Honeywell International [HON] has been making about 4 percent on its share buybacks, compared to 13 percent on business assets.
- · Oracle [ORCL] is spending half its cash flow in share buybacks, when the return on buybacks has been around 5 percent, compared to around 32 percent on past investments.
Still the world’s dumbest idea: maximizing shareholder value
There is another way: the Creative Economy
Is this shying away
from investment based on low returns from investment? Not so, says Mr. Berman.
In collaboration with hedge fund manager Jim Chanos, one of Wall Street’s
legendary short sellers, Mr. Berman concludes that the returns on “net business
assets” i.e. “actual stuff used in actual business,” have historically been
much higher than share buybacks. For instance:
Is this seemingly
irrational pursuit of lower returns by Corporate America based on a shrewd
assessment of an abrupt decline in investment opportunities? That’s hardly
plausible, given the immense possibilities being unleashed by new technology
and the Internet, as whole sectors of the economy are systematically
transformed. It could be argued that there has never been a better time to be
an entrepreneur. But entrepreneurship is not what’s driving this corporate
behaviour.
Instead, Messrs
Berman and Chanos suggest that the decisions are made “by rote and by fear”,
driven by the C-suite’s perception that they are under “the threat from
shareholder activists, who now patrol the market like prison guards with billy
clubs. Overspend and get whacked.”
C-suite compensation
also plays a role. Given that the current extraordinary levels of executive
compensation are directly linked to movements in the short-term share price,
amid faster executive turnover, we should hardly be surprised that the C-suite
is more focused on actions that can move the share price in positive
directions, and less on investments that will only pay off in the medium term.
As Upton Sinclair once pointed out, “it is difficult to get a man to understand
something when his salary depends on not understanding it.”
The decision-making
thus appears to be yet another disastrous consequence of what Jack Welch has
called “the world’s dumbest idea”: maximizing shareholder value.
A
brilliant study by economists from the Stern School of Business and Harvard
Business School, Alexander Ljungqvist, Joan Farre-Mensa, and John Asker,
entitled “Corporate
Investment and Stock Market Listing: A Puzzle,“ offers confirmation. The study
compares the investment patterns of public companies and privately held firms.
It turns out that the lag in investment is a phenomenon peculiar to public
companies.
Thus in standard
economic theory, it makes no sense that net investment by public firms is a meagre
4 per cent of output since the meltdown of 2008, when pre-tax corporate profits
are now at record highs – more than 12 per cent of GDP. When profits go up,
companies should be seizing investment opportunities to lay the groundwork for
even more profits in future. In turn, that investment should create jobs,
generate more capital goods and lead to higher wages. That’s how capitalism is
meant to work. So why isn’t it happening?
The study finds that
“ keeping company size and industry constant, private US companies invest
nearly twice as much as those listed on the stock market: 6.8 per cent of total
assets versus just 3.7 per cent.”
In other words, firms
that perceive themselves to be at the mercy of shareholder activists pursuing
the maximization of shareholder value invest roughly half as much as those
private firms that are relatively free from such pressures.
As
Matthew Yglesias at Slate writes:
“On this account we
are reaping the bitter fruits of the ‘shareholder value’ revolution. Executives
at publicly traded companies are paid to generate higher share prices, which is
done by hitting quarterly earnings targets. This leads to underinvestment
relative to the behaviour of managers of privately held firms. Not because
managers of private firms are indifferent to the interests of shareholders, but
because there’s less need for creating the shareholder value link via a
simplistic relationship between compensation, share price, and quarterly
earnings.”
As
Robin Harding in the Financial
Times concludes, it is “time to stop thinking about
corporate governance and executive pay as matters of equity and to regard them
instead as a macroeconomic problem of the first rank.”
There
is of course another way to run organizations, as illustrated by Amazon [AMZN]
and other companies that embody the Creative
Economy.
Their goal is not short-term profits or meeting quarterly targets, but rather
adding value for customers through investment in continuous innovation. The
returns from this different approach are extraordinary.
Thus while many
companies consume themselves with share buybacks, “Amazon [AMZN] continues to
pour in big dollars into actual technology. It grew its capital spending 14-fold
since 2008, and R&D spending fivefold.”
The argument offered
by executives that “Wall Street made us do it” has the same legitimacy as “the
dog ate my homework” when public companies like Amazon [AMZN], Whole Foods
[WFM] and Costco [COST] have been successfully pursuing customer value, with
broad applause from Wall Street.
So isn’t it time we
stop according extraordinary compensation to Corporate America’s leaders for
meeting their quarterly numbers through the short-sighted tactic of
self-cannibalism, and instead focus business on its true goal of adding value
to customers with investments and innovation in real products and services?
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