Shareholder value maximisation: a dumb idea that we really have to dump

The world’s dumbest ideas. The bad news is that you could make a pretty long list of these. The good news is that they generally get called out pretty quickly. But there are some that just won’t die.

Comments on others are welcome below, but for an increasing number of the people who look at corporate governance, one of the worst is ‘shareholder value maximisation’ (SVM).

I’ve written about this here before (see previous posts on the talent myth, on how bad CEO incentives lead to low business investment, stagnant economic growth, flat worker wages and rising inequality; and yesterday’s on how financial incentives are worse than useless if you want to nurture creative thinking)..

GMO’s wonderful James Montier has now written on it as well.  It’s worth reading his whole piece, particularly if you are interested in how the idea that a company has no responsibility but to its shareholders – and so management must be rewarded as though they were short-term shareholders – came to be accepted wisdom.

He makes a few good key points.

The first is just how extreme the shift has been. Look at the mission statements for IBM, for example. In the early days it was all about three core principles: 1) respect for individual employees 2) a commitment to customer service and 3) achieving excellence. Today? The ‘Roadmap 2010’ shifted to the “primary aim of doubling earnings per share over the next five years.”

You might think that’s just fine – after all, as a shareholder surely what you want is SVM. Not so. Montier proves pretty conclusively that “the underlying return generation of companies has fallen significantly under SVM”.

First, options are a bad idea: they give executives none of the downside of a real shareholder but all of the upside, something that can only lead to skewed decision making.

Second, because (as I showed in my blog on the candle task and this one on Tesco) “incentives don’t always work in the way one might expect”. In general, the higher (and more life changing) they are, the more people focus on the money (and the attempt to extract the maximum of it in the minimum amount of time) than on the task in hand – and the bigger a mess they make of the task in hand.

All this has resulted in low rates of business investment. Why would a CEO of a public company who is incentivised by short-term profit, and who knows his tenure is likely to be under five years, sign off on long-term investments that might cut short term profits? He’d be nuts. Rather than to retain and reinvest cash for the firm he is incentivised to “downsize and distribute.*”

Pre SVM, some 10%-20% of the average public firm’s cashflow was returned to shareholders. It was more like 50% by 2007. That isn’t good.

It has also led to rising inequality: the beneficiaries of SVM are at the top of the income tree – managers, shareholders and the financiers managing the buybacks and leverage that SVM encourages.

And finally, it has resulted in a low labour share of GDP: the victims of SVM are at the bottom of the income tree. Who puts up wages when they are trying to maximise short term profits? Quite. It’s time for change.

* For more on this please read Andrew Smithers’ Road to Recovery which I suggested here last year. More on it here.