If you agree with the economist John Maynard Keynes that “ideas shape the course of history,” then you ought to agree that the history of modern business and finance has been shaped by one influential idea: that the job of a company’s management is to maximize shareholder value. But according to James Montier, a distinguished investment professional and behavioural finance writer, shareholder value maximization is “a bad idea.” He believes it has not added any value for shareholders and has contributed to such major economic and social problems as short-termism and rising inequality.
Montier made his case against shareholder value maximization when delivering the closing keynote address at the 2014 European Investment Conference in London. In his characteristic iconoclastic style with a generous use of ironic humour, Montier labeled shareholder value maximization, the way Jack Welch, the former CEO of GE, had once described it in 2009, as “the dumbest idea in the world.”
An Academic Opinion without Much Evidence
Montier said that the idea of shareholder value maximization didn’t come from businesses but rather originated as an opinion in academia and was unsupported by much evidence. It is most directly traced to an op-ed written by economist Milton Friedman in 1970. Over the years, academic research papers on the subject, such as those by Michael C. Jensen and William H. Meckling (PDF) and Jensen and Kevin J. Murphy (PDF), have made it inseparable from the alignment of incentives. That is, top management of companies should be offered financial incentives (e.g., stock ownership and call options) to align their interest with maximizing the stock price.
The idea of shareholder value and incentives then worked its way into practice. Montier gave the example of Business Roundtable (BRT), an association of CEOs of major US companies. He said that in 1981, the mission of BRT referred to making quality goods and services, earning a profit, and building the economy, but by 1997, it became firmly focused on shareholder value.
Failing Shareholders
Montier claimed that shareholder value maximization has failed the shareholders — its intended beneficiaries. Despite enormous increases in compensation of CEOs and a rising proportion of financial incentives through stock ownership and options, shareholders are not better off. To illustrate this point with a case example, Montier compared the return performance of IBM, which switched its focus to shareholder value maximization, to that of Johnson & Johnson, which retained its credo (PDF) emphasizing responsibility to customers, employees, and communities. Montier showed that during 1971–2013, the stock of Johnson & Johnson had indeed outperformed that of IBM.
Widening his analysis, Montier asserted that during 1940–1990, what he called “the managerial era,” the annual real return to shareholders in listed equities was 7%. After the 1990s, during “the shareholder value maximization era,” it was also about 7%. But, he added, when adjusted for changes in valuation independent of shareholder value maximization, isolating yield and growth, the return in the shareholder value maximization era lags by about 2 percentage points.
What Went Wrong?
Montier said that financial incentives for management that were meant to maximize shareholder value did not work because of a flawed understanding of how human beings respond to incentives. Under the mantra of shareholder value maximization, CEOs are now being paid more than ever before and about two-thirds of that compensation is in the form of stock ownership and stock options. Call options, which only pay off if stock prices rise, encourage short-term gaming by CEOs rather than long-term value creation. More importantly, as research from behavioural finance shows, when incentives become large, those being incentivized become obsessed with the incentives themselves and lose sight of what the incentives are meant to achieve. Montier believes that rather than focusing on the long-term prosperity of their businesses, CEOs are focusing on how much more money they can make if they can game the system.
Instead of observing reality and deducing their theories from what they see, Montier claimed, economists supporting shareholder value maximization tried to fit available facts to their opinions about incentives and human behaviour. Montier quoted President Ronald Reagan: “An economist is someone who sees something happen in practice and wonders if it’d work in theory.”
A Cause of Short-Termism and Inequality
Montier contended that shareholder value maximization and financial incentives are a direct cause of short-termism and inequality. The life-span of an S&P 500 company has decreased from more than 26 years in 1971–1976 to close to 15 years in 2005–2010, and the average tenure of CEOs has shrunk from 10 years to six years. Private companies, not subject to the same short-termism pressures, invest more than public companies, and CFOs of listed companies are willing to forego projects with positive net present value to make quarterly earnings targets. From “retain and reinvest,” companies have moved to “downsize and distribute.” It is hard to argue that companies do not have ample investment opportunities available to them in the real economy, but many companies are instead buying back shares, often at record high prices.
Connecting short-termism with its effects on society and economy, Montier pointed to “three stylized facts”:
- Business investment as a percentage of GDP is declining.
- There is rising income inequality in society (PDF), and the share of income of business executives and financiers has increased dramatically.
- Labor is losing its share of GDP.
Short-termism and inequality hurt our societies and economies, Montier said. There are fewer new projects and jobs because companies are preoccupied with meeting quarterly earnings targets. There is also less spending in the economy, slowing down our economic growth, as those who spend a higher proportion of their income have a lower share of income.
Montier believes that our world would have looked different if instead of maximizing shareholder value and enriching themselves with exorbitant and problematic incentives, those managing companies were required to focus on running their businesses, producing quality goods and services, treating customers and workers fairly, and creating shareholder value as a by-product, not as an objective.
A video recording of James Montier’s talk at the conference is available here.
You can also read an Enterprising Investor blog post on the issue: “Maximization of Shareholder Value: Flawed Thinking That Threatens Our Economic Future.”
Copyright © Usman Hayat, CFA, CFA Institute, European Investment Conference
