The World's Dumbest Idea
excerpt by James Montier, GMO LLC
When it comes to bad ideas, finance certainly offers up an embarrassment of riches – CAPM, Efficient Market Hypothesis, Beta, VaR, portfolio insurance, tail risk hedging, smart beta, leverage, structured finance products, benchmarks, hedge funds, risk premia, and risk parity to name but a few. Whilst I have expressed my ire at these concepts and poured scorn upon many of these ideas over the years, they aren’ t the topic of this paper.
Rather in this essay I want to explore the problems that surround the concept of shareholder value and its maximization. I’m aware that expressing skepticism over this topic is a little like criticizing motherhood and apple pie. I grew up in the U.K. watching a wonderful comedian named Kenny Everett. Amongst his many comic creations was a U.S. Army general whose solution to those who “didn’t like Apple Pie on Sundays, and didn’t love their mothers” was “to round them up, put them in a field, and bomb the bastards,” so it is with no small amount of trepidation that I embark on this critique.
Before you dismiss me as a raving “red under the bed,” you might be surprised to know that I am not alone in questioning the mantra of shareholder value maximization. Indeed the title of this essay is taken from a direct quotation from none other than that stalwart of the capitalist system, Jack Welch. In an interview in the Financial Times from March 2009, Welch said “Shareholder value is the dumbest idea in the world.”
A Brief History of a Bad Idea
Before we turn to exploring the evidence that shareholder value maximization (SVM) has been an unmitigated failure and contributed to some very undesirable economic outcomes, let’s spend a few minutes tracing the intellectual heritage of this bad idea.
From a theoretical perspective, SVM may well have its roots in the work of Arrow-Debreu (in the late 1950s/early 1960s). These authors demonstrated that in the presence of ubiquitous perfect competition and fully complete markets (neither of which assumption bears any resemblance to the real world,1 of course) a Pareto optimal outcome will result from situations where producers and all other economic actors pursue their own interests. Adam Smith’s invisible hand in mathematically obtuse fashion. However, more often the SVM movement is traced to an editorial by Milton Friedman in 1970.2 Given Friedman’s loathing of all things Keynesian, there is a certain delicious irony that the corporate world is so perfectly illustrating
Keynes’ warning of being a slave of a defunct economist! In the article Friedman argues that “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits...” Friedman argues that corporates are not “persons,” but the law would disagree: firms may not be people but they are “persons” in as much as they have a separate legal status (a point made forcefully by Lynn Stout in her book, The Shareholder Value Myth ). He also assumes that shareholders want to maximize profits, and considers any act of corporate social responsibility an act of taxation without representation – these assumptions may or may not be true, but Friedman simply asserts them, and comes dangerously close to making his ar gument tautological.
Following on from Friedman’s efforts, along came Jensen and Meckling in 1976. They argued that the key challenge when it came to corporate governance was one of agency theory – effectively how to get executives (agents) to focus on maximizing the wealth of the shareholders (principals). This idea can be traced all the way back to Adam Smith in The Wealth of Nations
(1776) where he wrote:
The directors of such [joint stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give them a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.
Under an “efficient” market, the current share price is the best estimate of the expected future cash flows (intrinsic worth) of a company, so combining EMH with Jensen and Meckling led to the idea that agents could be considered to be maximizing the principals’ wealth if they maximized the stock price.
This eventually led to the idea that in order to align managers with shareholders they need to be paid in a similar fashion. As Jensen and Murphy (1990) wrote, “On average, corporate America pays its most important leaders like bureaucrats.” They argued that “Monetary compensation and stock ownership remain the most effective tools for aligning executive and shareholder interests. Until directors recognize the importance of incentives and adopt compensation systems that truly link pay and performance, large companies and their shareholders will continue to suffer from poor performance.”
Widespread Adoption of the Bad Idea
So far we have traced only the rise of SVM amongst academics and, frankly, who cares what a bunch of academics think? Of considerably more concern is the evidence that the tenet of SVM has become conventional wisdom (an oxymoron if ever there was one) amongst those who inhabit the real world. For instance, take a look at the statements issued by the Business Roundtable (an association of CEOs of leading U.S. companies). In 1981 they stated, “Corporations have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment...provide jobs, and build the economy .”
By 1997, this concern for the role of the corporation at large had transmuted into a single-minded focus on SVM as represented by the following edict: “The principal objective of a business...is to generate economic returns to its owners...if the CEO and the directors are not focused on shareholder value, it may be less likely the corporation will realize that value.”
In many ways that bluest of blue chips, IBM, represents a perfect microcosm of the general pattern of obsession with SVM. Cast your eyes over Exhibit 1. It charts the total returns to an investor in IBM since 1973. In those early days, IBM’s mission statement was outlined by Tony Watson (the son of the founder) and was based on three principles (in descending order of importance): 1) respect for individual employees; 2) a commitment to customer service; and 3) achieving excellence.
Read/download James Montier's complete note below:
