| The Dumbest Idea In The
World: Maximizing Shareholder Value |
| There is only one valid definition of a
business purpose: to create a customer |
| BY PETER DRUCKER,
The Practice of Management
(from
Forbes) |
|
|
 “Imagine an NFL coach,” writes Roger Martin,
Dean of the Rotman School of Management at the University of
Toronto, in his important new book, Fixing the Game, “holding a
press conference on Wednesday to announce that he predicts a win
by 9 points on Sunday, and that bettors should recognize that
the current spread of 6 points is too low. Or picture the team’s
quarterback standing up in the postgame press conference and
apologizing for having only won by 3 points when the final
betting spread was 9 points in his team’s favor. While it’s
laughable to imagine coaches or quarterbacks doing so, CEOs are
expected to do both of these things.”
Imagine also, to extrapolate Martin’s analogy, that the coach
and his top assistants were hugely compensated, not on whether
they won games, but rather by whether they covered the point
spread. If they beat the point spread, they would receive
massive bonuses. But if they missed covering the point spread a
couple of times, the salary cap of the team could be cut and key
players would have to be released, regardless of whether the
team won or lost its games.
Suppose also that in order to manage the expectations implicit
in the point spread, the coach had to spend most of his time
talking with analysts and sports writers about the prospects of
the coming games and “managing” the point spread, instead of
actually coaching the team. It would hardly be a surprise that
the most esteemed coach in this world would be a coach who met
or beat the point spread in forty-six of forty-eight games—a 96
percent hit rate. Looking at these forty-eight games, one would
be tempted to conclude: “Surely those scores are being
‘managed’?”
Suppose moreover that the whole league was rife with scandals of
coaches “managing the score”, for instance, by deliberately
losing games (“tanking”), players deliberately sacrificing
points in order not to exceed the point spread (“point
shaving”), “buying” key players on the opposing team or gaining
access to their game plan. If this were the situation in the
NFL, then everyone would realize that the “real game” of
football had become utterly corrupted by the “expectations game”
of gambling. Everyone would be calling on the NFL Commissioner
to intervene and ban the coaches and players from ever being
involved directly or indirectly in any form of gambling on the
outcome of games, and get back to playing the game.
Which is precisely what the NFL Commissioner did in 1962 when
some players were found to be involved betting small sums of
money on the outcome of games. In that season, Paul Hornung, the
Green Bay Packers halfback and the league’s most valuable player
(MVP), and Alex Karras, a star defensive tackle for the Detroit
Lions, were accused of betting on NFL games, including games in
which they played. Pete Rozelle, just a few years into his
thirty-year tenure as league commissioner, responded swiftly.
Hornung and Karras were suspended for a season. As a result, the
“real game” of football in the NFL has remained quite separate
from the “expectations game” of gambling. The coaches and
players spend all of their time trying to win games, not gaming
the games.
The real market vs the expectations market
In today’s paradoxical world of maximizing shareholder value,
which Jack Welch himself has called “the dumbest idea in the
world”, the situation is the reverse. CEOs and their top
managers have massive incentives to focus most of their
attentions on the expectations market, rather than the real job
of running the company producing real products and services.
The “real market,” Martin explains, is the world in which
factories are built, products are designed and produced, real
products and services are bought and sold, revenues are earned,
expenses are paid, and real dollars of profit show up on the
bottom line. That is the world that executives control—at least
to some extent.
The expectations market is the world in which shares in
companies are traded between investors—in other words, the stock
market. In this market, investors assess the real market
activities of a company today and, on the basis of that
assessment, form expectations as to how the company is likely to
perform in the future. The consensus view of all investors and
potential investors as to expectations of future performance
shapes the stock price of the company.
“What would lead [a CEO],” asks Martin, “to do the hard,
long-term work of substantially improving real-market
performance when she can choose to work on simply raising
expectations instead? Even if she has a performance bonus tied
to real-market metrics, the size of that bonus now typically
pales in comparison with the size of her stock-based incentives.
Expectations are where the money is. And of course, improving
real-market performance is the hardest and slowest way to
increase expectations from the existing level.”
In fact, a CEO has little choice but to pay careful attention to
the expectations market, because if the stock price falls
markedly, the application of accounting rules (regulation FASB
142) classify it as a “goodwill impairment”. Auditors may then
force the write-down of real assets based on the company’s share
price in the expectations market. As a result, executives must
concern themselves with managing expectations if they want to
avoid write-downs of their capital.
In this world, the best managers are those who meet
expectations. “During the heart of the Jack Welch era,” writes
Martin, “GE met or beat analysts’ forecasts in forty-six of
forty-eight quarters between December 31, 1989, and September
30, 2001—a 96 percent hit rate. Even more impressively, in
forty-one of those forty-six quarters, GE hit the analyst
forecast to the exact penny—89 percent perfection. And in the
remaining seven imperfect quarters, the tolerance was
startlingly narrow: four times GE beat the projection by 2
cents, once it beat it by 1 cent, once it missed by 1 cent, and
once by 2 cents. Looking at these twelve years of unnatural
precision, Jensen asks rhetorically: ‘What is the chance that
could happen if earnings were not being “managed’?”’ Martin
replies: infinitesimal.
In such a world, it is therefore hardly surprising, says Martin,
that the corporate world is plagued by continuing scandals, such
as the accounting scandals in 2001-2002 with Enron, WorldCom,
Tyco International, Global Crossing, and Adelphia, the options
backdating scandals of 2005-2006, and the subprime meltdown of
2007-2008. The recent demise of MF Global Holdings and the
related ongoing criminal investigation are further reminders
that we have not put these matters behind us.
“It isn’t just about the money for shareholders,” writes Martin,
“or even the dubious CEO behavior that our theories encourage.
It’s much bigger than that. Our theories of shareholder value
maximization and stock-based compensation have the ability to
destroy our economy and rot out the core of American capitalism.
These theories underpin regulatory fixes instituted after each
market bubble and crash. Because the fixes begin from the wrong
premise, they will be ineffectual; until we change the theories,
future crashes are inevitable.”
“A pervasive emphasis on the expectations market,” writes
Martin, “has reduced shareholder value, created misplaced and
ill-advised incentives, generated inauthenticity in our
executives, and introduced parasitic market players. The moral
authority of business diminishes with each passing year, as
customers, employees, and average citizens grow increasingly
appalled by the behavior of business and the seeming greed of
its leaders. At the same time, the period between market
meltdowns is shrinking, Capital markets—and the whole of the
American capitalist system—hang in the balance.”
How did capitalism get into this mess?
Martin says that the trouble began in 1976 when finance
professor Michael Jensen and Dean William Meckling of the Simon
School of Business at the University of Rochester published a
seemingly innocuous paper in the Journal of Financial Economics
entitled “Theory of the Firm: Managerial Behavior, Agency Costs
and Ownership Structure.”
The article performed the old academic trick of creating a
problem and then proposing a solution to the supposed problem
that the article itself had created. The article identified the
principal-agent problem as being that the shareholders are the
principals of the firm—i.e., they own it and benefit from its
prosperity, while the executives are agents who are hired by the
principals to work on their behalf.
The principal-agent problem occurs, the article argued, because
agents have an inherent incentive to optimize activities and
resources for themselves rather than for their principals.
Ignoring Peter Drucker’s foundational insight of 1973 that the
only valid purpose of a firm is to create a customer, Jensen and
Meckling argued that the singular goal of a company should be to
maximize the return to shareholders.
To achieve that goal, they academics argued, the company should
give executives a compelling reason to place shareholder value
maximization ahead of their own nest-feathering. Unfortunately,
as often happens with bad ideas that make some people a lot of
money, the idea caught on and has even become the conventional
wisdom.
During his tenure as CEO of GE from 1981 to 2001, Jack Welch
came to be seen–rightly or wrongly–as the outstanding exemplar
of the theory, as a result of his capacity to grow shareholder
value at GE and magically hit his numbers exactly. When Jack
Welch retired from GE, the company had gone from a market value
of $14 billion to $484 billion at the time of his retirement,
making it, according to the stock market, the most valuable and
largest company in the world. In 1999 he was named “Manager of
the Century” by Fortune magazine. Since Welch retired in 2001,
however, GE’s stock price has not fared so well: GE has lost
around 60 percent of the market capitalization that Welch
“created”.
Before 1976, professional managers were in charge of performance
in the real market and were paid for performance in that real
market. That is, they were in charge of earning real profits for
their company and they were typically paid a base salary and
bonus for meeting real market performance targets.
The change had the opposite effect from what was
intended
The proponents of shareholder value maximization and stock-based
executive compensation hoped that their theories would focus
executives on improving the real performance of their companies
and thus increasing shareholder value over time. Yet, precisely
the opposite occurred. In the period of shareholder capitalism
since 1976, executive compensation has exploded while corporate
performance has declined.
“Maximizing shareholder value” turned out to be the disease of
which it purported to be the cure. Between 1960 and 1980, CEO
compensation per dollar of net income earned for the 365 biggest
publicly traded American companies fell by 33 percent. CEOs
earned more for their shareholders for steadily less and less
relative compensation. By contrast, in the decade from 1980 to
1990 , CEO compensation per dollar of net earnings produced
doubled. From 1990 to 2000 it quadrupled.
Meanwhile real performance was declining. From 1933 to 1976,
real compound annual return on the S&P 500 was 7.5 percent.
Since 1976, Martin writes, the total real return on the S&P 500
was 6.5 percent (compound annual). The situation is even starker
if we look at the rate of return on assets, or the rate of
return on invested capital, which according to a comprehensive
study by Deloitte’s Center For The Edge are today only one
quarter of what they were in 1965.
Although Jack Welch was seen during his tenure as CEO of GE as
the heroic exemplar of maximizing shareholder value, he came to
be one of its strongest critics. On March 12, 2009, he gave an
interview with Francesco Guerrera of the Financial Times and
said, “On the face of it, shareholder value is the dumbest idea
in the world. Shareholder value is a result, not a strategy…
your main constituencies are your employees, your customers and
your products. Managers and investors should not set share price
increases as their overarching goal. … Short-term profits should
be allied with an increase in the long-term value of a company.”
The shift to delighting the customer
What to do? Given the numbers of the people and the amount of
money involved, rescuing capitalism from these catastrophically
bad habits won’t be easy. For most organizations, it will take a
phase change. It means rethinking the very basis of a
corporation and the way business is conducted, as well as the
values of an entire society.
“We must shift the focus of companies back to the customer and
away from shareholder value,” says Martin. “The shift
necessitates a fundamental change in our prevailing theory of
the firm… The current theory holds that the singular goal of the
corporation should be shareholder value maximization. Instead,
companies should place customers at the center of the firm and
focus on delighting them, while earning an acceptable return for
shareholders.”
If you take care of customers, writes Martin, shareholders will
be drawn along for a very nice ride. The opposite is simply not
true: if you try to take care of shareholders, customers don’t
benefit and, ironically, shareholders don’t get very far either.
In the real market, there is opportunity to build for the long
run rather than to exploit short-term opportunities, so the real
market has a chance to produce sustainability. The real market
produces meaning and motivation for organizations. The
organization can create bonds with customers, imagine great
plans, and bring them to fruition.
“The expectations market,” says Martin, “generates little
meaning. It is all about gaining advantage over a trading
partner or putting two trading partners together, then tolling
them for the service. This structure breeds a kind of amorality
in which information is withheld or manipulated and trading
partners are treated as vehicles from which to extract money in
the short run, at whatever the cost to the relationship.”
By contrast, the real market contributes to a sense of
authenticity for individuals. Because individuals can find
meaning in their jobs. They are not playing a zero-sum game.
They are doing something real and positive for society.
Examples of the shift
Martin cites three examples of firms that are, even within the
legal limits of today’s world, focused on the real world of
customers and products more than gaming the stock market.
One is Johnson & Johnson [JNJ]. In 1982, when the Tylenol
poisonings occurred, “J&J was in a terrible bind. Tylenol
represented almost a fifth of the company’s profits, and any
decline in its market share would be difficult to reclaim,
especially in the face of rampant fear and rumor. Yet, rather
than attempt to downplay the crisis—it was after all, likely the
work of an individual madman in one tiny part of the country—J&J
did just the opposite. Chairman James Burke immediately ordered
a halt to all Tylenol production and advertising, distributed
warnings to hospitals across the country, and within a week of
the first death, announced a nationwide recall of every single
bottle of Tylenol on the market. J&J went on to develop
tamper-proof packaging for its products; an innovation that
would soon become the industry standard.” Burke’s actions were
not the heroic act of a single individual, says Martin. The
actions flowed from the company credo which is engraved in
granite at the entry to company headquarters, which makes
crystal clear that customers are first, then employees, and
shareholders absolutely last. Martin contrasts J&J’s handling of
the Tylenol crisis with the handling of the Deepwater Horizon
oil spill in 2010 by BP [BP], which he sees as driven by a
short-term concern for BP’s profits.
A second example is Procter & Gamble [PG] which “declares in its
purpose statement: ‘We will provide branded products and
services of superior quality and value that improve the lives of
the world’s consumers, now and for generations to come. As a
result, consumers will reward us with leadership sales, profit
and value creation, allowing our people, our shareholders and
the communities in which we live and work to prosper.’ For P&G,
consumers come first and shareholder value naturally follows.
Per the statement of purpose, if P&G gets things right for
consumers, shareholders will be rewarded as a result.”
A third example is Apple. Steve Jobs seemed to delight in
signaling to shareholders that they didn’t matter much and that
they certainly wouldn’t interfere with Apple’s pursuit of its
original customer-focused purpose: ‘to make a contribution to
the world by making tools for the mind that advance humankind.’
Jobs’s feisty, almost combative demeanor at shareholder meetings
is legendary. At the meeting in February 2010, one shareholder
asked Jobs, “What keeps you up at night?” Jobs quickly
responded, ‘Shareholder meetings.’”
Making needed legal changes
Admonishing CEOs (and investors) to ignore the expectations
market and refocus on delighting the customer isn’t going to
work, says Martin. It’s as likely to be “as effective as
admonishing frat boys to stop chasing girls.” For CEOs, there
are massive incentives for staying attuned to it and severe
punishments for ignoring it. Investors, analysts, and hedge
funds continue to reward firms that meet expectations and punish
those that do not. Missing expectations, a dropping stock-price,
and real-asset write-downs can together create an unstoppable
downward spiral. In the current environment, to simply ignore
the expectations market is to court disaster.
One of the great values of the Martin’s book is that he puts his
finger on the needed legal changes that can help shift the
dynamic of business away from gaming the expectations market and
back to doing the real job of delighting customers.
One is the repeal of 1995 Private Securities Litigation Reform
Act, which contains what has become known as the “safe harbor”
provision. “To move ahead productively,” he writes, “the safe
harbor provision should simply be repealed. Executives and their
companies should be legally liable for any attempt to manage
expectations. Without the safe harbor provisions, there would be
no earnings guidance and that would be a great thing.” Making
this change would immediately bring the practice of giving
guidance to the stock market, and so gaming expectations, to a
screeching halt. There is, says Martin, simply no societal value
to earnings guidance. The market will know exactly what earnings
are going to be at the end of the quarter, in just three or
fewer months. Society is not better off to have an executive
publicly guess at what that number is going to be. We need to
turn executives from the useless, vapid task of managing
expectations to the psychologically and economically rewarding
business of creating value.
A second is the elimination of regulation FASB 142 which forces
the real write-downs of real assets based on the company’s share
price in the expectations market. The current rule forces
executives to concern themselves with managing expectations in
order to avoid write-downs. Changing the rule would remove the
major sanction that now exists for executives who ignore the
expectations market.
A third is to restore the focus of executives on the real market
and on an authentic life by eliminating the use of stock-based
compensation as an incentive. This doesn’t mean that executives
shouldn’t own shares. If an executive wants to buy stock as some
sort of bonding with the shareholders or for whatever other
reasons, that’s just fine. However, executives should be
prevented from selling any stock, for any reason, while serving
in that capacity—and indeed for several years after leaving
their posts. Stock based compensation is a very recent
phenomenon, one associated with lower shareholder returns,
bubbles and crashes, and huge corporate scandals. In 1970, stock
based compensation was less than 1 percent of compensation. By
2000, it was around half of compensation. For the last 35 years,
stock-based compensation has been tried. It had the opposite
effect of what was intended. We should learn from experience and
discontinue it.
Other needed changes
Martin also argues for associated changes:
We must restore authenticity to the lives of our executives. The
expectations market generates inauthenticity in executives,
filling their world with encouragements to suspend moral
judgment. They receive incentive compensation to which the
rational response is to game the system. And since they spend
most of their time trading value around rather than building it,
they lose perspective on how to contribute to society through
their work. Customers become marks to be exploited, employees
become disposable cogs, and relationships become only a means to
the end of winning a zero-sum game.
We need to address board governance. Boards have become
complicit in gaming the expectations market, and the associated
inflation of executive compensation.
We need to regulate expectations market players, most notably
hedge funds. Net, hedge funds create no value for society. They
have huge incentives to promote volatility in the expectations
market, which is dangerous for us but lucrative for them. So, we
need to rein in the power of hedge funds to damage real markets.
What’s next?
In a book that offers so much, one is tempted to ask for more.
Perhaps in subsequent writings, Martin will expand and carry his
thinking forward. In future writings, he might document more of
the economically disastrous practices that enable firms to meet
their quarterly targets, such as looting the firm’s pension fund
or cutting back on worker benefits or outsourcing production to
a foreign country in ways that further destroy the firm’s
ability to innovate and compete.
He might also spell out the specific management changes that are
necessary to delight the customer. The command-and-control
management of hierarchical bureaucracy is inherently unable to
delight anyone–it was never intended to. To delight customers, a
radically different kind of management needs to be in place,
with a different role for the managers, a different way of
coordinating work, a different set of values and a different way
of communicating. This is not rocket science. It’s called
radical management.
He might also show how the shift from maximizing shareholder
value to delighting the customer involves a major power shift
within the organization. Instead of the company being dominated
by salesmen who can pump up the numbers and the accountants who
can come up with cuts needed to make the quarterly targets,
those who add genuine value to the customer have to re-occupy
their rightful place.
He might also build on the theme that the shift from maximizing
shareholder value to delighting the customer doesn’t involve
sacrifices for the shareholders, the organizations or the
economy. That’s because delighting the customer is not just
profitable: it’s hugely profitable.
Bottom-line: capitalism is at risk
American capitalism hangs in the balance, writes Martin. His
book gives a clear explanation as to why this is so and what
should be done to save it. A large number of rent-collectors and
financial middlemen making vast amounts of money are keeping the
current system in place. The fact that what they are doing is
destroying the economy will not sway their thinking. As Upton
Sinclair noted, “It is difficult to get a man to understand
something, when his salary depends upon his not understanding
it.”
Is change possible? Martin believes so, quoting Vince Lombardi:
“We would accomplish many more things if we did not think of
them as impossible.” Other “impossible” changes have been
accomplished.
“Not long ago, it seemed fanciful that public smoking would be
restricted and tobacco companies would sponsor public service
ads that discourage smoking,” wrote Deepak Chopra and David
Simon in 2004. “But this shift in awareness occurred when a
critical mass of people decided they would no longer tolerate a
behavior that harmed many while benefited a few.”
For instance, the Aspen Institute’s Corporate Values Strategy
Group has been working on promoting long-term orientation in
business decision making and investing. In 2009, twenty-eight
leaders representing business, investment, government, academia,
and labor (including Warrent Buffett, CEO of Berkshire Hathaway,
Lou Gerstner, former CEO of IBM and Jim Wolfensohn, former
president of the World Bank) joined with the Institute to
endorse a bold call to end the focus on value-destroying
short-term-ism in our financial markets and create public
policies that reward long-term value creation for investors and
the public good.
Ultimately, the change will happen, not just because it’s right,
but because it makes more money. Once investors realize what is
going on, the economics will drive the change forward. The
recognition that maximizing shareholder value is the dumbest
idea in the world is an obvious but still a radical idea.
Like all obvious, radical ideas, in the first instance it will
be rejected. Then it will be ridiculed. Finally it will be
self-evident and no one will be able to remember why anyone ever
thought otherwise.(i)
Buy the Martin’s book. Read it. Implement it. The very future of
our society “hangs in the balance”. |
|
| |
|
 |
|
