I’m a day late to get to a revealing Financial Times comment by Edward Luce, who has among other things served as Larry Summers’ speechwriter. Luce has written important articles on politics (for instance, being one of the first prominent writers to finger how Obama was served poorly by his undue reliance on a handful of long-established retainers like Valerie Jarret and David Axelrod). However, his close connections to Washington insiders means his economics pieces are too often reflections of thinking inside America’s Versailles, as opposed to real world conditions.
Luce’s latest article is a bizarre combination of a solid description of the symptoms of economic pathology and an executive-exclupating, demonstrably erroneous diagnosis.
The Financial Times columnist describes how much firepower major corporations are devoting to propping up their stock prices. Mind you, this is hardly news to anyone who has been paying attention, but it is still useful to have a current reading. From his article:
At a time of soaring profitability, US companies have piled up huge amounts of cash, much of it parked offshore. Yet investing it in long-term growth is the last thing on their mind. According to Barclays, US companies have lavished more than $500bn in the past year on stock buybacks – a multiple of what most are spending on research and development and other capital investments. In the first six months of the year, buybacks surged to $338.3bn – the largest half-yearly volume since 2007. The rationale is simple. By reducing the volume of outstanding shares, chief executive officers increase earnings per share. That in turn lifts their pay, which is heavily tied to short-term stock performance. If you need an explanation for why the top 0.1 per cent is doing so well, start with equity-based compensation.
But the impact is much broader than that. According to William Lazonick, a scholar at the University of Massachusetts Lowell, seven of the top 10 largest share repurchasers spent more on buybacks and dividends than their entire net income between 2003 and 2012. In the case of Hewlett-Packard, which spent $73bn, it was almost double its profits. For ExxonMobil, which came top with $287bn in buybacks and dividends, it amounted to 83 per cent of net income. Others, such as Microsoft (125 per cent), Cisco (121 per cent) and Intel (109 per cent) were even more extravagant. In total, the top 449 companies in the S&P 500 spent $2.4tn – or more than half their profits – on buybacks in those years. They spent almost the same again in dividend payouts. Taken together, they came to 91 per cent of net income.
Yves here. This section is solid, well argued, and suitably urgent.
But then having fingered the real driver of this trend in passing, lousy incentives created by equity linked pay, Luce succeeds in walking that back by spending the bulk of his piece justifying looting lite by US executives. At the very top of the article, he stresses the need to keep share prices up to fend off hostile takeovers. Huh? CEO profit handsomely from losing to an acquisition bid, whether the seriously endangered hostile species or the prevalent faux-friendly type, thanks to golden parachutes. And most deposed CEOs can at a minimum look forward to a lucrative afterlife on big corporate boards, with even the lousy ones having a decent shot landing a new CEO assignment (witness how one of America’s famously bad corporate chieftans, Robert Nardelli, was picked up by Cerberus).
But the big canard that dominates the piece is that US companies don’t have decent investment opportunities. The evidence for that claim? Larry Summers’ “secular stagnation” talk, which was long on intuition and short on evidence.
In fact, it is well documented that corporations have become so short term in their orientation that they have been underinvesting for nearly a decade. Yours truly wrote about that syndrome in 2005 in the Conference Board Review and updated the argument in a 2010 New York Times op-ed with Robert Parenteau. That is not to suggest that Luce could have or should have known of our work, merely that the drivers of the corporate profits have been cost-savings because they are easy to achieve, easy to explain to investors, and thus low risk. But they result in systematic, slow liquidation as companies chronically underinvest.
Had Luce done his homework, he could have readily found ample, rigorous proof that companies are choosing to underinvest, and not that they are plagued with dearth of good options. For instance, the widely respected Andrew Haldane of the Bank of England determined that companies are using overly high discount rates when assessing possible investments.
To translate that out of economics-speak, that means they are seeking unreasonably high returns. Overly high return targets = underinvestment. QED. His conclusion: “Capital markets myopia is real.”
Haldane further demonstrated that these excessively high return targets penalized long-term projects, which are often the ones that produce the greatest payoffs and spillover benefits
One way to remedy that gap would be to have government take up the slack, as it often does by making infrastructure investments and subsidizing R&D (for instance, the National Institutes of Health and other Federal agencies have provided over time an estimate 30% of drug industry R&D, in particular the more fundamental research). But the “starve government” exercise has slashed these investments. Similarly, the trend towards pernicious “public/private partnerships” as the means of making infrastructure investments results in private sector (as in excessive) return targets being imposed on supposedly societally-benefitting projects, which again produces underinvestment (as any look at the state of US transportation services will confirm).
For a far more accurate picture of executive-suite value extraction, Roy Poses reviews recent studies of corporate investments and how the behavior they depict manifests itself in the health care industry. And what is particularly telling about his post, Value Extractors, “Super-Managers,” Vampires and the Decline of the US and US Health Care, is that it also makes clear that Edward Luce cherry picked one of his major sources, the stock buyback study by William Lazonick.
By Roy Poses, MD, Clinical Associate Professor of Medicine at Brown University, and the President of FIRM – the Foundation for Integrity and Responsibility in Medicine. Cross posted from the Health Care Renewal website
Appearing during the last few weeks were a series of articles that tied the decline of the US economy to huge systemic problems with leadership and governance of large organizations. While the articles were not focused on health care, they included some health care relevant examples, and were clearly applicable to health care as part of the larger political, social, and economic system. The articles reiterated concerns we have expressed, about leadership of health care by generic managers, perverse executive compensation, the financialization of health care, in part enabled by regulatory capture, and the abandonment by effective stewardship by boards of directors, but with new takes on them.
The articles included “Profits Without Prosperity,” by William Lazonick in the the Harvard Business Review, “Why Have US Companies Become Such Skinflints,” by Paul Roberts in the Los Angeles Times, and “How Business Leaders Turned Into Vampires,” by Steve Denning in Forbes, which in turn was partially based on “The Rise (and Likely Fall) of the Talent Economy,” in the Harvard Business Review.
Let me summarize the main points, and discuss some health care examples.
“Super-Managers” as Value Extractors
Steve Denning’s article contrasted people who add value to the economy versus those who extract value. The first species of value extractor he listed was:
‘Super-managers’ are people who hold administrative positions in the C-suite of private-sector bureaucracies but are masquerading as entrepreneurs. They are, to use Thomas Piketty’s slyly ironic term, “super-managers.” As such, they have been able to extract extraordinary levels of compensation. They have been lavished with stock and stock options and have been able to ‘manage’ the share price of their firms with massive share buybacks and other financial engineering so that they receive massive bonuses. As Bill Lazonick documented in the September 2014 issue of HBR, the net effect of their activities is to extract value, rather than create value [see below].
Presumably, “super-managers” as health care executives are also likely to be generic managers, unlikely to have much actual knowledge of caring for patients, unsympathetic to the values of health care professionals, and hence unlikely to uphold the health care mission.
He noted that
there is a tendency to dismiss the activities of ‘vampire talent’ as de minimis. ‘That’s capitalism, right? Every man for himself. It’s no big deal if there’s an occasional bad apple in the barrel. The ‘invisible hand’ of capitalism will make everything come out right for society in the end.’
The problem today is that the super-sized executive compensation, the gambling and the toll-keeping of the financial sector aren’t tiny sideshows. They have grown exponentially and are now macro-economic in scale. They have become almost the main game of the financial sector and the main driver of executive behavior in big business. When money becomes the end, not the means, then the result is what analyst Gautam Mukunda calls ‘excessive financialization‘ of the economy, in his article, ‘The Price of Wall Street Power,’ in the June 2014 issue of Harvard Business Review.
Mr Denning further asserted that the value extraction of super-managers is augmented by the value extraction of two different groups of players, hedge funds that speculate with other peoples’ money, and “tollkeepers” who extract rents through the financial system.
Furthermore, Mr Denning stated that
The growth of super-sized executive compensation is inversely related to performance. The super-managers are in effect being rewarded for doing the wrong thing.
Of course, if executives in health care, like those in other sectors, are mainly concerned with enriching themselves in the short-term, than they are not mainly concerned with patients’ and the public’s health, or the values of health care professionals, and hence the performance of their organizations in terms of health care processes and outcomes will suffer.
Furthermore, the ability of commercial health care firms to actually make a positive impact on health care will be decreased as they are whipsawed by other value extractors like hedge funds and tollkeepers.
Example – Renaissance Technologies
Mr Denning’s first example of tollkeepers’ value extraction was:
James Simons, the founder of Renaissance Technologies, ranks fourth on Institutional Investor’s Alpha list of top hedge fund earners for 2013, with $2.2 billion in compensation. He consistently earns at that level by using sophisticated algorithms and servers hardwired to the NYSE servers to take advantage of tiny arbitrage opportunities faster than anybody else. For Renaissance, five minutes is a long holding period for a share.
In fact, as we noted here, Renaissance Technologies does not hesitate in trading health care firms. Furthermore, that company has a noteworthy direct tie to health care. Its current co-CEO, Peter F Brown, is married to the current Commissioner of the US Food and Drug Administration (FDA).
Value Extraction and Share Buybacks
William Lazonick’s article also emphasized how corporate leadership is now focused on extracting value from their companies for their own personal benefit, rather than promoting growth, innovation, better products and services, etc. In particular, large public for-profit companies now tend to use their surplus capital to buy back shares of their own stock, rather than invest in new facilities, equipment, employees, etc. Perhaps we should not be surprised that this was facilitated by changes in US government regulation, that is deregulation, in this case instituted during the Reagan administration:
Companies have been allowed to repurchase their shares on the open market with virtually no regulatory limits since 1982, when the SEC instituted Rule 10b – 18 of the Securities Exchange Act.
The rule was a major departure from the agency’s original mandate, laid out in the Securities Exchange Act of 1934. The act was a reaction to a host of unscrupulous activities that had fueled speculation in the Roaring ’20’s, leading to the stock market crash of 1929 and the Great Depression.
Given the context, and that the deregulation was implemented by an SEC chair who was “the first Wall Street insider to lead the commission,” this seems to be an example of regulatory capture in service of corporate insiders.
The issue here is that while it might make some financial sense for companies to buy back their own shares if they are priced at bargain rates, after this change they could buy shares at any price without supervision. On one hand, such purchases could lead to short-term bumps in stock prices. On the other hand, a major reason for these buybacks appears to be that they enrich corporate insiders, particularly top hired executives, who now receive much of their pay in the form of stock and stock options, and often can get bonuses based on short-term increases in stock prices. Lazonick wrote,
Combined with pressure from Wall Street, stock-based incentives make senior executives extremely motivated to do buybacks on a colossal and systemic scale.
Consider the 10 largest repurchasers, which spent a combined $859 billion on buybacks, an amount equal to 68% of their combined net income, from 2003 through 2012. (See the exhibit “The Top 10 Stock Repurchasers.”) During the same decade, their CEOs received, on average, a total of $168 million each in compensation. On average, 34% of their compensation was in the form of stock options and 24% in stock awards. At these companies the next four highest-paid senior executives each received, on average, $77 million in compensation during the 10 years—27% of it in stock options and 29% in stock awards. Yet since 2003 only three of the 10 largest repurchasers—Exxon Mobil, IBM, and Procter & Gamble—have outperformed the S&P 500 Index.
Example – Pfizer
Mr Lazonick’s noted some potential outcomes of the frenzy of stock buybacks affecting the US pharmaceutical industry and hence the US health care system.
In response to complaints that U.S. drug prices are at least twice those in any other country, Pfizer and other U.S. pharmaceutical companies have argued that the profits from these high prices—enabled by a generous intellectual-property regime and lax price regulation— permit more R&D to be done in the United States than elsewhere. Yet from 2003 through 2012, Pfizer funneled an amount equal to 71% of its profits into buybacks, and an amount equal to 75% of its profits into dividends. In other words, it spent more on buybacks and dividends than it earned and tapped its capital reserves to help fund them. The reality is, Americans pay high drug prices so that major pharmaceutical companies can boost their stock prices and pad executive pay.
Moreover, during approximately the same period Pfizer compiled an amazing record of legal misadventures including settlements of allegations of unethical behavior, and some convictions, including one for being a racketeering influenced corrupt organization (RICO), as most recently reviewed here, and then updated here. So while it was putting huge amounts into buybacks, it also put billions into legal fines and costs. This suggests that note only does executive compensation not correlate with “performance,” it may also correlate with corporate bad behavior.
The “Shareholder Value” Dogma
In explaining how US corporate executives turned to stock buybacks to boost their own pay, at the expense of essentially everyone else, Mr Lazonick sounded some familiar themes. One was focus on short-term revenues and short-term stock performance drive by the “share-holder value” dogma out of business schools,
the notion that the CEO’s main obligation is to shareholders. It’s based on a misconception of the shareholders’ role in the modem corporation. The philosophical justification for giving them all excess corporate profits is that they are best positioned to allocate resources because they have the most interest in ensuring that capital generates the highest returns. This proposition is central to the ‘maximizing shareholder value” (MSV) arguments espoused over the years, most notably by Michael C. Jensen. The MSV school also posits that companies’ so-called free cash flow should be distributed to shareholders because only they make investments without a guaranteed return — and hence bear risk.
But the MSV school ignores other participants in the economy who bear risk by investing without a guaranteed return. Taxpayers take on such risk through government agencies that invest in infrastructure and knowledge creation. And workers take it on by investing in the development of their capabilities at the firms that employ them. As risk bearers, taxpayers, whose dollars support business enterprises, and workers, whose efforts generate productivity improvements, have claims on profits that are at least as strong as the shareholders’.
Mr Denning similarly noted
The intellectual foundation of all this behavior is the notion that the purpose of a firm is to maximize shareholder value. Unless we do something about this intellectual foundation, the problem will remain. Changes in a few regulations or the tax code won’t make much difference. ‘Vampire talent’ will find ways around them.
Nor will change happen merely by pointing out that shareholder primacy is a very bad idea. Bad ideas don’t die just because they are bad. They hang around until a consensus forms around another idea that is better.
Mr Roberts’ article “Why Have US Companies Become Such Skinflints,” went at this issue from a slightly different angle, noting first
The bigger story here is what might be called the Great Narrowing of the Corporate Mind: the growing willingness by business to pursue an agenda separate from, and even entirely at odds with, the broader goals of society.
He attributed this to the notion promulgated by
conservative economists, [that] the best way for companies to help society was to ditch the idea of corporate social obligation and let business do what business does best: maximize profits.
He noted that this focus on short-term revenues has led to the decline in long-term results,
But because management is so focused on share price and because share price depends heavily on current company earnings, strategic focus has grown ever more short term: do whatever is needed to hit next quarter’s earnings target. And since cost-cutting is a quick way to boost near-term earnings, layoffs and other downsizing once regarded as emergency measures are now routine.
And here is the paradox. Companies are so obsessed with short-term performance that they are undermining their long-term self-interest. Employees have been demoralized by constant cutbacks. Investment in equipment upgrades, worker training and research — all essential to long-term profitability and competitiveness — is falling.
Of course, this is antithetical to the “innovation” that current corporate boosters proclaim as the goal of drug, biotechnology, medical device companies and other players in the brave new world of corporate health care.
The Incestuous Mechanisms Used to Set Executive Compensation
Another explanation for the rise in value extraction, and specifically the use of share buybacks to reward top corporate hired executives, was the incestuous way in which corporations set pay for top hired executives. Mr Lazonick wrote,
Many studies have shown that large companies tend to use the same set of consultants to benchmark executive compensation, and that each consultant recommends that the client pay its CEO well above average. As a result, compensation inevitably ratchets up over time. The studies also show that even declines in stock price increase executive pay: When a company’s stock price falls, the board stuffs even more options and stock awards into top executives’ packages, claiming that it must ensure that they won’t jump ship and will do whatever is necessary to get the stock price back up.
This is enabled by boards of directors who seem to represent the ‘CEO union,’ not stockholders, and certainly not other less favored employees, customers, clients or patients, or society at large,
Boards are currently dominated by other CEOs, who have a strong bias toward ratifying higher pay packages for their peers. When approving enormous distributions to shareholders and stock-based pay for top executives, these directors believe they’re acting in the interests of shareholders.
Once again, this was also enabled by the dergulation that started with during the Reagan administration, and continues this day (although the specific relevant deregulatory change occurred during the Clinton administration),
In 1991 the SEC began allowing top executives to keep the gains from immediately selling stock acquired from options. Previously, they had to hold the stock for six months or give up any ‘short-swing’ gains. That decision has only served to reinforce top executives’ overriding personal interest in boosting stock prices. And because corporations aren’t required to disclose daily buyback activity, it gives executives the opportunity to trade, undetected, on inside information about when buybacks are being done.
Note that while all the discussion above has been about for-profit corporations, we have seen that in health care, various non-profit organizations, particularly hospitals, hospital systems, academic medical institutions, and health insurers, which all now operate in the current market fundamentalist environment, are acting more and more like for-profits. So while non-profit corporate executives cannot do stock buybacks, they are also all too often generic managers, given huge compensation, but not often for upholding the mission, putting patients’ and the public’s health first, or upholding health care professionals’ values.
It is striking that we are beginning to see protests like those above not in radical publications, but in the Harvard Business Review and Forbes. It is more striking that these protestors are beginning to fear the worst. Mr Roberts wrote,
Sooner or later, markets punish such myopic behavior. Companies that neglect innovation run out of things to sell. Companies that demoralize workers see performance lag.
Although Mr Denning hopefully wrote,
We are thus about to witness a vast societal drama play out. That’s because we have reached that key theatrical moment, which Aristotle famously called ‘anagnorisis’ or ‘recognition.’ This is the moment in a drama when ignorance shifts to knowledge.
He then warned,
As usual with anagnorisis and the shock of recognition at a disturbing, previously-hidden truth, there is a disquieting sense that the accepted coordinates of knowledge have somehow gone awry and the universe has come out of whack. This can lead to denial and a delay in action, even though the facts are staring us in the face.
If the recognition of our error comes too late, as in Shakespeare’s Lear, the result will be terrible tragedy. If the recognition comes soon enough, the drama can still have a happy ending. We are about to find out in our case which it is to be.
Let us hope that anagnorisis is really beginning, the anechoic effect is fading, and the drama may yet have a happy ending.