Yves here. Lazonink’s key points may seem a bit abstract at first, but they do get to the essence of the big defects of the “shareholder value” ideology.
Professor of Economics, University of Massachusetts Lowell. Originally published at the Institute for New Economic Thinking website
Conventional wisdom holds that the primary function of the stock market is to raise cash that companies use to invest in productive capabilities. The conventional wisdom is wrong. Academic research on corporate finance shows that, compared with other sources of funds, stock markets in advanced countries have in fact been insignificant suppliers of capital to corporations. What, then, is their function? If we are to understand employment opportunity, income distribution, and productivity growth, we need an accurate analysis of the role of the stock market in the corporate economy.
The insignificance of the stock market as a source of real investment capital exposes as fallacious the fundamental assumptions of the prevailing ideology that, for the sake of economic efficiency, a business corporation should be run to “maximize shareholder value” (MSV). As a rule, public shareholders do not invest in a corporation’s productive capabilities; they simply buy shares outstanding on the market, hoping to extract value that they have played no role in helping to create. And in practice, MSV advocates modes of corporate resource allocation that undermine innovative enterprise and result in unstable employment, inequitable incomes, and sagging productivity.
The most obvious manifestations of the corporate misbehavior that MSV incentivizes are the lavish, stock-based incomes of top corporate executives and the massive distributions of corporate cash to shareholders in the form of stock buybacks, coming on top of already-ample dividends. Indeed, with stock-based pay incentivizing senior executives to do stock buybacks—i.e., having a company repurchase its own shares to give manipulative boosts to its stock price—over the past three decades the stock market has had a negative cash function. On the whole, U.S. business corporations fund the stock market, not vice versa.
My INET paper, “The Functions of the Stock Market and the Fallacies of Shareholder Value,” provides an analysis of the evolving role of the stock market in the U.S. corporate economy over the past century. I ask how the changing functions of the stock market have influenced the processes of value creation (hence, the size of the economic pie), as well as the relation between value creation and value extraction (hence, the distribution of the economic pie). This essay is part of an ongoing project aimed at making “The Theory of Innovative Enterprise” central to an economic analysis that comprehends institutions’ and organizations’ roles in supporting or undermining stable and equitable economic growth.
The Theory of Innovative Enterprise posits that three social conditions of innovative enterprise—strategic control, organizational integration, and financial commitment—determine whether a business can generate goods and services that are higher quality and lower cost than those previously available. The process of value creation enabled by innovative enterprise enhances the performance of both the company and the economy of which it is a part. Once armed with a theory of innovative enterprise, we can analyze the relation between those who contribute to the processes of value creation and those who reap incomes through value extraction. We can discern how “predatory value extractors,” who make little if any contribution to value creation, use their power to dominate the distribution of income.
In terms of the three social conditions of innovative enterprise: Strategic control gives decision makers the power to allocate the firm’s resources to transform technologies and access new markets to generate higher-quality, lower-cost products; organizational integration creates incentives for people working together to engage in the collective learning that is the essence of the value-creation process; financial commitment secures funds to sustain the cumulative learning process, from the time when investments in productive capabilities are made until innovative products generate financial returns.
The functions of the stock market may support or undermine the social conditions of innovative enterprise. The functions of the stock market go well beyond “cash” to include four others, which can be summarized as “control,” “creation,” “combination,” and “compensation.” Historically, as the U.S. economy grew to become the world’s largest and most powerful, the key function of the stock market was control. Specifically, the stock market enabled the separation of managerial control over the allocation of corporate resources from the ownership of the shares in the company.
Yet, assuming that the key function of the stock market is cash, academic economists known as agency theorists see this separation of control from ownership as the “original sin” of American capitalism. They argue that the evils of managerial control can be overcome by incentivizing or, if necessary, compelling corporate managers as “agents” to maximize the value of the stock possessed by corporate shareholders as “principals.” The agency-theory mantra is that the key role of managers is to “disgorge” the “free” cash flow to shareholders in the forms of dividends and buybacks.
What is missing from the agency theory argument is a theory of how a firm creates value—that is, a theory of innovative enterprise. The functions of the stock market may support the types of strategic control, organizational integration, and financial commitment that can result in the generation of higher quality products at lower unit costs—the economic definition of innovation. It is possible, however, that the functions of the stock market may undermine the types of strategic control, organizational integration, and financial commitment that the innovation process requires.
Indeed, by following the prescriptions of agency theory—that senior executives should be incentivized by stock-based pay to “create value” for shareholders—corporate managers have undermined the conditions of innovative enterprise in U.S. corporations over the past three decades. Consider each of the three social conditions:
Strategic control: Senior executives who are willing to waste hundreds of millions or billions of dollars annually on buybacks to manipulate their companies’ stock prices can lose the capacity to determine what types of organizational and technological investments are required to remain innovative in their industries. Instead, the current structure of stock-based executive remuneration—as prescribed by agency theory—creates incentives for senior executives to allocate resources in ways that boost stock prices and increase their take-home pay. The stock buyback is a powerful tool at the disposal of corporate executives for manipulating the stock market for their personal gain.
Organizational integration: Collective and cumulative learning about the technologies, markets, and competitors relevant to a particular industry is the foundation for generating the higher-quality, lower-cost goods and services that result in productivity growth. What I call “collective and cumulative careers” are essential for organizational learning, especially in industries that are technologically and organizationally complex. Organizational learning depends on a “retain-and-reinvest” regime. In such an arrangement, senior executives make corporate resource-allocation decisions that, by retaining people and profits in the company, permit reinvestment in the productive capabilities that can generate competitive (high-quality, low-cost) products. Our research supports the hypothesis that, as part of a corporate resource-allocation regime that downsizes the U.S. labor force and distributes corporate cash to shareholders, stock buybacks are done at the expense of investments in collective and cumulative careers. For working people who are the real value creators, the “disgorged” cash flow is far from “free.”
Financial commitment: The cash flow that MSV calls “free” can deprive the business enterprise of the foundational finance for investment in innovative enterprise. Stock buybacks represent a depletion of internally-controlled finance that could be used to support investment in the company’s productive capabilities. Every once in a while, a major company that has done massive buybacks over a period of years hits a financial wall. At that point the billions of dollars it wasted on buybacks are not available to support the restructuring needed for it to become innovative once again. The process of predatory value extraction that destroys innovative enterprise is irreversible. It must be stopped before it starts.
True innovation is hard, true innovation that drives both top and bottom line growth is even harder. Why do all the hard stuff when you can just hire a rockstar ceo (many of whom have been bull market beneficiaries, but of course no one says this), dangle the access journalism carrot by giving some eager and compliant journalists “exclusive” interviews with the rockstar (and politely make it known that continued exclusive access will depend on the vigor of their willingness to buttress the fetishization of the rockstar and push the “our company as a crucible of innovation and disruption” narrative in their various publications), go on a stock buyback binge fuelled by zero percent interest rate debt, starve the folks down in r&d of much needed investment etc. And then, pop the champagne in the boardroom while you sit back and watch as this cocktail delivers on the holy grail: the stock keeps going higher and higher, as if by magic. Many a short tenured ceo would find it extremely difficult to not be seduced by such a powerful aphrosidiac, wrapped as it is in all manner of shortcuts to the promised land of “maximising shareholder value”.
Very interesting and, for the most part, sounds quite plausible and explains a great deal.
I also wonder about IPOs: i.e. they do seem like a genuine way to raise capital via the stock market.
(Note: I did read the link to the excerpt of his paper, but I didn’t read the paper in its entirety.)
This comment is not in any way meant to discredit this text! I’d simply like to understand it better, i.e. either I’m missing some knowledge (about IPOs) and/or the author needs to better address this issue.
Corporate sales of stock represent a very small portion of total corporate funding
The biggest source of funding is retained earnings. The second is borrowing (not just corporate debt, but short term borrowings like commercial paper and credit provided by suppliers). Stock sales are a distant third.
Moreover, the motivation for IPOs is often primarily for the founders, share-owning insiders, and any VCs to partly cash out. Investors very much frown on that, so there usually has to be some blather in the offering documents that they really do need more dough for great expansion plans…..very nebulously described…..whether they need them or not.
Similarly, the overwhelming majority (by an insane amount) of stock trading is so-called secondary market trading, as it has absolutely nada to do with corporate money-raising.
Which raises an interesting conundrum, if losses mount and retained earnings are eliminated as a source of capital, the company might be in for a liquidity crunch as the other two sources largely depend on confidence in the performance of the enterprise from the providers of said capital (i.e. suppliers and investors in an IPO). I suppose this is where “amping up” the narrative about “current losses being necessary to lay the foundation for a profitable future” might help allay the fears of nervy investors and bring back the confidence to make the prospect of injecting their capital more palatable …
“amping up” the narrative about “current losses being necessary to lay the foundation for a profitable future”
No narrative is necessary. The accounting profession long ago sold out and reported Retained Earnings are now pretty much useless noise. Review a couple of Enron financial statements for example. The accounting profession is now deemed to be too small to fail – bad ones have been put or gone out of business so that prosecuting any more of the big fraudsters would cause a systemic shortage. A toxic combination – banks TBTF and the accounting profession TSTF. What could go wrong? Warren Buffett is actually talking about companies’ financial statements when he says, “You never know who is swimming naked until the tide goes out”.
See the FT article on phony earnings reports in today’s links for an example of what I speak. We are not talking about individuals or even small groups of individuals committing fraud. We are talking about systemic fraud which the 1% share a role in perpetrating on those who don’t understand what’s going on. On slow days, I try to imagine Bill Black’s frustration because he truly understands the magnitude of the fraud and the enormous number of people participating knowingly in it, while unfortunately having the knowledge of how to stop it. Prosecute just a very few and it will fall like a house of cards. Instead we are made to believe it is more complicated than curing cancer and, of course, he knows that very well. Frustrating.
Keep in mind, what yves says has been known to be true for decades. I recall Doug Henwood’s book ‘Wall Street’ which was written around 1990ish making very similar points.
What the academic studies reveal is very different story than the one that the business press would like to tell.
Robert Ringer wrote a number of books on how to skim money from others as a business model. His first book: “Winning Through Intimidation” (1973) was the foundation of what is described today as the FIRE sector of the economy. HIs secret: Put yourself in a place where large sums are changing hands in real productive business transactions, and skim a relatively small % off the top for yourself”. Unfortunately, in business as in the real world, a parasite cannot be too greedy or the host dies. More unfortunately FIRE participants subscribe to the theory that anything worth doing is worth over doing. While the FIRE parasite is thriving, its host is now dying, but humans are too stupid to know what real parasites know by instinct.
So, contrary to my naive assumptions, stock buy backs aren’t likely to be a way of storing capital for later? That always struck me as one explanation for buy backs, that they were a way of accumulating capital in good times, to be used when retooling was needed or when there was a dip in sales.
My impression (and I could be wrong), is that the primary purpose of stock buy-backs is to increase the price per share at a time when the CEO wants to exercise his bonus stock options by selling.
I have been involved in advising natural resource (non fuel) start ups in mining, refining, fabricating, and marketing their products for 40 years. I realized early on that the only time for an IPO for that sector is when the generated funds are sufficient to advance the development (e.g., of a “deposit” into a producing “mine”) of a project to a stage in which it can raise further capital by borrowing against the collateral of existing (best) or future “profitable” product sales or through the issuance of bonds. However it soon became obvious to me that the junior (exploration) mining business was focused on “mining the street.” The recent rare earth circus resulted in nothing, nothing at all for those who bought shares to hold. Mining the street was accomplished by a false narrative of the danger to the West in general and to the US in particular if the world’s dependence on China as a sole source of rare earths were allowed to continue. Molycorp’s story was a strange dichotomy; it alone raised sufficient capital in an IPO to go to have a high probability to go to production, but its management, which originated the false narrative as a marketing tool, was no competent to do so technically. The Molycorp “insiders” and “promoters” mined the street for more than 7 billion dollars and sucked the life out of any possibility of a well managed, technically competent, start up to proceed. Early buyers; insiders; and unscrupulous or crooked promoters alone reaped “shareholder value” by killing any hope of innovation.
Thus endeth the rare earth lesson.
Molycorp was signed on to be the buyer for my AZ REE project. I suspect they used our proposed production to pad their stats. Since or mineral was REE phosphate and theirs carbonate, I wondered how it was so easy to convince them to take our minerals.
It seams to me that the only place where MSV has any traction is in the financial speculative side (pretty much all of it) the rentier side, the side that is a negative to actual productive business.
Of course, the media, the public generally, have bought into the absurdities that these (lame and lazy) rock stars of CEOS and financial geniuses do anything more than shill goods for the rock star investors to pawn off on smurfs while the media believe high stock market equals great economy..despite the opposite being true.
Innovation and real productivity requires people be challenged and valued at all levels in a crazy cooperative way. There are companies and places where that happens but, seams that MBAs and economists have been trained to miss the boat….unless, of course, they see the bullsh## and don’t put their BS detectors on off while learning the fantasies that are pawned off on you while you grab that sheepskin.
the media, the public generally, have bought into the absurdities
The media: yes. The public generally, however, I think is simply confused. They hear stories that don’t make sense, stories that do make sense of which they are told are untrue, and lots of simple corporate PR.
We need a socialist business press.
What a wonderful understatement!
Agreed.
I think one of the major issues here is that the world revolves too much around investing in the markets. And markets BET on the future. They don’t invest in the future. If sustainable growth is to be achieved, you have to invest in the productive capabilities of companies to boost productivity.
To a certain extent, it’s a variation of the prisoners dilemma. Nobody wants to make investments without what they perceive to be prospects for growth, so everyone waits around for someone else to move first.
This is where a competent government needs to step it up and provide sound economic leadership, as opposed to lying down and rolling over for additional and damaging crap like deregulation.
If a big part of motivation for MSV is plumping executives compensation and cashing out VCs, what are strategies for putting executives on straight salary plus bonues from a portion of retained earnings? Similarly, why can’t VCs likewise recapture their initial investment from set asides in retained earnings? What if among conditions for IPOs distribution of proceeds limited the amounts withdrawn by founders and VCs so that the bulk goes to stabilizing and expanding the enterprise? That way, it’s in everyone’s interest to embrace the long-term.
Great post. Thanks.
What about the fact that now a large portion of the US retirement system is predicated on extracting shareholder value (among other things but primarily so, especially for those under 55) via defined contribution plans and IRAs? One could argue that this democratizes the “extraction”, and so the corporations end up financing not only the “stock market” but also the general public (those in the middle class anyway).
And, couldn’t an IPO be viewed as a way to democratize access to corporate earning power, even as we admit that it its primary purpose it NOT raising capital?
So, while the point that this may be strangling innovation looks to be valid, how about the larger systemic implications of the way capital flows between corporations and the public?
I don’t have a formed view on these questions, but would love an astute commentary on them.
Fascinating post, thank you for bringing it to us. I will try to read the referenced materials.
Excellent post. CEOs aren’t educated and don’t spontaneously arise in a vacuum, but a petrie dish of shared ideology and values. These individuals are heavily vetted by a network of boards, Wall Street, big accounting firms, white shoe law firms, major consulting firms, VCs, corporate media and academic sponsors who share similar personal income incentives, values and a common ideological framework. To change the dynamic of this very damaging behavior will require a change in the law to make stock buybacks illegal.
In addition to the long-term corrosive effects this activity has had on R&D funding, productivity and employee compensation, I believe the enormous amount of debt that has been borrowed to fund these buybacks will prove to be deeply damaging over time
In an incisive Forbes article last month in which he also cited William Lazonik’s work, Nick Hanauer pointed to the rising level of economic inequality and social damage that has been caused by this mechanism:
https://www.forbes.com/sites/aalsin/2017/07/10/qa-nick-hanauer-believes-stock-buybacks-are-the-root-of-american-inequality/#2446897731a1
Companies I’ve known that have pursued the MSV have also maximized, quietly, the potential for the CEO to earn. As the worker bees were squeezed and demoralized, and the innovation tapered off, the beatings continued but the morale didn’t improve.
Now, when I hear the phrase MSV, I reach for my Short-The-Stock gun.
This article reminds me to repost Doug Henwood’s essential book on Wall Street:
http://www.leftbusinessobserver.com/WSDownload.html
What has happened is that the US began a transformation in the 1970s from a more productive economy into a plutocracy, and a kleptocracy. I Would not be unsurprised, if there were those on top who knew that this whole “Shareholder Value” hypothesis is a totally insane idea, but they will religiously defend it because they are getting rich off of the status quo.
Less discussed is the excessive compensation on CEO pay, the fact that CEO pay is negatively correlated with shareholder returns, and how employees bear all of the costs. Whenever something goes wrong, excessive regulations, unions, or employee salaries are scapegoated.
We are seeing very limited investment in R&D, capital goods, worker training, and the blue skies research that might actually do something for society. Most of the money is spent on share buybacks.
As one of the comments above notes, real innovation is difficult. It is filled with lots of risks and no assurance of a pay-off. It requires many years of investment to make it from a risky experiment into a successful product. That is at odds with the relentless focus on short term profits that many CEOs have.
I think too that this is a good argument against using equity financing and publicly traded corporations. There will always be very heavy pressure to deliver short-term profits, even at the expense of greater long term profits.