Maximization of Shareholder Value: Flawed Thinking That Threatens Our Economic Future
One of the most widely promulgated falsehoods in investing is the notion that those managing publicly held companies are obligated to maximize shareholder value. In recent years, US companies have taken on record amounts of debt to fund share repurchases on a scale only exceeded in 2007, in the name of enhancing shareholder value.* Often undertaken at the behest of a vocal minority, these buybacks have served to enrich CEOs at the expense of other important stakeholders, diminish the health of our economy, and threaten the long-term future of our corporations. That there is no legal basis for this fixation on shareholder value is either poorly understood or conveniently ignored by much of the investing public. Thankfully, the doctrine of shareholder primacy is now being challenged with more vigor and frequency than ever before. It’s time to put to rest an idea that too often promotes myopic thinking and imperils long-term value creation.
Many observers trace the rise of shareholder primacy theory to the influence of economist Milton Friedman. In 1970, Friedman argued that the social responsibility of business is to increase profits. Six years later, in “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” academics Michael C. Jensen and William H. Meckling turned to agency theory to explain why it was the sole obligation of corporations to maximize profits. They posited that corporate executives acted as agents for the owners of the business, the principals. Maximizing shareholder value became a shared goal that served to align the interests of shareowners and management, the latter via generous incentive compensation plans.
What got lost along the way was that the goal of maximizing shareholder value has no foundation in US corporate law. Directors and officers of publicly held companies have general duties of loyalty and care to the corporations they serve, but not to shareholders of the firm. Lynn Stout, professor of corporate and business law at Cornell Law School, notes in The Shareholder Value Myth that “maximizing shareholder value is not a managerial obligation, it is a managerial choice.” Only during takeovers and in bankruptcy does US law give special consideration to common stockholders. Importantly, Stout also points out that shareholders are hardly monolithic. Hedge fund manager Carl Icahn has a different time horizon, risk tolerance, and objectives than the typical pension fund. Stout likens strategies to unlock shareholder value to “fishing with dynamite.” That is, short-term success is often at the expense of “aggregate shareholder wealth over the long term.”
The bull market that began in 1982 helped fuel a hostile-takeover boom, and corporate raiders commonly invoked the noble ideal of maximizing shareholder value as they sought leveraged buyouts, greenmail, spinoffs, and asset sales. The classic book Barbarians at the Gate: The Fall of RJR Nabisco is a fair depiction of the times. Today’s corporate raiders are called activist investors, and while the tools at their disposal may have changed, their motives are similar, and the recent surge in share repurchases suggests that CEOs are heeding their call. The result has been a buyback binge of epic proportions, almost certainly violating one of Warren Buffett’s cardinal rules of investing. In his 2011 letter to Berkshire Hathaway shareholders, Buffett said:
Charlie [Munger] and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions — even serious ones — are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted.
There’s little doubt that capital used to fund many buybacks over the past decade has been diverted from more worthwhile investments. As a result, innovation has suffered, crimping growth, and other important stakeholders, particularly employees, have been left behind. This is the argument put forth by William Lazonick, professor of economics at the University of Massachusetts Lowell, in “Profits Without Prosperity.” He notes that since the late 1970s, companies have migrated from a “retain-and-reinvest” approach to a “downsize-and-distribute” philosophy, resulting in chronic short-termism and accompanying social costs in the form of “employment instability and income inequality.”
Lazonick points the finger at stock-based executive incentive plans, buybacks run amok, and poor oversight on the part of corporate boards. CEOs at S&P 500 firms now have a majority of their pay tied to their firm’s stock price, which may explain the record $270 billion spent on buybacks in the first half of this year. In fairness, Lazonick distinguishes between good and bad share repurchases. He acknowledges that tender offers can be a viable strategy for buying back undervalued shares at a designated stock price, according to the precepts of Buffett. However, he considers most open-market purchases ill-advised and undisciplined, noting that companies have a track record of buying at inflated prices.
Lazonick boldly proposes reforming the system by disallowing open-market share buybacks; curbing stock-based pay and tying compensation to innovation; and giving board seats to taxpayers and workers. While his call for reform is likely to meet stiff resistance, Lazonick should be applauded for drawing attention to a critically important issue.
Rather than enriching themselves by buying back stock at prices near all-time highs, CEOs should instead reinvest in their businesses, including their employees. Doing so will drive long-term growth and sustainability for corporations and the economy at large, better balancing the interests of all stakeholders.
*An earlier version of this blog post characterized the scale of share repurchases as “unprecedented.”
This October at the European Investment Conference in London, James Montier of GMO will explore the negative consequences of maximizing shareholder value in his presentation “Shareholder Value Maximization: The World’s Dumbest Idea?”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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