Burgess COMMENTARY

Peter Burgess

HBR: How CEOs Became Takers, Not Makers Business leaders generally present themselves as the creators of jobs, the real makers of the economy, claiming to add value to their organization, to the economy and to society. But in the US over the last few decades, through the pervasive practice of share buybacks, the incumbents of C-suite have turned themselves into takers, not makers. That’s the thrust of “Profits Without Prosperity,” an article by William Lazonick, professor of economics at the University of Massachusetts Lowell, in the September issue of Harvard Business Review. Instead of creating value for their firms, their shareholders and society, top executives of these firms are, through the massive use of share-buybacks, doing the opposite: they are extracting value. Although the purported goal of share buybacks is to be “friendly to shareholders,” the overall impact of share buybacks is to destroy long-term shareholder value, jobs and the economy. Thus between 2003 and 2012, publicly-listed firms in the S&P 500 used a colossal amount of their earnings—54 percent or $2.4 trillion—to buy back their own stock. The article reveals that this wasn’t done for the most part when stock prices were low: astonishingly, most of the big purchases came when the stock price was high. Why? “Because stock-based instruments make up the majority of executives’ pay, and buybacks drive up short-term stock prices.” These firms are engaged, the article says, in “what is effectively stock-price manipulation.” In addition to helping themselves through share buybacks, the C-suite also generated windfall benefits for other “takers” from the economy: activist shareholders. For instance, “in recent years, hedge fund activists such as David Einhorn and Carl Icahn—who played absolutely no role in [Apple’s] success over the decades—have purchased large amounts of Apple stock and then pressured the company to announce some of the largest buyback programs in history.” The transaction transferred large profits to the activists, with no gain to the real economy. The consequences of these share buybacks are an economic, social and moral disaster: net disinvestment, loss of shareholder value, crippled capacity to innovate, destruction of jobs, exploitation of workers, runaway executive compensation, windfall gains for activist insiders, rapidly increasing inequality and sustained economic stagnation. Yet despite these obvious problems, the practice of share buybacks is now pervasive and increasing. According to Lazonick, share buybacks area now “an obsession”, even “an addiction.” The situation is one of fundamental institutional failure. CEOs are extracting value from their firms. Business schools are teaching them how to do it. Institutional shareholders are complicit in what the CEOs are doing. Regulators do no more search for individual wrongdoers, usually those below the C-suite, while remaining blind to overall systemic failure. In a great betrayal, the very leaders who should be fixing the system are complicit in malfeasance. Unless our society reverses course, it is heading for a cataclysm. How did “value creation” turn into “value extraction”? How did this disaster happen? Lazonick’s research reveals that the shift came in the late 1970s, i.e. at precisely the time that shareholder value theory got going. From 1945 to the late 1970s, the dominant approach was retain-and-reinvest. Firms “retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what I call ‘sustainable prosperity.’” From the late 1970s to day, it became downsize-and-distribute: The principal focus has been on “reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality.” “Given incentives to maximize shareholder value and meet Wall Street’s expectations for ever higher quarterly earnings per share (EPS), top executives turned to massive stock repurchases, which helped them ‘manage’ stock prices. The result: Trillions of dollars that could have been spent on innovation and job creation in the U.S. economy over the past three decades have instead been used to buy back shares for what is effectively stock-price manipulation.” The root cause: maximizing shareholder value Lazonick is explicit on the root cause of the problem: the philosophy of “maximizing shareholder value” (MSV), namely, the idea that the purpose of a firm is to maximize shareholder value and increase the share price, or what Jack Welch has called “the dumbest idea in the world.” MSV theory ignores the claims of “other participants in the economy who bear risk by investing without a guaranteed return… 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’.” It also ignores Peter Drucker’s foundational insight of 1973: the only valid purpose of a firm is to create a customer. It’s through providing value to customers that firms justify their existence. Profits and share price increases are the result, not the goal of a firm’s activities. “Executives who subscribe to MSV,” says Zalonick, “are thus copping out of their responsibility to invest broadly and deeply in the productive capabilities their organizations need to continually innovate. MSV as commonly understood is a theory of value extraction, not value creation.” Debunking the justifications for buybacks Executives give four main justifications for open-market share buybacks, Lazonick says. They are: “I’m helping shareholders who own the company—everyone knows that.” “We’re preventing shareholder dilution.” “We’re buying when prices are low to strengthen the company.” “We have run out of good investment opportunities.” Not so, says Lazonick. He debunks them all. “Creating value for shareholders:” Wrong! Most share buybacks provide temporary wins, but systematically kill long-term value for shareholders. “Signaling confidence in the company’s future.” How can this be so, asks Lazonick, when “over the past two decades major U.S. companies have tended to do buybacks in bull markets and cut back on them, often sharply, in bear markets”? What sort of a game is it when executives “buy high and, if they sell at all, sell low”? Lazonick is unambiguous. It’s “share price manipulation.” “Offsetting the dilution of earnings from employee stock options” Bad idea! This defeats the purpose of using stock options in the first place, namely, to encourage long-term performance. “Nowhere to invest?” A smokescreen! This pretext signals, says Lazonick, that the chief executives are not performing their principal function of discovering new investment opportunities. In effect, executives are setting aside the hard work of creating sustained innovation, when they can—risk-free–make money for themselves and their colleagues with the stroke of a pen? Top management, says Lazonick, are not doing their jobs properly. In any event, the case for shying away from investment because returns are low is weak. Dennis Berman in the Wall Street Journal points out that the returns on “net business assets” i.e. “actual stuff used in actual business,” have historically been much higher than share buybacks. For instance: Honeywell International [HON] has been making about 4 percent on its share buybacks, compared to 13 percent on business assets. Oracle [ORCL] is spending half its cash flow in share buybacks, when the return on buybacks has been around 5 percent, compared to around 32 percent on past investments. Why don’t CEOs see this? Clayton Christensen has argued in HBR that the analytic tools in use, such as the various ways of measuring rates of return, have led managers to go for short-term investments and miss real investment opportunities. If the members of the C-suite are not doing their jobs properly, it has yet to register in their paychecks. C-suite compensation is now a large multiple of what it was when firms were doing their jobs properly and focused on “retain and reinvest.” In the period 1978 to 2013, CEO compensation increased by an astonishing 937 percent, while the typical worker’s compensation grew by a meager 10 percent. As Upton Sinclair noted long ago, “It is hard to get a man to understand something when he is being paid not to understand it.” Moreover, this is not a situation where each CEO is on his or her own. The problem is compounded by cronyism and reciprocal rent-seeking. Thus in a recent study published in the Accounting Review, an astounding 62 percent of directors, who had a disclosed friendship with the CEO, said they would cut the budget for research and development in order to assure the bonus for their friend, the CEO. The most highly paid people, who should be actively leading in fixing the system, are busy helping their friends extract rents from it. The failure in leadership is breathtaking. The reasons given by the C-suite for share buybacks thus are shields to hide what’s really going on. Lazonick offers “a simple, much more plausible explanation for the increase in open-market repurchases: the rise of stock-based pay. Combined with pressure from Wall Street, stock-based incentives make senior executives extremely motivated to do buybacks on a colossal and systemic scale.” In business, it’s now official: greed is seen as good. Good buybacks and bad True, not all share buybacks are bad. Lazonick argues that some private share buybacks are justifiable. Share buybacks thus could make sense “when the share price is—truly—below the intrinsic value of the productive capabilities of the company and the company is profitable enough to repurchase the shares without impeding its real investment plans.” But these “constitute only a small portion of modern buybacks.” Surgical interventions with private tenders are the exception. Most of the $2.4 trillion in share buybacks have been made on the open market, often when the share price is high. Open-market share buybacks generally “come at the expense of investment in productive capabilities.” Share buybacks are thus being undertaken, says Lazonick, for “what is effectively stock-price manipulation.” Theoretically, the SEC has power to intervene to prevent share price manipulation. But here, as in other areas, the SEC is asleep at the wheel. “The SEC has only rarely launched proceedings against a company for using them to manipulate its stock price.” The consequences of share buybacks The economic consequences of pervasive share buybacks are dire: Net disinvestment: “the amount of stock taken out of the market has exceeded the amount issued in almost every year; from 2004 through 2013 this net withdrawal averaged $316 billion a year. In aggregate, the stock market is not functioning as a source of funds for corporate investment.” Declining shareholder value: Even shareholders are finally waking up that maximizing shareholder value actually destroys long-term shareholder value. Thus Laurence Fink, the chairman and CEO of BlackRock, the world’s largest asset manager, in an open letter to corporate America in March 2014. “Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.” Crippling the capacity to innovate: With 54 percent of earnings going to share buybacks, and 37 percent going out in dividends, there is little left for investing in innovation. “Many academics—for example, Gary P. Pisano and Willy C. Shih of Harvard Business School, in their 2009 HBR article “Restoring American Competitiveness” and their book, Producing Prosperity,—have warned that if U.S. companies don’t start investing much more in research and manufacturing capabilities, they cannot expect to remain competitive in a range of advanced technology industries.” Destruction of jobs: “While the top 0.1% of income recipients reap almost all the income gains, good jobs keep disappearing, and new ones tend to be insecure and underpaid.” Exploitation of workers: Workers are no longer receiving their fair share of the gains in productivity that their work has generated. Lazonick’s article shows how since the mid-1970s, the share of returns that should have gone to workers has been increasingly “diverted” into share buybacks, dividends and executive compensation. Trickle-down economics doesn’t work when the gains made by workers are being diverted to the pockets of their bosses. Runaway executive compensation: Buybacks are driven by, and contribute to, runaway executive compensation—an almost tenfold increment over the last couple of decades. Windfall gains for activist investors: The windfall gains made by hedge fund activists David Einhorn and Carl Icahn from the buybacks at Apple, undertaken at their urging, are in effect the fruits of a massive gambling casino that adds nothing to the real economy. Increasing inequality: “Buybacks contribute to economic inequality in a major way… “Though corporate profits are high, and the stock market is booming, most Americans are not sharing in the economic recovery… Instead of investing their profits in growth opportunities, corporations are using them for stock repurchases…” Economic stagnation: “Because they extract value rather than create it, their overuse undermines the economy’s health.” Moreover, practices like share buybacks, writes Roger Martin in Fixing the Game, generate 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. A kind of reverse-Ponzi scheme In the US, many publicly-owned companies have thus turned into a kind of giant reverse Ponzi-scheme. A Ponzi-scheme attracts investments into a firm on the false premise that it is a valuable company. A reverse-Ponzi scheme takes a valuable firm and systematically extracts value from it. The firm appears to be making profits even as it systematically destroys its own earning capacity. A reverse-Ponzi scheme is what’s happening now in many publicly owned American firms. By themselves, massive share buybacks are a bad idea. But when combined with other types of financial engineering, the consequences are even worse. Take IBM [IBM]. It has combined share buybacks with tax gimmicks, capability-crippling outsourcing, unsustainable work pressures, relentless cost-cutting, automatic culling of staff, fading technical expertise, strengthened bureaucracy, acquisitions ahead innovation, and reliance on financial incentives, and has committed to doing so over two successive five-year period. The result is sagging staff morale, an imploding business model, a cloudy future strategy and systematic destruction of long-term shareholder value. What to do about share buybacks? What to do about such a massive intractable problem? Lazonick’s article has some suggestions. I have more: if we look carefully, I believe that we can find a clear bright light within this heart of darkness. What is clear that the solution to fundamental institutional failure goes beyond passing a few regulations or changing the behavior of a few CEOs. It involves a whole set of institutions: business firms, institutional investors, legislators, regulators and business schools will need to think and act differently. The good news is that some of this is beginning to happen, as a consensus is emerging on the way forward. To learn what should be done about these problems, read Part Two of this article—From CEO ‘Takers’ To CEO ‘Makers’: The Great Transformation. And read also: Why Corporate America is Eating Itself Alive Why the World’s Dumbest Idea Is Finally Dying Why IBM Is In Decline How America lost the capacity to compete The five surprises of radical management ________________________ Follow Steve Denning on Twitter @stevedenning