Ideas
Lynn Stout

To Increase Investment, Change the Definition of ‘Shareholder Value’

Burgess COMMENTARY

Peter Burgess

Pocketing Profits or Reinvesting Them INTRODUCTION rfdinvest André da Loba Corporations have gone from retaining about 60 percent of their profits in the 1970s, to about 10 percent today, William Lazonick wrote in a recent Harvard Business Review article. Profits are instead being used to pay dividends to investors and to buy back stock to boost its price, benefiting the company’s executives. Can this trend be reversed to help fuel growth that benefits everyone?\ An earlier version incorrectly stated that corporations retained 90 percent of their profits in the 1970s.

To Increase Investment, Change the Definition of ‘Shareholder Value’ Lynn Stout Lynn Stout is the Distinguished Professor of Corporate and Business Law at Cornell Law School. UPDATED SEPTEMBER 15, 2014, 2:47 PM For most of the 20th century, managers believed public corporations should serve not only their shareholders, but also employees, customers, the nation and future generations. American companies pursued long-term research that would not produce profits for years or even decades. The result was a host of corporate breakthroughs, like the transistor and the desktop computer, that contribute immeasurably to our lives today. For decades, economists have wrongly argued that a company's stock price always captures its true economic value. All this changed in the 1980s. Economists began arguing, confidently if incorrectly, that shareholders “own” corporations and that stock price always captures a firm’s true economic value. Thus shareholders should have more power over corporate boards, and executive pay should be tied to shareholder returns. These academic arguments were embraced by activist investors seeking to buy shares, pump up price, and sell for a quick profit. They also appealed to C.E.O.s hoping to enrich themselves by boosting share price by any means possible (including, at Enron, outright fraud). The result is today’s world, where “shareholder value” is king. When a company’s stock price languishes, its directors worry they will targeted for an embarrassing proxy campaign. C.E.O.s worry their pay will drop and they might be fired. (The average C.E.O. now lasts less than six years). Proxy advisory services like Institutional Shareholder Services, which advises most mutual funds and pension funds on how to vote the shares in their portfolios, define “good corporate governance” only in terms of what raises shareholder returns -- right now. The cult of “shareholder value” makes it difficult or impossible for firms to pursue the long-term, truly innovative projects that the Nobel prize-winning economist Robert Solowe demonstrated are essential for economic growth. When stock price lags, nervous boards and C.E.O.s know that they can almost surely raise it, at least temporarily, by cutting research and development and other investment expenses and giving the cash to shareholders through a dividend or share repurchase. That’s a hard temptation to resist when your reputation, position and, in the case of executives, compensation depend on short-term results. There are a number of ways to fix the problem. We can discourage short-term investing by amending the capital gains rules to reward longer shareholding periods. We can uncouple executive pay from share price and find better metrics that reward, rather than punish, executives for investing in research and development. We can pressure Institutional Shareholder Services (the most powerful business institution you’ve never heard of) to define “good corporate governance” in terms of long-term results rather than short-term share performance. But none of these solutions are likely to be adopted until we recognize the nature of the problem — the ideology of “shareholder value.” Join Room for Debate on Facebook and follow updates on twitter.com/roomfordebate.

The idea that economic activity is undertaken simply for the benefit of the owners of corporations is quite nonsensical. The purpose of economic activity is so that people can have the goods and services they need and want. The corporate organization has proved in the main to be the most efficient way of implementing an economic activity.

The problem is that when you make the success of the corporate organization as the driver of the economy, then the impact on people becomes secondary, or even gets ignored.

I argue that capitalism has had an undue focus on financial capital, ignoring all the other capitals. Everything has a focus on creating financial capital or financial wealth, but without considering impact on human capital, social capital, physical capital, institutional capital, knowledge capital and natural capital.

All the metrics that are in play concern themselves with money based measures ... corporate profit, stock prices and corporate value, and GDP growth. These are powerful measures and there is nothing like them for the other capitals. However, the fact that there are no metrics does not mean that these capitals are not being impacted.

I want to see accounting that does as much for all the capitals as accounting does for financial capital. This requires some measures other than money to facilitate quantification everything that makes up all these capitals.

I also want to see much great clarity in the analysis of society and economy between what is state and what is flow. One of the problems is that GDP is a measure of flow and being used as a proxy for state ... something that is not at all valid in any of the richer economies around the world.

Accounting for the 21st century is needed together with rethinking of capitalism for this century. Taking into account all the capitals will change the way we think of profit, progress and performance.

Peter Burgess Topics: Wall Street, corporations, economics, taxes