Mankind’s mistakes: maximizing shareholder value

Mankind’s mistakes is a series of articles that explores some of the worst ideas that our current societies came up with, and how we can fix them. Up first: maximizing shareholder value.

The Dutch government has at times apologized for their past deeds, such as their history of colonization, their treatment of Indonesians in the 1940s, or more recently for proposing laws that transgenders needed to undergo surgery to get their gender legally changed. Perhaps the government should also apologize for the existence of the Dutch East India company.

It was this company that introduced the concept of share-ownership to the world, and it is arguably one of the worst things to happen to society. Shareholders have a tendency to destroy company profits, and managers often complain that shareholders just interfere with doing business. The problem is that the goals of shareholders rarely align with what’s best for the company. So the question is, why do we have shareholders at all?

Shareholders, what are they good for?

In theory we have shareholders to provide firms with the capital they need to operate. In addition, financing firms through easily tradable shares creates some needed liquidity that makes capital markets function. And the market should in theory be the best aggregator of all the available information. This means that shareholders should be in the best position to determine the actual value of a company, which is then reflected in its share price.

But do these benefits really matter all that much? When it comes to providing capital, established firms are more likely to use retained earnings or debt to finance investments instead of issuing shares, and firms that use debt financing tend to make much better investment decisions. In fact, shareholders sometimes take more money out of companies than they put in, when companies pay their shareholders in the form of dividends. And in spite of a dip in dividend payouts at the start of the Covid-19 pandemic, the general trend is that payments of dividends continues to increase.

“The question is, who really benefits from this system?”

Younger firms have a more compelling case of relying on shareholders for initial investment, but it’s not like issuing shares is their only option. For example, organizations like angel investors and venture capital firms exist for the specific reason to finance young and starting firms, and are continuously on the lookout for new investment opportunities.

The liquidity provided by easily tradable shares also isn’t always a positive. While increased liquidity can help an effective functioning of the market, it turns out that shares that are too easily tradable can actually be detrimental. When there is too much liquidity in the market (i.e. when trading shares is common and rapid), the volatility of the market increases, which makes everything more uncertain. And when there is too much uncertainty, trading actually decreases, meaning that liquidity goes down as well.

And the benefits of aggregating information in the public domain? It turns out that stock markets actually aren’t all that great at valuating companies and predicting future value. As Nobel laureate Paul Samuelson said, “stock markets are micro efficient but macro inefficient.” In other words, while stock markets might be able to reflect small changes to individual firms, in the aggregate stock markets are woefully blind and often have little idea about actual worth.

Instead, shareholder trading actually exploits deficiencies in the information of the general public by facilitating insider trading. While it is technically illegal to make trades based on information that is not available to general public, it does happen all the time, and is actually one of the easiest crimes to get away with. It’s probably no surprise that this is especially problematic when it comes to politicians, who are often able to make miraculous stock trading decisions that outperform those of investment funds.

Read more about the problems with our current politicians.

Sad but true

We tend to think of shareholders as the owners of a company, but it probably makes more sense to view them as short-term renters instead. To start, shareholders are not liable for any costs or damages of the company beyond their initial share investment. In addition, shareholders usually only own shares for a relatively short period of time before selling them on. Whereas shares used to be held for years during the 1960s and 70s, the trend has been nothing but downward, and the average share-holding time is currently measured in months.

This shift from long-term ownership to short-term renting that begun in the 1970s has had massive financial implications. Part of the reason for this shift likely comes from academic research during this time that started to become wary of managers and their incentives. Academics devised a concept known as agency theory, where they argued that managers operate based on their own self-interest, instead of what might be best for the organization that employs them.

“These days, maximizing shareholder value is king, and few other things seem to matter.”

The premise is that instead of focusing on maximizing profits and value for the company, managers are more likely to engage in practices that increase their own status and social standing. A popular tactic was to undertake large scale, costly (but not always profitable) acquisitions, in order to increase the size of the company. This would increase the standing of those who worked for the company, but was often detrimental to actual success of the organization.

As a response to this, over time power slowly shifted away from CEOs and managers, and towards shareholders. In the meantime, shareholders started to prioritize their own goals over those of the company as well, which often led to more short-term investments when there was money to be made. As a result, most companies are now largely beholden to the (often) sole demand of their shareholders: a high return on investment.

The combined shift in power towards shareholders and ever shrinking times of share-ownership have caused a massive shift in the goals of organizations. These days, maximizing shareholder value is king, and few other things seem to matter. This shift has been incredibly detrimental to society overall.

Nothing else matters

The biggest problem with maximizing shareholder value as the main goal is that it heavily incentivizes short-term thinking. Shareholders often have limited interests in long-term results, when there are short term-gains to be had instead. After all, once short-term gains are realized, shareholders are free to sell their shares and move on to the next firm, where they can once again focus on short-term gains.

This means that the shareholder voting decisions and their outcomes tend to be more short-term oriented, which makes companies much worse off in the long run. And the shorter-term the outlook, the bigger the chance that companies get sold at a discount, overpay for other acquisitions, and perform worse than the market.

Thus, shareholders have made companies far more short-term oriented in their outlook. And when companies focus more on the short-term, they’ll care less about building long-lasting and valuable relationships with suppliers when there are short-term discounts to be had elsewhere. They care less about keeping customer satisfaction high when they can exploit them in the short run. They care less about creating a pleasant working environment for their employees, as they can always hire replacements. And they care less about investing in riskier long-term projects, when there are short term gains to be had.

Shareholders don’t share

In response, increasing the return on shareholder investment has become the primary motivating mechanism for CEOs. CEOs can realize this return on investment in two ways: increase the value of shares, or transfer the profits earned by the company to shareholders in the form of dividends. Both are problematic.

In case of the former, share value depends fully on the perceptions and expectations of the market, as share price is supposedly a reflection of the expected profitability of a company. But share price has long been detached from actual profitability, and it’s instead becoming increasingly based on speculative future growth. Companies such as AirBnB, Uber, Lyft or Pinterest have seen incredible share price evaluations, without actually ever having made a profit.

And when the main goal of CEOs is to maximize share price over actual profitability, all CEOs really need to do is to manage the perceptions of the firm. This means that they are incentivized to give the appearance that the company will do well in the future, irrespective of how well the company is actually doing. At the same time managers have little reason to share information about any structural issues that may exist within they company. As a result, shareholders often lack adequate information to base their decisions on.

“The market favors the organizations that invest least in improving themselves”

And unfortunately, simply creating the appearance of doing something is often sufficient for a positive evaluation: for example, research shows that announcing the implementation of long-term incentive plans is enough to boost share prices, irrespective of whether these plans are actually implemented or not. When CEOs manage expectations instead of outcomes, everything turns into overpromising and speculation. And we’ve seen how that story ends: look no further than the dot-com bubble, the global financial crisis, or more currently crypto currencies.

Paying out profits in the form of dividends for shareholders is also not without issue. All the money that goes to shareholders is not used in other avenues such as further re-investments into the company itself, for example to foster technological innovation or provide better compensation for employees.

As a consequence, too much money bleeds out of the company, and public firms severely lag behind private firms when it comes to how much they re-invest. It should be no surprise that actual returns on capital investment have consequently decreased ever since maximizing shareholder value became paramount.

And while paying dividends does nothing to help the organization itself, shareholders value dividend-paying stocks more than non-dividend paying stocks. In other words, the market favors the organizations that invest the least in improving themselves.

No gain, just pain

It’s probably no coincidence that the shift towards maximizing shareholders gains went hand-in-hand with what is known as the wage-productivity gap: for decades, increases in employee productivity went in lockstep with increase in employee compensation. Until the 1970s that is, when the two trajectories started to decouple. Ever since, productivity continued to rise but employee compensation remained relatively stagnant. The implication is clear: when companies need to maximize shareholder value, there is no room for better employee compensation.

Shifting attention towards shareholders has also created a disconnect between the goals of the employees and the goals of the organization. While some employees might be motivated to do what’s best for their colleagues or customers, it’s rare to find those who can get excited about the prospect of maximizing shareholder value. And when employees are used as just another tool to increase the income of some anonymous shareholders, why should they be care about the well-being of their company?

On top of all that, an increasingly smaller number of shares is owned by individuals or households. Instead, most shares go towards large institutions and foreign investors. So the question is, who really benefits from this system?

How do we solve this?

Even if we take the existence of shareholders for granted, shareholder value should be an outcome, not a strategy. Maximizing shareholder value as the main organizational goal is incredibly stupid, and has previously been expressed by people such as from former GE CEO Jack Welch, Unilever CEO Paul Polman, and top strategist James Montier. Yet even these influential people are trapped in a system that demands that we prioritize shareholder value over all other options. We need a broader societal change to fix this.

The obvious solution would be to do away with shares altogether. By taking away the option to own shares, we remove most of the incentives that emphasize short-term gains over long-term goals. I’ve shown earlier that the actual gains from using shares are quite limited, and come with several downsides on top of their tendency towards a short-term view. It’s not at all clear that shares contribute more than the damage they cause.

Some might say that doing away with shares altogether is a bit too drastic. Even if we assume that is true, we still have several other options that are worth pursuing. In this case, the main focus needs to be on the root cause of the issues: minimizing short-term outlooks, and realigning the goals of the organization.

The most important avenue to pursue would be to prevent short-term trading of shares. Right now there is an entire industry of day-trading, where shares are bought and sold on the same day, with the intent to exploit small arbitrage differences. This means there is no incentive to think of what’s best for a company in the long run. We should instead treat shares more like bonds, and for example prevent the selling of shares within the first year that they are bought. This would lead to somewhat less liquidity in the market, but large gains towards re-establishing a long-term perspective.

“For some reason, we chose the worst outcome to maximize”

As a related measure, the shares of CEOs and other managers should be heavily restricted. CEOs, often compensated in shares, should not be allowed to sell these shares until several years past their tenure date. This encourages them to make decisions that are good for the company in the long run, instead of creating a brief window of positive appearances, quickly selling of all shares, and leaving the company. When CEOs are not freely able to sell their shares, they are less incentivized to manipulate the perceptions of the company, and are more focused on realizing actual success.

Another option would be to link shareholding tenure with voting rights. For example, shareholders could be barred from voting unless they’ve owned the shares for at least one year. This would also help realize a shift away from making decisions to score a quick buck and towards more longer-term outcomes.

A final promising idea is that of shares being used to compensate the employees of the organization. While some companies do this already, it’s rarely more than a token incentive, or a small retirement pool. For this to work employees would need to receive a significant ownership stake in the companies they work for. This will likely make them far more motivated to do a good job and see their company succeed, instead of toiling for mainly the benefit of some faceless financial traders. And when employees have a say in their company, we’ll likely see far less short-term profit maximizing. On top of that, people generally want to be able to take pride in the work they do. If employees have a say in the actions of their organizations, we might therefore see them engage in more ethical decision making as well.

But regardless of what we do, something has to change. Organizations have to deal with many different interest groups: Employees, customers, investors, trading partners, and so forth. All of these groups have different expectations and demands for the organization. Yet the demands we’re maximizing are those of shareholders, the group that arguably has the least positive contribution to society overall. For some reason, we chose the worst outcome to maximize. It’s time that we got our priorities straight.

Ron Maas
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