What’s Wrong With The Cult of Shareholder Value?

What’s Wrong With The Cult of Shareholder Value?

In the early 1980s, when the first stirrings of global competition began to hit American shores, and computers started to make inroads into productivity gains, a generation of “corporate raiders” and disgruntled investors began proposing ideas such as a corporate management mandate that shareholder value should become priority number one.

While it made sense at the time, after a decade of stagnant growth, high inflation and abysmal stock market returns, this imperative has become so much a part of the everyday corporate culture that the country’s entire economic system is now affected by it, and most people would agree that such an effect has been extremely negative.

In fact, many of today’s financial issues can be traced in part to this management theory: slow growth, income inequality, unemployment. The corporate focus on maximizing shareholder value, to the exclusion of early all other corporate goals, has resulted in a hyper-focus on short-term results, which in turn has led to massive layoffs, less investment in long-term projects, and top management being paid incredibly exorbitantly.

The Godfather of Shareholder Value

Jack Welch, formerly of General Electric, was perhaps the first CEO to really institutionalize the concept of maximizing shareholder value. During his tenure he increased the market capitalization of GE from $41 billion in 1980 to $410 billion in 2004. In a speech to financial analysts in 1981, which was called “Growing fast in a slow-growth economy,” he outlined his theories and ushered in the idea that among a business’s stated goals should be a pledge to maximize shareholder value.

Alfred Rappaport explained Welch’s premise in a 1986 book, Creating Shareholder Value: “The ultimate test of corporate strategy, the only reliable measure, is whether it creates economic value for shareholders.”

By 2009, Welch had recognized that his initial beliefs may have resulted in undesirable economic consequences, and he backtracked, saying, “On the face of it, Shareholder Value is the dumbest idea in the world. Shareholder Value is a result, not a strategy. Your main constituencies are your employees, your customers and your products.”

However, by 2009 it was far too late; the cult members had been drinking the Kool-Aid for nearly three decades, and the concept of maximizing shareholder value had become as entrenched in corporate cultures as any management theory has ever been.

What Happened Next

When successful at managing their short-term stock prices, corporate management teams were rewarded with extravagant bonuses and stock option packages, ensuring that they became even more invested in boosting their company’s stock price. As institutional investors demanded even greater returns on their dollars, the quarterly performance numbers became the primary measure by which a company’s stock price rose or fell.

As the management team grew to resemble the investors, those two stakeholders became the only ones that mattered. Employees, customers, and communities were irrelevant and fell by the wayside.

Cost-cutting was the means to creating greater profits, so employees were one of the first stakeholder groups to suffer. Expenses like employee wages can be reduced by outsourcing to countries whose employees make a fraction of what U.S. workers make. Robot technology, while initially expensive to install, can replace employees and run 24/7 with no need for breaks or sick days. Benefits and pay are stingy, because there is no need to care about employee satisfaction. And with the unemployment rate still high, turnover is also not a problem; it’s easy to find another worker.

Long-term investment projects that might be detrimental to short-term earnings are being reduced and eliminated – resulting in less innovation, less product improvement, fewer new products being brought to market.

And since pleasing customers is no longer a priority, we get poorly-made products and incredibly bad customer service.

What have We Gotten?

We now have a group of executives who are so obscenely overpaid, that they have zero concept of what it means to be one of their employees. And despite the fact that Congress required companies to reveal their actual CEO-to-worker salary ratios nearly three years ago, when they passed the Dodd-Frank Act, most companies do not publish the numbers. The SEC has not yet devised rules regarding the requirement, and many large companies (unsurprisingly) are lobbying against it.

Estimates from trade-union groups and academics have estimated the ratio at 20 to 1 during the 1950s, 40 to 1 in 1980, and 120 to 1 in 2000. Today the number is more like 200 to 1.

The rest of us are not participating in any growth. At all.

The 1%, that fabled group of people who are rich beyond belief, whose wealth is so vast that most ordinary people could not even imagine it, have received ninety-five percent of the effects of the recent recovery.

It’s frankly an unbelievable number, but it comes courtesy of UC Berkeley and the Paris School of Economics. The average real growth in income (defined as income plus realized capital gains) during the 3 years since the recession ended has amounted to a reasonable 6%. But that number consists of the 1% receiving real growth of over 31%, and the 99% achieving real growth of just 0.4%.

This Cannot Continue

Our economy cannot continue to reward the ultra-wealthy far beyond their desert, while the rest of us struggle and work hard just to stay where we are.

Our executives cannot focus so exclusively on the short-term that they fail to provide for any long-term at all. They cannot be rewarded so ridiculously for meeting goals that are ultimately inconsequential. They cannot be compensated for choosing to take morally questionable actions that benefit only the bottom line.

We need investment in our employees. We need more education, higher wages and better benefits. If employees cannot afford to buy things, then who will be buying the products that a company makes?

We need investment in R&D. We need innovation, and product improvement. We need to return the focus to pleasing the customer.

In The Long Run, We’ll All Be Dead

One of the greatest examples of what will happen in the long run to a company that is managed to maximize shareholder value is the case of General Electric. Jack Welch was the shareholder-value king. He increased shareholder value at GE in part by managing GE’s earnings so precisely that the company exactly met expectations in 41 of 48 quarters from 1989 to 2001. During the other remaining 7 quarters, the company beat once by 1 cent, four times by 2 cents, and missed by 1 cent and 2 cents once each. The chances of earnings being so precise without being completely manipulated? Zero.

And then reality caught up with whatever short-term madness had become rampant regarding the company; GE is now worth a fraction of what it was worth at its height. Of course, many other companies have also suffered tremendous losses, but GE still stands nearly alone as the poster child for misplaced emphasis.

Furthermore, it’s not much of a leap from a management team that manipulates its earnings in order to boost short-term share price, to a management team that actually falsifies its numbers for the same reason. Scandal after scandal has demonstrated that when shareholder value is the desired goal, many executives seem to lose sight of what is legally and morally correct.

Executives need to recognize what is happening, and begin making changes to corporate culture and behavior before every company in America goes the way of GE. The price of your company’s stock should not be the sole measure of its value to the world. Your product, your employees and your customers are what are precious.

It does not have to be a shareholders-versus-everyone else type of game. Many companies have shown that it is quite possible to do well by doing good. I’ll explore some of those in an upcoming post.

Karin Hernandez has been interested in personal finance since she began reading Money magazine in high school. Over the years, she has traded stocks, IPOs, options, futures and forex. She became a freelance financial writer in 2012, and currently writes stock market analysis for The Motley Fool and Seeking Alpha, as well as financial blog posts and articles for numerous private clients. She now totally believes that dividend-growth companies are the best way to invest.

2 Responses to “What’s Wrong With The Cult of Shareholder Value?”

  1. Robt says:

    Great analysis, but you left out the Board of Directors of these companies…..Have they all become puppets? When has a Bd. of Directors criticized a CEO, or made sense to his contract when he was hired into the CEO position. It’s often these golden parachutes that inflate outrageous salaries as they job hop from company to company. The emphasis that a CEO (manager) can manage any operation without knowledge of the process involved that gets the company in trouble. Examples include HP and HD in the recent past.

  2. Karin Hernandez says:

    This isn’t just about the CEO of these companies, the BoD is definitely part of the problem. Many of these BoDs are comprised of people who get paid staggering amounts of money to attend a couple of meetings a year and essentially do nothing. They have no incentive to actually care about the employees or the customers. It’s the entire upper echelon of management of these companies that has failed the rest of us.

Leave a Reply

Your email address will not be published. Required fields are marked *