No rabbit and no money What happened to shareholder value

Thursday, 01 August 2002


    Investors are being fed a steady diet of corporate scandals fuelled by greed, corruption and collusion and this is reflected in the performance of the world’s sharemarkets. 

    With billions of dollars of investor funds gone missing in action, Edward Chancellor* looks at the concept of shareholder value and how this was used as a disguise for corporate crime.

    Despite the ending of the long bull market and the collapse of the technology bubble, Americans retain a strong belief in the superiority of their business practices. As President George W. Bush said in a speech to the Stock Exchange: "The American economy is the most creative and enterprising and productive system ever devised." These practices, we are told, have not only been responsible for the longest period of growth in US history, but also the briefest of recessions. The cause of this great turnaround can be summed up in two words: shareholder value. For the past 15 years or so, this has been the mantra for those who believe that companies should be run for the exclusive benefit of shareholders, with the interest of management aligned to shareholders through the use of stock options and similar equity-linked incentives schemes. Following the scandal at Enron and a string of other high-profile failures, however, the idea of shareholder value has come under increasing scrutiny. Critics claim that its successes have been exaggerated and that its most obvious result has been the personal enrichment of management at the expense of the very shareholders it was supposed to benefit.

    Managers' pursuit of shareholder value has been accompanied by the manipulation of earnings and other tricks which threaten to undermine the trust essential to the market system. Shareholder value can also be criticised on a theoretical level: it assumes the stock market is efficient, in the sense that share prices reveal intrinsic value, and advises managers to let those prices guide their actions. Yet market efficiency is dependent on the stock market passively reflecting value. Once the market starts determining business activities, a feedback loop is created which can lead to instability. The boom and bust in the stock market, the rise and fall of the technology companies, the massive sums wasted during the telecoms boom and the ensuing corporate scandals have all followed more or less directly from the indiscriminate pursuit of shareholder value. It is time for the business and financial world to wake up to its shortcomings. Shareholder value was nurtured in the free-market ideology of the 1980s. Its popularity as a management philosophy was accelerated by two developments. First, privatisation – driven in part by the need of governments to raise money and in part by ideology – required that former nationalised industries make themselves attractive to investors by improving their business returns.

    Secondly, the abolition of foreign exchange controls at the beginning of the decade led to internationalisation of company financing. Since the professional investors who managed international funds were only concerned about returns to their portfolio, this promoted a gradual convergence around the idea of shareholder value. European corporate traditions – such as complex ownership structures, institutional protection from hostile takeovers, and different classes of voting and non-voting shares – were deemed inferior to the Anglo-Saxon model. In the US, the progress of shareholder value took a different, more abrupt, course. The great depression had left scars on the corporate world that took a generation to heal. Rightly or not, the free-wheeling business practices of the 1920s were held responsible for the calamity. In the post-war era, the priorities of leading businessmen shifted away from maximising the profit of their companies, or their own fortunes; other goals, such as stability, continuity and responsibility towards employees predominated.

    In The Quest for Wealth (1956), a history of man's acquisitiveness, economic historian Robert Heilbroner claimed that the individual pursuit of wealth had been replaced by a corporate ideal. The corporation had become something akin to the feudal household. But the cosy world of US corporations was shaken in August 1984, when a Texas oil tycoon, T Boone Pickens, launched a hostile bid to gain control of the giant Gulf Oil. Pickens didn't himself have the funds to purchase Gulf, but he was supported by Michael Milken, the junk-bond guru of investment bank Drexel Burnham Lambert, who promised to raise the money by selling bonds secured on the oil company's future earnings. Although the bid for Gulf failed, the era of the "leveraged buy-out" (LBO) had arrived. Milken and his corporate raiders needed an ideology to justify their activities: shareholder value supplied it. Incumbent managers of large corporations were attacked as "corpocrats" who ran their businesses without regard to the real owners, the shareholders.

    James Goldsmith, the Anglo-French businessmen, who launched a bid for Goodyear and later for British-American Tobacco, robustly asserted the congruence of public and private interests during the LBO boom: "Takeovers are for the public good – but that's not why I do it. I do it for the money." The senior managers of big US corporations were forced to respond. Their initial reaction was to protect themselves against hostile bids, with "poison pill" defences and, if these failed, luxurious "golden parachute" pay-offs for senior executives. However, they soon realised that the best way to see off the raiders was to imitate them. Many companies made themselves less attractive to raiders by returning surplus cash to shareholders and taking on more debt, known as "leveraged recapitalisations". A judicious increase in leverage tends to lower a company's cost of capital. When combined with the repurchase of a company's shares, leverage usually causes the share price to rise. Corporations also imitated the example of LBOs by divesting themselves of "non-core" businesses. The age of corpocracy had been one of idiosyncratic diversification. Coca-Cola, for instance, at one stage owned a shrimp-farming business and a Hollywood studio. "Focus" became the buzzword of the late 1980s and 1990s. Another LBO practice, adopted by mainstream business, included the sacking of large numbers of surplus workers, or "downsizing." The aim was to reduce the capital tied up in the business as much as possible and maximise its cash returns.

    The raiders commonly dismissed incumbent managers as bureaucrats, rather than entrepreneurs, who didn't have enough "skin in the game". They were addressing an age-old problem: "The good shepherd giveth his life for his sheep. But he that is an hireling, and not the shepherd, whose own the sheep are not, seeth the wolf coming, and leaveth the sheep, and fleeth: and the wolf catcheth them, and scattereth the sheep. The hireling fleeth, because he is an hireling, and careth not for the sheep." (John, 10.11-13) In The Wealth of Nations, Adam Smith wrote that the separation of ownership from administration in publicly-quoted companies created an insuperable conflict of interest: "Negligence and profusion," he concluded, "must always prevail in the management of the affairs of such a company." The raiders dealt with the "principal-agent problem" by taking companies off the stock market into private ownership. But consultant Alfred Rappaport, in Creating Shareholder Value (1986), argued that it wasn't necessary to privatise companies. Rather, the interest of managers could be aligned with shareholders through the use of stock options and other equity-linked incentives. As with Milken's raiders, the self-interest of managers would be harnessed for the benefit of investors.

    The consultants' message of shareholder value and the example of the corporate raiders combined to determine the corporate culture of the 1990s: a focus on the core business; the use of financial engineering to reduce the corporate cost of capital; an emphasis on the business's ability to generate cash; and the linking of managers' interests to that of outside shareholders through the use of executive stock options. A host of new business phrases sprang up to describe these steps: market-value added (MVA), total shareholder return (TSR), cashflow return on investments (CFROI), cashflow return on capital employed (CROCE) and so on. To exponents of shareholder value, the longest period of prosperity in US history is proof enough of its efficacy. The implementation of shareholder value practices is said to have improved the allocation of capital by corporate executives, who in the bad old days were engaged in wasteful empire-building. Improvements in business investment and the speedier response of management to changing conditions, say the shareholder-value pundits, have injected an indomitable flexibility into the US economy, enabling it to overcome both recession and the shock of the terrorist attacks.

    During the 1990s, annual increases in US productivity averaged about 2 percent, a big improvement on the previous two decades. The return on equity of the 500 top companies in the Standard & Poor's index, climbed from 17 percent in the early 1990s to 22 percent by 2000. The US stock market climbed more than fourfold during the decade. The trillions of dollars worth of stock market gains bolstered the confidence of entrepreneurs and consumers, who fuelled the prosperity with rising business investment and household spending – while foreigners remained happy to invest the hundreds of billions of dollars required to cover the US trade deficit. But things are not quite as they seemed. First, it is likely that the US economic "miracle" has been exaggerated. Official productivity and national income statistics were inflated towards the late 1990s by the practice of making adjustments for improvements in technology. These "hedonic" adjustments added around half a percent a year to US productivity figures towards the end of the decade.

    If we subtract this figure, then productivity shows only a marginal improvement on the figures of the 1970s and 1980s, and is much inferior to the annual growth of roughly 3 percent in the 1960s. US business in the golden age of corpocracy actually generated greater gains in efficiency than in the period of shareholder value. Secondly, the evidence that corporations have improved their allocation of capital is not compelling. A large part of the rise in returns on equity (calculated exclusive of debt) came from replacing equity with debt. If we include debt, the return on corporate assets during the 1990s rose more modestly from 11 percent to around 13 percent, rather than 22 percent. In fact, US profits as a percentage of national income have been falling for the past five years. Every year businesses re-invest a large portion of their profits. A test of the success with which corporations allocate capital is to measure the returns on these retained profits. In theory, the rate of dividend growth in an efficient business should be no less than the rate of retained profits. On average, US companies in the 1990s re-invested profits each year equivalent to 2.4 percent of their market value.

    However, they only managed to generate dividend growth of 1.3 percent. Somewhere, the re-invested money has been frittered away. Again, these figures compare poorly with the 1960s, although they do show an improvement on intervening decades. Nor can the rise in the stock market be taken as prima facie evidence of the greater efficiency of US businesses. Shares rose by an average of roughly 15 percent a year during the 1990s. But the rise in share prices far outstripped that of profits. A more fundamental complaint against the theory of shareholder value is that its perverse incentives have caused more harm than good in the business world. At the heart of the shareholder value doctrine is the efficient market hypothesis – the claim that a company's share price and market value is the same as its intrinsic value. The real goal of management should therefore be to raise its share price. The assumption of market efficiency that underpins the doctrine of shareholder value is questionable. Warren Buffett, America's best-known investor, is fond of repeating the words of his mentor, Benjamin Graham, that "the market in the short run is a voting machine but in the long run it is a weighing machine." What he means is that over the long run, market price will come to approximate intrinsic value, but in the short run sentiment may cause shares to be over or under-valued.

    Recent events appear to confirm Buffett's view. Up until the spring of 2000, stock markets were signalling their approval of companies that invested in telecoms and the internet. Yet companies which allowed market expectations to guide their investment decisions ended up making some of the most expensive mistakes in business history. Notable examples include the tens of billions of euros spent by European telecoms companies on licences to operate 3G mobile phone systems. Never mind that the technology was untried and the demand for the services unproven, the market was indicating that the money was well spent. Similar errors were made by telecoms which invested hundreds of billions in new broadband networks, both in Europe and the US. In this case, the market failed to anticipate that the enormous increase in supply would lead to falling prices and surplus capacity. While the technology boom continued, sceptical fund managers who queried these investments were told by telecoms executives that they were merely doing what the stock market demanded of them. The honest dilemma was expressed by Martin Bouygues, head of a French mobile phone operator, who observed that, owing to its great expense, to buy a 3G licence would produce a slow death, but failure to purchase one would lead to instant death.

    In this case, it did not take long for the market to recognise its folly. Only a few months after the 3G auctions, the shares of the new licence-holders were severely under-performing those of the mobile phone companies which had missed out. It is not simply that market expectations are occasionally irrational, but they are also too dynamic to provide a sound basis for corporate decision-making. Markets are constantly testing and discarding new ideas. The corporate world moves, or should move, at a much slower pace. But some tortoise-like managers, who if left alone were destined to win the race in the long run, were threatened with dismissal for poor performance. Worse, their companies were on occasion taken over by the hares, as happened when the giant media group, Time Warner, was acquired by the upstart internet company, America Online. In the late 1990s, corporate takeovers, invariably justified on the grounds of shareholder value, rose to an unprecedented peak. Most of these have ended up destroying value as evidenced by the hundreds of billions of dollars of "goodwill" written off by the acquiring companies in the past year or so.

    A recent report by KPMG Consulting reveals that one-third of the largest international takeovers agreed at the height of the boom are now being unwound. Just as excessively optimistic market expectations may induce over-investment, so market pessimism can lead companies to invest too little. During the late 1990s, the market was divided into two: the high-flying "new economy" and the maligned "old economy" whose businesses were deemed to offer few growth prospects. Capital spending by industrial companies in cyclical industries was particularly suspect, since in the past such companies had typically over-invested during boom-times, only to be left with surplus capacity in the downturn. According to US broker Sanford Bernstein. in the half-century from 1950 the shares of US companies with the largest investment expenditures substantially under-performed those with the lowest capital spending budgets. The message delivered by shareholder value to the old economy was simple: don't invest. Heeding this message, management at old economy firms reduced expenditure on new plant and equipment throughout the 1990s. Bernstein estimates that the companies in the S&P 400 cut capital spending from 70 percent in 1982 to less than 50 percent of the cash generated by their businesses.

    The money saved was spent on buying back their shares. By this policy of reducing investment and repurchasing shares, old economy firms were putting themselves through a gradual process of liquidation. One result of this course of action was seen in the energy industry, where lack of investment led to shortages, causing energy prices to climb steeply in 2000, bringing the decade-long boom to an end. This prolonged period of low investment has damaged the competitiveness of other US industries. Big US paper companies operate with equipment that is around 17 years old, roughly twice the European average. Likewise, the average age of the aircraft of US commercial carriers is now around 20 years, far above the international average. And the plant and equipment at the giant US Steel is substantially older than that of Usinor, its main European rival. Had US companies invested more in recent years, it is unlikely that the Bush administration would now be seeking to protect the steel industry with tariffs on imports.

    In The Alchemy of Finance (1987), George Soros argued that markets could never be efficient since, contrary to theory, perceptions in the stock market change the reality for businesses in the real world. There is a feedback loop between share prices and companies, which Soros called "reflexivity." This is one of the principal causes of booms and crashes. Responsible managers should act to dampen the process of reflexivity. But by giving primacy to market expectations in management decision-making, shareholder value has instead nurtured instability. Of all the claims made by the advocates of shareholder value, none is more ludicrous than the assertion that by rewarding managers with stock options it has resolved the principal-agent problem. In practice, the generous compensation of top executives with stock options has created an overwhelming incentive to manipulate earnings in order to inflate share prices. In many instances, this has allowed senior executives to cash in their options, leaving the shareholders to suffer heavy losses.

    In the US, the rewards to chief executives for increasing their share price have been mouth-watering. Before his death in 1997, Roberto Goizueta, the chief executive of Coca-Cola, had amassed more than $US1 billion in bonuses. In the past, such fortunes had only been achieved by entrepreneurs and financiers. US business leaders now measure their success in how many "units" of $US100 million they can acquire for themselves, not in whether they have built lasting businesses. Companies have turned to financial engineering, replacing equity with debt, to push up the share price. Increasing debt has caused the volatility of individual stocks to rise to record levels, hardly a comfortable experience for shareholders. Companies have also reduced their dividend payments and used the money to buy back their own shares. The advantage of a share repurchase is that capital gains on shares are taxed at a lower rate than dividends. However, most shares are owned by pension funds which, being tax exempt, are indifferent as to whether they receive their investment returns through share price appreciation or dividends.

    The same does not apply to the holders of stock options, which decrease in value when money is paid out in dividends, but become more valuable when the same cash is used by the company to acquire its own shares. Christine Jolls of Harvard University found that the typical buyback in 1993 added around $350,000 to the value of the CEO's options package. By 1995, the amount of money spent on buybacks exceeded outlays on dividends for the first time in history. Over the following five years, more than $US1 trillion worth of buybacks were announced by US companies, despite the fact that share prices were at record highs. Many companies burdened themselves with excessive debt to repurchase shares at prices far above their current level. They now find themselves having to issue new shares to solve their debt problems: having bought high, they are selling low. As Warren Buffett commented, share repurchases "are all too often made... to pump the stock price." Current US accounting rules encourage but do not require companies to report the costs of options in their earnings statements. As a result, the London research firm Smithers & Company estimates that in aggregate US profits were overstated by nearly 20 percent in 2000. In the same year, the earnings of technology companies were exaggerated by over 70 percent.

    For some companies, the hidden cost is staggering. By excluding the true cost of its stock options, the internet company Yahoo! overstated its earnings by more than twenty-fold in 2000. In any year, the cost of stock options for senior employees seems small. It may involve issuing new equity equivalent to 2 percent of existing shares. Over just five years, however, shareholders will find themselves stripped of 10 percent of their company. It is possible to repurchase shares to avoid dilution from stock options. However, this can be very expensive. Dell Computer spent $2.7 billion on repurchasing shares in 2001, but owing to its generous options grants, the number of Dell's shares in circulation actually rose by 2 percent. Managers often claim that the decline in dividend payments does not matter since share repurchases have replaced them. But they fail to observe that nearly half the money spent on buybacks in recent years has been used to offset the new issue of shares for options schemes. The dividend income has, in effect, been discreetly re-routed from shareholders to managers.

    The defenders of stock options claim the failure to account for stock options does not matter since an efficient market should be able to determine their true cost and factor it into the price of the stock. Whether this has happened or not is impossible to prove. However, it seems no coincidence that the biggest issuers of stock options over the last decade – the technology companies – have also experienced the sharpest rise and fall in their share prices. The hidden cost of stock options is only part of the greater game of "earnings management," which developed during the past decade. There are now three tiers of corporate earnings in the US: at the bottom are estimates of profits in the official national income accounts; in the middle, are the earnings of companies as reported in their officially audited accounts, (which exclude the cost of stock options); and at the top, come the so-called "pro forma" earnings, otherwise known as "earnings before bad stuff," which exclude just about anything that management would prefer shareholders to ignore.

    The number of accounting scandals and earnings restatements have risen sharply in recent years. In each of the major cases of accounting fraud – at Waste Management, Cendant, Sunbeam, Xerox, Lucent and Enron – the motive for boosting profits seems to have been a desire to increase the value of managers' options. Since the bull market ended a couple of years ago, the press has hounded investment bank analysts for their failure to warn investors of the collapse. Why did analysts perform so poorly? Because managers typically reacted to a negative report by taking corporate finance business away from the analyst's investment bank. Chief executives would also threaten to cut off recalcitrant analysts from information about their businesses, until the SEC instituted a new rule preventing such behaviour. During the same period, companies spent fortunes on financial PR and investor relations, whose message was invariably bullish. A change in US law in 1995 has made it more difficult to sue company officers for making misleading or false statements about company prospects. As a result, chief executives have talked up their shares with impunity and shareholders have been unable to base investment decisions on accurate information or impartial advice.

    The truth is that the holders of stock options have different interests from shareholders. Firstly, unlike shareholders, the recipients of employee stock options have no costs and face no losses. They therefore have an incentive to take larger risks. If they are unsuccessful, then they can always demand that new options be granted at a lower price. Research shows that managers have systematically milked shareholders, giving themselves more options before good news is released and shares are anticipated to rise, and then further grants after shares have collapsed. Technology companies which have fallen on hard times regularly blackmail their investors with the message that unless employees are given more options at lower prices, staff will defect and the business disintegrate. Secondly, options holders and investors have different time scales. The average tenure of US chief executives has fallen to roughly four years. Stock options can usually be exercised after around 18 months. Most holders of stock options cash them in at the earliest possible date (forgetting that options were meant to put them in the same boat as outside investors). Outside investors, on the other hand, own shares to meet pension obligations some 20 years in the future.

    In recent years, however, investors seem to have realised that it has been the policy of managers to ramp shares. They have reduced the length of time they invest in stocks accordingly. The average holding period by shareholders of US stocks has fallen from over seven years in the 1970s to under 18 months today. Individual investors who are speculating in shares for short periods are less interested in the minutiae of accounting or the long-term consequences of companies' investment decisions. The alliance between shareholders and managers has faltered on the greed of the latter. Before shareholders realised they had been robbed, corporate insiders were cashing in their options. It is no coincidence that insider sales reached a record $11 billion in February 2000, just as the Nasdaq bubble was about to burst. Arguably it was these sales which popped the bubble. Since then, the papers have been replete with stories of companies, such as Enron and Global Crossing, the telecoms firm, where managers escaped with billions of dollars in stock option profits and investors were left with worthless shares.

    So much for the resolution of the principal-agent problem. Scarcely a week now passes without shareholders complaining publicly about another massive options grant at some under-performing company. Shareholders at Vivendi Universal, the distressed media conglomerate, have recently rebelled against a plan to issue new options to staff, equivalent to 5 percent of the company's outstanding shares. There is also growing support among institutional investors for the proposal of David Tweedie, head of the International Accounting Standards Board, to oblige companies to report the cost of their option schemes. However, the corporate world is not willing to give up its lucrative compensation arrangements and lobbying in the US against Tweedie's proposals is fierce. As a result of slavishly pursuing the shareholder value fad, many companies have badly damaged their relationships with their other "stakeholders" – suppliers, customers and employees. Some of the largest companies in the US, such as IBM and General Electric, have spent more in the past decade on repurchasing their shares than on developing their businesses.

    Yet according to consultant Jim Collins, the successful running of companies has little to do with executive compensation schemes or satisfying the whims of the stock market. Rather, great managers are motivated by the pride they take in their work. They are prepared to take decisions that are often initially unpopular with shareholders and have the courage to stick by them. Similarly, John Kay, the business writer, applies JS Mill's principle of obliquity to corporate profits. Just as Mill argued that happiness could not be achieved when pursued directly, so Kay claims that profitability should never be the purpose of a business. Profit, says Peter Drucker the management theorist, is not the rationale of a business, just the test of its validity. When shareholder value becomes the prime purpose of management, disappointment is inevitable.

    * Edward Chancellor is the author of Devil Take the Hindmost – a history of financial speculation. This essay was first written for Prospect, a UK business magazine. This edited version is published by permission from Prospect


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