Not my view, but that of commentator James Montier.
And I can see exactly where he is coming from. And thinking through his views, what superficially seems like a good idea- reward CEOs for increasing share price- has taken a damaging and illogical turn.
In short, SVM (Shareholder Value management) theory states that the only relevant detail corporations have to focus on is delivering increased financial returns to shareholders. According to James Montier, author of the GMO paper, SVM, (see here) has proven to be the dumbest idea in the world. And that explains this posts title, ‘The world’s dumbest idea’.
Montier says while SVM might have deep historical roots, it traces its modern preeminence to the ideas created in the 1970s by hard-line right-wing economist (and Nobel laureate) Milton Friedman. However, Montier says SVM only really took hold in corporate boardrooms from the late 1980s, where it continues to hold sway today.
So what was supposed to significantly BOOST company performance has resulted in lowering performance.
By comparing a number of factors (including total shareholder returns, company lifespan and CEO pay levels) over the SVM era (1990s to now) and the managerial culture that preceded it, Montier concludes that the obsession with shareholder value has failed on a number of levels – even on its core promise to deliver higher returns to shareholders. As you can see in the above graph, returns were lower under the new management approach.
I’m not going to go over all of his findings here (at only 14 pages, including a number of nice graphics, Montier’s paper is easy enough to read in a single sitting) but the conclusion is that by linking CEO compensation closely to share price, it has led to the pure short term focus on growing share price at the cost of all else.
There have been three results of this short term, quarterly obsession with shareholder returns.
1. Reduction in investment into the company, in exchange companies have given the cash back to their shareholders (either through dividends or through share buy backs) and this has been a strong drag on medium and long term performance. There is no money to grow businesses, except by borrowing.
2. Focus on short term cost-cutting exercises to boost the next quarters profits. Companies increasingly seek to shrink them selves into growth, cutting investment, cutting costs, reducing staff numbers and avoiding pay increases. (as a means to increase executive remuneration)
3. Badly timed share buy backs. When things get tough in the business, the easy way to increase performance per share is to borrow money to buyback shares meaning stagnant profits are split amongst a smaller number of shares
Graph showing that US businesses prefer to buy shares when their pricing is HIGH, and avoid buying them when the pricing collapses… probably not good business sense. But when the CEO’s remuneration is linked to increasing share price, when the fundamental business won’t support that (lack of cash to invest) then you borrow money to buy back your own shares to give a short term boost.
There’s a lesson there for us all as shareholders in these corporations, Montier says: “Shareholders are but one very narrow group of our broader economic landscape. Yet by allowing companies to focus on them alone, we have potentially unleashed a number of ills upon ourselves.”
Montier concludes his analysis with lessons for shareholders, companies, and everybody else:
- Shareholders returns haven’t increased meaningfully and it may have led to poorer corporate performance.
- Peter Drucker was right: “The only valid purpose of a firm is to create a customer.” Montier compares superb customer focused company J&J, with SVM focussed IBM, and J&J’s performance wins hands down.
- Shareholders are just one small piece of the broader economic landscape, but if we allow companies to focus on then alone, “we have potentially unleashed a number of ills upon ourselves.”
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good views