According to Ibbotson data, the US stock market has delivered a 10.1% annualized return from 1926 to 2014. I mention this data, which includes two significant market corrections, because the numbers speak for themselves. The US entrepreneurial spirit, along with a vibrant capital markets system, is alive and well. We see this today in the slew of new technology startups, healthy corporate profits even in the face of a strong dollar, and record foreign investments in US companies. That being said, there’s something I believe investors have gotten wrong, and that’s the virtually unquestioned tenet that a company’s main responsibility is to maximize shareholder value.
This seemingly obvious truth is surprisingly, a new idea, conjured up in the early 1970’s by economist Milton Friedman who wrote a scathing rebuke of corporate social responsibility in an op-ed piece for the New York Times Magazine. Shortly thereafter, two business school professors ran with the notion and published multiple journal articles extolling the virtues of maximizing shareholder profits. The idea stuck and today most in the financial industry agree that this is the primary, if not only, responsibility of a corporation.
Perhaps because I started out as a high school science teacher, followed by a stint at a local zoo, I came to my first financial position at an institutional money management firm with a slightly different perspective. My first year as a stock analyst was confusing. I quickly learned that companies reported two sets of financial data, one based on GAAP or Generally Accepted Accounting Principles, and another set called “pro forma” that excluded a lot of recurring “one-time” expenses. Then I realized that while my Chartered Financial Analyst (CFA) studies helped me gauge the health of a company and its growth prospects (among other things), it became clear that the stock market game had more to do with beating Wall Street’s expectations for the upcoming quarter.
What was going on? Roger Martin in his book titled “Fixing the Game” suggests that a misguided focus on maximizing shareholder returns is incenting companies to boost earnings per share in the near-term at the cost of important, and often uncomfortable, investment decisions for the long-term. He notes that executive compensation is now more closely tied to stock and earnings per share (EPS) performance than ever before. This might be one reason why companies in the S&P 500 Index bought back shares at almost record levels in 2014. While reducing a company’s share-count provides a short-term boost to EPS growth, it leaves less cash on a company’s balance sheet for the critical business investments needed to drive shareholder value for the long-term.
So if maximizing shareholder value is not what company management teams should focus on, then what is? As with most pursuits in life, I find that fixating on a certain result often ends badly. No one can know the future, let alone deliver a certain outcome in perpetuity. Sure we can do it here and there in the short run, but in the grand scheme of things, our jobs – as individuals and companies – is to serve our clients and our communities. I believe that when companies focus on their customers, their employees, and their vision for the future, they are much more likely to maximize shareholder value – with the added benefit of contributing to society along the way. But when management teams and investors alike focus on profits for the sake of profits, the whole system becomes twisted and warped. We’re seeing this today in the rampant short-termism on Wall Street, outsized executive compensation packages, and subpar business investment levels – the lifeblood of our economy and capital markets.
While all this may sound discouraging, the good news is that more and more well-regarded financial professionals – among them, Warren Buffet, Jack Welch, and Blackrock’s CEO, Laurence Fin – are speaking up. One of our industry’s leading organizations, the CFA Institute, hosted a distinguished investment professional at its latest annual event whose presentation was called, “Shareholder Value Maximization: The World’s Dumbest Idea?” His research found that companies that focused on responsibility to customers, employees, and communities tended to outperform those that did not. All this to say that investors are starting to wake up the outdated and erroneous notion that corporations exist only to maximize shareholder value. We’re finally starting to put the cart back behind the horse, where it belongs.
Carrie A. Tallman, CFA
Director of Research