Figure 24. CEO-to-worker compensation ratio in the US28
Figure 25. CEO tenure in the US29
Palmisano’s statement reflects what most corporate CEOs would parrot to their investors these days. This measure of a company’s performance comes down to its two major components: earnings and the number of shares. The first, earnings, is an output from the profit and loss account of a company. It is notoriously vulnerable to manipulation. Earnings are usually calculated according to the Generally Agreed Accounting Principles (GAAP), the widely accepted framework of standards, rules and conventions accountants follow in drawing up financial statements. But within GAAP there is scope to adjust earnings to allow for exceptional items (which must be reported but can recur for several years), such as company restructuring charges, and extraordinary items (isolated events which do not need to be reported), such as hurricane damage. Managers therefore have some leeway to massage earnings. More than that, earnings are fundamentally determined by the company’s operating profits, which in turn are the product of sales growth and earnings margins.
The number of shares outstanding is less vulnerable to accounting manipulation, but corporate actions can definitely influence it: for example by granting shares and share options for CEO and management compensation, and via share buy-backs. A delicate balance must be struck. Awarding shares to managers as part of their pay reduces EPS growth. Buying back shares can raise EPS, provided that the cost does not offset the gains from lowering the number of shares in issue.
Sales growth and improved profit margins, the two components of earnings growth, are positively influenced by investment, whether in plant and equipment (capital expenditure) or R&D. Investment is the story corporate managers like to tell. But there is another, quicker and more predictable way to improve margins, about which managers are less forthcoming: cutting costs. It’s a process that companies have embraced – to the detriment of investment.
Figure 26 shows how business investment in the US is now around its lowest level for more than sixty years, an amazing and disturbing phenomenon.
At the same time, as discussed in the previous chapter, the decoupling of average productivity and earnings means that the share of total value added going to wage earners has also steadily declined. William Lazonick, the chronicler of share buy-backs, has characterized these two trends, when taken together, as a shift from a model of ‘Retain and Invest’ to ‘Downsize and Distribute’. The first strategy – ‘Retain and Invest’ – uses finance only to set up a company and start production. Once profits are being made loans are likely to be at least partly repaid because retained earnings are a cheap way of financing the next production cycle and investments to expand market share. The second strategy – ‘Downsize and Distribute’ – is entirely different. It views companies merely as ‘cash cows’ whose least productive branches have to be sold. The resulting surplus is then distributed to managers and owners, rather than to others such as the workers who have also contributed to the business. The result may hamper the growth of the company and even cut the workforce – ‘Downsize’. If the shareholders are happy, however, the strategy is justified.
Figure 26. Business investment as percentage of US GDP30
One way of testing whether ‘Downsize and Distribute’ is a necessary corporate strategy is to compare public and private companies. Figure 27 shows that on several basic criteria such as size, sales, growth and return on assets (ROA), private companies seem to invest more than public ones.
It could be said that public companies are less profitable and therefore have less money to invest. But that doesn’t seem to be true. Figure 28 illustrates that there is little difference between the profit margins of major US public companies (the S&P’s 500) and those of all US firms derived from the National Income and Product Account (NIPA) compiled by the Bureau of Economic Analysis, which is part of the US Department of Commerce. The graph clearly shows a steady rise in profitability over forty-five years, culminating in record highs in recent years: truly ‘profits without prosperity’. In other words, the agent–principal problem does not have to result in declining investment and short-termism.
Figure 27. Private-sector firm vs public firm investment rates (percentage of total assets)31
Figure 28. Non-financial sector public company profitability (GMO)32
So, if margins are high but investment is low, what have companies done with their profits? Following the money leads us directly to shareholders. As we can see from Figure 29, corporations have largely returned profits to shareholders in the form of dividends and share buy-backs. Having averaged 10–20 per cent in the 1970s, the percentage of cash flow returned to shareholders has remained above 30, and sometimes substantially more than that for most of the past thirty years, although it dipped during the tech boom in the early 2000s when companies were investing.
What emerges from the evidence presented so far is that, just like finance, the financialization of the productive sector extracts value – objectively, rent. But not only in the productive sector. In recent years a wide range of businesses in the UK, from social providers like care homes to utilities such as water, both of which had previously been regarded as steady and unexciting investments, have been subject to financial engineering by new owners, often PE firms. The result is a transformation of public goods into private goods.
Figure 29. Percentage of cash flows returned to shareholders (US non-financials five-year moving average)33
Financialization has a long arm. It reaches into society as well as the economy, and despite claims that its encroachment into the productive economy is a solution to issues such as average earnings, skills and inequality, the evidence is not encouraging. As John Bogle has noted: ‘The highest-earning 0.01 per cent of U.S. families (150,000 in number), for example, now receives 10 per cent of all of the income earned by the remaining 150 million families, three times the 3 to 4 per cent share that prevailed from 1945 to 1980. It is no secret that about 35,000 of those families have made their fortunes on Wall Street.’34
FROM MAXIMIZING SHAREHOLDER VALUE TO STAKEHOLDER VALUE
Shareholder-value ideology is based on shareholders being the ‘residual claimants’. They are the lead risk takers, with no guaranteed rate of return. Friedman summarized the classic view of entrepreneurial firms as eternally struggling to stay afloat in a turbulent market (while hinting at the temptation to escape by subverting that market) by defining the purpose of a business as being to ‘use its resources and engage in activities designed to increase profits so long as it stays within the rules of the game, which is to say, engages in open and free competition, without deception or fraud’.35
A truth more complex than the primacy of the shareholders, however, is that wealth creation is a collective process. After all, important as shareholders are, it is hard to imagine a company being successful without the involvement of many groups, including employees, suppliers, distributors, the broader community in which the company’s plants and headquarters are located, and even local and central government. Moreover, it is wrong to assume that these groups have a guaranteed return while shareholders are stuck at the back of queue. Indeed, as we shall see in the next chapter, governments which make risky investments in new technologies and basic research – both of which are later adopted by companies reluctant to assume this high level of early risk – have no guaranteed return at all.
Recognizing the collective nature of value creation takes us from a shareholder to a stakeholder view. Whereas MSV boils valuation down to a single measure – the share price – an opposing argument is that corporations should focus on maximizing stakeholder value: creating as much value as possible for all stakeholders and seeing any decision as a balance of interests and trade-offs to achieve that goal – hardly an easy task, given the complexity of many business decisions. The charge which proponents of stakeholder value level against MSV is that the ‘pursuit of gains for shareholders at the expense of other stakeholders [is] a pursu
it which ultimately destroys both shareholder and stakeholder value’.36 Even Jack Welch, whose twenty years as General Electric CEO were often hailed as a triumph for the MSV approach, begged to differ when in 2009 he cited customers, employees and products as the key to that success, denouncing shareholder value as ‘the dumbest idea in the world’.
The stakeholder theory of business is more than a theory of how to run a company better; it also has far-reaching social and economic implications. It answers the question, ‘What makes a business successful?’ very differently to the proponents of MSV. In sharp contrast to Friedman and Michael Jensen, who advocated strongly that a company succeeds simply through profit maximization, a stakeholder view emphasizes the social relationships between management and employees, between the company and the community, the quality of the products produced, and so on. These relationships give the company social goals as well as financial ones. Together they can create more sustainable ‘competitive advantage’. And because value is created collectively, through investments of resources by a multitude of actors, it should also be distributed more collectively – not just to the shareholders.
In contrast to MSV and its goal of short-term profit maximization and its marginalization of human capital and R&D, stakeholder value sees people not just as inputs but as essential contributors who need to be nurtured. Trust – critical for any enterprise – is then built between workers and managers, in a process that acknowledges the vital role of workers in value creation. Investing in people is an admission that workers add value.
We have seen how short-termism distorts finance, making it more speculative. A stakeholder understanding of value denotes a very different type of finance: one that is more ‘patient’ and supports necessary long-term investments. In some countries this is achieved through public banks, such as the Kreditanstalt für Wiederaufbau (KfW) in Germany. KfW was intimately involved in Germany’s post-war recovery and economic growth, lending more than €1 trillion since its founding in 1948.37 Most of the countries that have public banks tend to follow a stakeholder model of corporate governance, for example by having workers on company boards.
Of course, no form of corporate governance is perfect – as the recent Volkswagen (VW) ‘dieselgate’ scandal proves. The car maker boasted several attributes which agency theorists consider helpful for far-sighted investment and honest practice, widening the shareholder base and extending its interests beyond short-term profit. German workers, who would have little to gain from tricking the US government, had a powerful say in the company’s affairs. A family holding company, a German state and a Middle Eastern sovereign fund control 90 per cent of the shareholder votes. All are very long-term investors. The company had a reputation among customers and industry specialists for engineering excellence. It did not seem like the sort of company that would get into serious trouble.
But it did. VW wilfully designed a system to reduce emissions during testing but not during driving, and has paid fines of $20 billion and lost roughly $100 billion of stock market capitalization as a result. Half a century earlier, Ford incurred similar financial and reputational damage when top managers very deliberately calculated that the cost of fixing a fatal flaw in its Pinto model exceeded the cost of paying compensation for the customers it killed.38 At VW, a hidden design flaw (potentially just as injurious to life and health) arose less through cynical calculation at the top than through pressures placed on subordinates to promote financial performance. The problem seems to have been a culture of competitiveness and fear which drove some engineers to take desperate measures to drive sales and many others to remain quiet about what they knew was a deception. There was long-term thinking at the top – but only about increasing market share, not about reputation. The unspoken but clear message to the employees who could have refused to comply was that failure to pass emissions tests was unacceptable, so it was preferable to cheat than admit defeat. In short, the VW scandal tells us that corporate governance structures and rules are unlikely to work unless corporate values are aligned with public values (a concept we will visit in Chapter 8).
CONCLUSION
Sky-rocketing rewards for the lucky few have widened social divisions and increased inequality in much of the Western world, notably in the US, the home of financialization.
This state of affairs can be – and is – attacked on moral grounds. Inequality reveals what we think of millions of our fellow humans. The economic issue with value extraction is not normative, however. As we have seen, in a capitalist economy some rent is necessary: there is an unavoidable price tag to maintaining the circulation of capital in the economic system. But the scale of the financial sector and of financialization generally has increased value extraction to the point where two critical questions must be answered: where is value created, extracted and even destroyed? And how can we steer the economy away from excessive financialization towards true value creation? Proposals such as taxing away very high incomes and accumulations of wealth may treat some of the symptoms of excessive finance. They do not, however, treat the causes, which lie deep in a system of value extraction which has grown up over the last forty years or so.
If the objective is long-term growth, the private sector must be rewarded for making decisions that target the long-term over the short-term. While some companies might be focusing on boosting their stock prices through share buy-backs, aimed at increasing stock prices and hence stock options (through which executives are paid), others may be taking on the difficult investments to increase the training needed for workers, introduce risky new technology, and investment in R&D, eventually leading, with luck, to new technology and more likely leading to nowhere. Companies could be rewarded for doing more of the latter and less of the former.
Executive pay should be kept in check through an understanding that there are many other stakeholders who are critical to value creation, from workers and the state to civil society movements. Reinvestment of profits back into the real economy – rather than hoarding or engaging in share buy-backs – should be a condition attached to any type of government support, whether through subsidies or government grants and loans.
The British-Venezuelan scholar Carlota Perez has argued that the decoupling of finance from the real economy is not ‘natural’ but an artefact of deregulation and excess belief in the power of free markets. Her groundbreaking work has identified a pattern of intense financialization followed by its reversal in each technological revolution.39 She shows that the early decades of each of the five revolutions to date (from the steam engine to the IT revolution) have been times of financial mania and increasing inequality. But after the financial bubbles collapse, and amid the ensuing recession and social turmoil, governments have tended to rein in finance and promote a period that favours the expansion of production, benefiting society more broadly and making finance serve its real purpose. But if and when government does not step in and play its part, financialization can have no end.40
The next chapter turns to the world of innovation, a glamorous arena of inspired inventors and fearless entrepreneurs where ‘wealth creation’ is not all it is claimed to be.
7
Extracting Value through the Innovation Economy
First, only invest in companies that have the potential to return the value of the entire fund.
Peter Thiel, Zero to One: Notes on Startups, or How to Build the Future (2014)
STORIES ABOUT VALUE CREATION
The epicentre of a still-unfolding technological revolution, Silicon Valley is the most dynamic industrial district in the world for high-tech start-ups. Since the 1980s it has made millionaires of many thousands of founders, early-stage employees, executives and venture capitalists – and billionaires of a significant number too. The ingenuity of these people has undoubtedly been instrumental in changing how we communicate, transact business and live our lives. Their products and services epitomize our contemporary idea of progress.
Silicon Valley’s entrepreneurs are
often viewed as heroic do-gooders. Indeed, Google’s stated mission is Do No Evil. In April 2016 a front cover of the Economist showed the Facebook founder Mark Zuckerberg dressed like a Roman emperor under the headline ‘Imperial Ambition’. Meanwhile, innovation is seen as the new force in modern capitalism, not just in Silicon Valley but globally. Phrases like the ‘new economy’, ‘the innovation economy’, ‘the information society’ or ‘smart growth’ encapsulate the idea that it is entrepreneurs, garage tinkerers and their patents that unleash the ‘creative destruction’ from which the jobs of the future come. We are told to welcome the likes of Uber and Airbnb because they are the forces of renewal that sweep away the old incumbents, whether black cabs in London or ‘dinosaur’ hotel chains like Hilton.
The success of some of the companies has been extraordinary. Google’s share of the global desktop search engine market is more than 80 per cent,1 while just five US companies (Google, Microsoft, Amazon, Facebook and IBM) own most of the world’s data, with China’s Baidu being the only foreign company coming close. This market share also results in immense wealth: Apple’s cash pile was over $250 billion in 2017.
These companies’ huge profits, and their domination of their respective markets, are claimed to be justified in terms of the value they create: such profits and such domination are simply a reflection of their enormous wealth-creating power. Similarly, big pharmaceutical companies have justified the enormous increase in drug prices – where cures for diseases like hepatitis C can cost up to a million dollars –through stories about their extraordinary innovation capability and associated costs, or – when those costs are revealed to be much lower and/or actually picked up by the taxpayer – through the notion of ‘value’-based pricing.
The Value of Everything (UK) Page 22
