The Shareholder Value Myth

by Lynn Stout

Short-Term Speculators versus Long-Term Investors

  Of all the possible problems posed when corporations adopt “maximize shareholder value” as their goal, one in particular has captured the attention of the business community almost from the beginning of the standard model’s ascendance. This is the fear that companies whose directors focus on stock price will run firms in ways that raise that price in the short term, but harm firms’ long-term prospects. For example, a company might seek to raise accounting profits by eliminating research and development expenses, or cutting back on customer relations and support in ways that eventually erode consumer trust and brand loyalty. The result is a kind of corporate myopia that reduces long-term returns from stock ownership.

  Beyond the Efficient Market Hypothesis

  Until 1987, many finance economists argued that the myopia argument made no sense, because it was impossible for managers to adopt strategies that harmed the firm’s future without producing an immediate decline in share price. This argument was based on widespread embrace of a theory called the “efficient markets hypothesis.”94 Although the literature on the efficient markets hypothesis is both enormous and technical enough to induce narcolepsy, the basic idea can be summarized as follows: stock markets are “fundamental value efficient” when the market price of a company’s stock incorporates all information relevant to its value, producing a share price that reflects the best possible rational estimate of the stock’s likely future risks and returns. In a fundamental value efficient market, there is no need for an investor to stay up late at night trying to figure out what her shares are really worth. She can sleep soundly knowing the market has done her valuation homework for her. Nor is there any fear that today’s stock price might not reflect the firm’s long-run value. Long run and short run merge, because there is only one accurate way to measure a stock’s future risks and returns: by its current market price. Corporate myopia cannot be a problem, because the stock market punishes shortsightedness.

  Even during the 1970s and early 1980s, the heyday of efficient market theory, many CEOs, directors, and professional investors had their doubts about whether stock prices really captured fundamental value. Even finance theorists understood there were some limits to market efficiency. For example, absent rampant insider trading, private information that is available only to corporate insiders (say, news that a promising new drug for male pattern baldness has just been discovered to cause impotence) might not be fully reflected in stock price until the bad news is made public.

  But collective confidence in the accuracy of stock market prices was shattered on October 19, 1987. On that day, the Dow Jones industrial average inexplicably lost 23 percent of its value in a single trading session. (The value appeared again, equally mysteriously, a few months later.) The tech stock bubble of the late 1990s further undermined trust in market prices, as did companies like Enron and Global Crossing, whose stock price soared beyond any sane estimate of value before crashing spectacularly.

  It is nearly impossible today to find a finance economist under the age of fifty who would claim stock market prices always capture true value. Indeed, many respected theorists now occupy themselves exploring alternatives to efficient market theory that can explain how markets go wrong. These alternatives include “heterogeneous expectations” models that incorporate the possibility of investor disagreement; new work on the “limits of arbitrage” that explains how some information gets incorporated into prices only slowly and incompletely; and the burgeoning field of “behavioral finance,” which examines how human emotions and irrationalities can distort prices and drive trading.95

  If the idea that stock prices always reflect true value is not entirely dead, it is at least seriously wounded. (Economist John Quiggen calls it a “zombie” idea, neither living nor quite dead.)96 But substantial support remains for the claim that—barring unusual circumstances and occasional fits of collective investor irrationality—over the long run, stock prices tend to be reasonably related to actual values. In the words of famed finance professor Fischer Black, many experts might argue that the market is efficient in the sense that “price is within a factor of [two] of value, i.e., the price is more than half of value and less than twice value.”97

  For many shareholder primacy enthusiasts, this is good enough. They argue that shareholders still benefit when managers look to share price as their guiding star, because even if the market temporarily misvalues companies, mistakes correct themselves over time. Thus shareholders themselves have reason to try to prevent managerial myopia: they understand that pressuring managers to raise share price through strategies that harm the company’s future will likely end up hurting the value of their own shares.

  This view ignores an inconvenient reality. Long-term shareholders fear corporate myopia. Short-term shareholders embrace it—and many powerful shareholders today are short-term shareholders.

  The Role of Short-Term Investors in Today’s Stock Market

  To understand just how hyperactive today’s stock markets have become, consider that in 1960, annual share turnover for firms listed on the New York Stock Exchange (NYSE) was only 12 percent, implying an average holding period of about eight years. By 1987, this figure had risen to 73 percent.98 By 2010, the average annual turnover for equities listed on U.S. exchanges reached an astonishing 300 percent annually, implying an average holding period of only four months.99

  This is a very odd phenomenon. At the end of the day, most stocks are held either by individuals with long-term investing goals (like saving for retirement or for a child’s college tuition), or by institutions like pension funds and mutual funds that run portfolios on behalf of these individuals.100 Even hedge fund clients are typically pension funds, universities, and foundations looking for steady, long-run returns on their endowments.

  If most investors want long-term results for themselves or for their clients, why is there so much more short-term trading? Part of the answer lies in the fact that deregulation and advances in information technology have made stock trading much cheaper than it used to be. Once upon a time, someone who thought a particular stock was under- or overpriced had to call a broker, pay a fixed commission, and possibly pay a transfer tax as well to trade. High transactions costs discouraged hyperactive trading. Now trading has become so inexpensive that some funds specialize in computerized “flash trading” strategies in which shares are bought and held for mere seconds before being sold again.

  But another very important part of the short-term equation, emphasized in a recent report from the Aspen Institute, is the growing role that institutional investors like mutual funds, pension funds, and hedge funds play in the market.101 As already noted, such funds mostly invest on behalf of individuals with long-term goals. Unfortunately, these individual clients tend to judge the fund managers to whom they have outsourced their investing decisions based on their most recent investing records. This explains why many actively-managed mutual funds turn over 100 percent or more of their equity portfolios annually and why “activist” hedge funds that purport to make long-term investments in improving corporate performance typically hold shares for less than two years. The mutual fund manager whose continued employment depends on her relative performance for the next four quarters finds it hard to resist the temptation to support management strategies that will raise share price just long enough that she can sell and move on to the next stock that might see a short-term bump in its stock. As mutual fund guru and Vanguard Funds founder Jack Bogle puts it, the mutual fund industry has become a “rent-a-stock” industry.102

  Short-Term Shareholders Push for Short-Term Results

  The result is that mutual funds and hedge funds pressure directors and executives to pursue myopic business strategies that don’t add lasting value. For example, the information arbitrage literature suggests that when information is public but not widely available, or is technical and difficult to understand, it filters into market prices relatively slowly.103 Thus cutting expenses by fi
ring employees or reducing customer support may produce a short-term bump in stock price because the market understands immediately that corporate expenses have been reduced but is slow to see the negative long-term impact of employee disaffection or weakening brand loyalty. One recent survey of 400 corporate finance officers found that a full 80 percent reported they would cut expenses like marketing or product development to make their quarterly earnings targets, even if they knew the likely result was to hurt long-term corporate performance.104

  An even better way to raise share price without improving real performance is old-fashioned accounting fraud. The market eventually figured out that Enron and Worldcom were cooking their books. But for several years, institutional investors profited as Enron and Worldcom executives “unlocked” enough shareholder value to make those who sold some or all of their shares before the frauds were discovered quite rich. For example, suppose a mutual fund invested $100,000 in Enron stock in 1993, when it was trading at just over $10 per share. Then suppose, realistically, the fund sold some of its Enron holdings each year as Enron’s price skyrocketed upward, in order to maintain fund diversification. By 2000, when Enron was trading over $90 per share, the fund might have earned a profit many times larger than its initial $100,000 investment—even if it still owned $100,000 in Enron stock when the company cratered in 2001. Financial fraud is not bad for all investors, only for those unlucky investors who buy and hold most of their shares until after the fraud is discovered.

  “Heterogeneous expectations” asset-pricing models (which differ from conventional financial-pricing models by assuming, realistically, that people disagree about the future) also suggest a number of “financial engineering” tricks that short-term investors can push corporate managers to adopt to raise share price without improving long-term performance. For example, practical and legal limits on short selling ensure that the shares of any particular company are typically held, and market price set by, investors who are relatively optimistic about that company’s future. By making a large share repurchase on the open market, the company can shrink its pool of shareholders until price is set only by the wildly optimistic. For similar reasons, a sale of the entire company—which typically requires a buyer to purchase shares not only from the relative realists in the shareholder pool but from the more-optimistic as well—usually demands that the bidder pay a substantial premium over market price.105 As yet another example, splitting up companies by selling off assets or divisions can create “shareholder value” by allowing different investors to invest only in the particular line of business they favor most. It’s much easier to be wildly optimistic about the future of a single product or division than the fate of a conglomerate that sells everything from pet food to airplane engines to financial services.

  Different Time Frames, Clashing Interests

  Once we recognize that stock markets are not perfectly fundamental value efficient and that managers can raise share price without improving real economic performance, we also have to recognize that shareholders with different investing time horizons have conflicting interests. The shareholder who plans to hold her stock for many years wants the company to invest in its employees’ skills, develop new products, build good working relationships with suppliers, and take care of customers to build consumer trust and brand loyalty—even if the value of these investments in the future is not immediately reflected in share price. The short-term investor who expects to hold for only a few months or days wants to raise share today, and favors strategies like cutting expenses, using cash reserves to repurchase shares, and selling assets or even the entire company. An important empirical study of activist hedge funds by Bill Bratton at the University of Pennsylvania confirms these are exactly the strategies activist funds demand. In Bratton’s words, “Activist hedge funds look for four things in their targets—potential sale of the whole, potential sale of a part, free cash, and cuttable costs.”106

  This poses a dilemma for the standard shareholder-oriented model. Toward which shareholders is it oriented? If stock prices do not always capture fundamental value, a conflict of interest exists between long-term investors who want directors to invest in the company’s future, and short-term investors, especially activist hedge funds, who simply want to raise share price today. In the words of corporate lawyer Martin Lipton, directors must decide “whether the long-term interests of the nation’s corporate system and economy should be jeopardized in order to benefit speculators interested not in the vitality and continued existence of the business enterprises in which they have bought shares, but only in a quick profit on the sale of those shares?”107

  Lipton’s language makes clear he’s on the side of the long-term investors, not the short-term speculators. I share his view, but I do not attempt in this book to provide a definitive answer to the difficult question of when and how directors should favor the interests of one kind of shareholder over those of another. The most important thing is to recognize that long-term investors and short-term activist hedge funds do not compete on a level playing field. Activist hedge funds have the clear advantage, because they concentrate their investment portfolios into just a few securities. This means it is worth their while to spend the time and effort necessary to become involved in a particular firm’s affairs. Diversified retail investors, by contrast, rarely have a big enough stake in any single company to make it sensible to closely monitor what’s going on; they suffer from their own rational apathy. Mutual funds are not much better. Most fund managers rationally conclude it is not in their clients’ interests for them to exercise an active governance role in the dozens or even hundreds of firms whose stocks the fund manager keeps in his portfolio. If there’s a problem, the fund manager will do the “Wall Street Walk” and sell the shares quickly and quietly, before anyone else catches on. As a result, mutual fund managers mostly vote the shares they hold as directed by RiskMetrics’ Institutional Shareholder Services (ISS), a “proxy advisory service” whose ideas about good corporate governance can be criticized for focusing on short-term stock price performance.108 The end result is that the only shareholders that are likely to engage in any serious way with incumbent management are hedge funds and ISS-shepherded mutual funds, both of which are biased toward the short term.

  Managing Shareholder Value Means Managing Expectations

  Finally, in his 2011 book Fixing the Game, business school dean Roger Martin has pointed out yet another reason why measuring corporate success by stock price ends up harming long-term shareholders: because it drives directors and executives to focus not on real corporate performance (sales, revenues, growth, new products) but on what Martin dubs “the expectations market”:

  The expectations market is the world in which shares in companies are traded between investors—in other words, the stock market. In this market, investors assess the real market activities of a company today and, on the basis of that assessment, form expectations as to how the company is likely to perform in the future. The consensus view of all investors and potential investors as to the expectations of future performance shapes the stock price of the company.109

  According to Martin, using the expectations market to gauge performance—especially when this is done by compensating CEOs and other executives primarily with options, stock grants, or bonuses tied to share price—puts executives in a terrible bind. Suppose a company is doing well; the firm is operating at peak performance and looks as if it can hum along at peak performance indefinitely. The stock market will incorporate this expectation of optimal future performance into today’s stock price. How then can a CEO raise stock prices any further?

  In Martin’s words, “Modern capitalism dictates that the job of executive leadership is to maximize shareholder value, as measured by the market value of the company’s stock. To that end, the CEO should always be working to increase the stock price, to raise expectations about the company’s stock price ad infinitum … the lesson is that no matter how good you are, you cannot beat expectations
forever.”110 Focusing on shareholder value gives managers “a task that is ultimately unachievable, in that it requires that they raise other people’s expectations continuously and forever.”111

  What’s a CEO to do? If she is a mere mortal, she may decide not to attempt the unachievable but instead to do the achievable: manage expectations, for example by using accounting manipulations (“earnings management”) to produce one disastrous quarter that dramatically lowers and resets the market’s expectations, so she can raise expectations again thereafter. Alternatively, she may elect to avoid the slow, hard, thankless task of developing new products, hiring new employees, and increasing sales and profits, and focus instead on cost-cutting (firing employees, reducing R&D) or financial engineering (selling off assets, making massive share repurchases) that temporarily raises stock prices without adding real long-term value.

  Stock-based compensation schemes thus create an unhealthy alliance between short-term institutional investors like activist hedge funds and ISS-advised mutual funds who move in and out of stocks, and executives whose compensation plans drive them to focus obsessively on stock market expectations. Consider the case of Kraft Foods. In 2010, Kraft completed a controversial takeover of iconic British candy manufacturer Cadbury, causing the disappearance of one of the United Kingdom’s few internationally recognized non-financial companies. Only 18 months later, under pressure from hedge fund shareholders, Kraft is now planning to split itself into two companies again. One will sell snack foods like Oreos cookies and Cadbury chocolate, and the other will sell grocery staples like Oscar Meyer cold cuts and Kraft macaroni and cheese. The split seems unlikely to result in any dramatic changes in the way the company manufactures or markets chocolates and cold cuts, although it might produce some duplication of expenses. Nevertheless, Kraft’s hedge-fund shareholders and stock-compensated executives can reasonably hope that splitting the company in two will “unlock shareholder value” by allowing the price for a one business to be set only by investors who are optimistic about the future of sugar-laden snack foods, while the other is set by investors bullish on basic groceries.112