The Shareholder Value Myth

by Lynn Stout

  Another tragedy of the investing commons results. Stakeholders eventually cotton on to what shareholders are doing, and become reluctant to make firm-specific contributions to public corporations subject to shareholder primacy pressures. Instead, they prefer making firm-specific investments in private corporations with controlling shareholders who have shown personal trustworthiness (there is evidence that corporations with more entrenched boards take better care of their employees and are more socially responsible), or not at all.121

  Shareholder Value Thinking Discourages Team Production

  Shareholder value thinking thus changes potential stakeholders’ perceptions of public corporations in ways that make it harder to pursue projects that require team production. There is some evidence this is occurring. Surveys report that as U.S. firms have embraced the ideology of shareholder primacy, employee loyalty has declined.122 Similarly, as noted in the Introduction, the number of U.S. public corporations has dropped dramatically as public firms “go private,” and many new companies opt not to go public at all.

  Further support for this thesis can be found in the empirical observation, mentioned in Chapter 5, that the United Kingdom’s relatively few global corporations are concentrated in finance and commodities extraction, especially minerals, oil, and gas production.123 This pattern may be driven by the United Kingdom’s relatively shareholder-friendly laws (for example, shareholders vote on dividends and can more easily remove directors). These laws make it more difficult for U.K. corporations to lock in shareholder capital. For example, under pressure from the American government in the wake of the Deepwater Horizon oil spill, BP announced it would suspend paying its regular dividends. This sparked a firestorm of protests from British pensioners who relied on BP dividends for retirement income. BP agreed to quickly resume paying dividends after announcing plans to sell off approximately $30 billion in assets, including many BP oil fields.

  BP’s reluctance to suspend dividends for more than a short period of time, and its willingness to sell off assets rather than disappoint its shareholders, illustrates how greater shareholder primacy means less ability to lock in corporate capital in a fashion that protects stakeholders. This likely explains why U.K. public companies concentrate in finance and commodities extraction. Neither industry demands much firm-specific investment. Productive mines and oil fields are not firm-specific because, as BP’s asset sales show, they can be sold off fairly easily for full value. Finance requires money and people, but money is not firm-specific: a dollar is worth the same to HSBC and Barclays. Nor do finance employees invest much in firm-specific human capital. Goldman Sachs investment bankers and Morgan Stanley traders can easily take their skills and their client relationships to other banks, and often do, and at least in the United States, any attempt to stop them would run afoul of the U.S. Constitution’s Thirteenth Amendment.

  Shareholder value thinking, which is even more prevalent in the United Kingdom than in the United States, may have prevented the U.K. business sector from developing much beyond finance and commodities extraction. One can argue that because the United Kingdom is a relatively small economy, it can afford to keep most of its economic eggs in the finance and commodities extraction baskets. (Some pensioners in the United Kingdom might beg to differ: before the spill, BP dividends accounted for nearly 15 percent of all dividends paid by U.K. firms).124 But such extreme specialization is not a viable strategy for a nation as large as the United States, nor for the global economy as a whole. Someone, somewhere, needs to build cars, ships and airplanes; research new drugs and medical devices; develop new software and information technologies; and create trusted brand names to sell televisions, computers, and breakfast cereals.

  Team production theory teaches that such businesses cannot thrive if they are run according to shareholder primacy ideology. There is an inevitable conflict between shareholders’ ex ante interest in “tying their own hands” to encourage their own and other stakeholders’ firm-specific contributions, and their ex post interest in opportunistically trying to unbind themselves to unlock capital and exploit others’ specific contributions. This conflict—a conflict between shareholders’ ex ante selves and their ex post selves, if you will—puts public corporations governed by the rules of shareholder primacy at a disadvantage when it comes to projects that require firm-specific investments. Rejecting shareholder value thinking, and instead inviting boards to consider the needs of employees, customers, and communities, allows boards to usefully mediate not only between the interests of shareholders and stakeholders, but between the interests of ex ante and ex post shareholders as well.

  CHAPTER 7

  Hedge Funds versus Universal Investors

  To most people, corporations are abstractions. As one old English case famously put it, corporations have “no soul to damn and no body to kick.” By contrast, shareholders seem concrete. When we imagine shareholders, we picture parents saving for a child’s college tuition; retirees waiting for dividend checks; or, sometimes, a wealthy hedge fund baron driving his Ferrari up a long driveway between manicured lawns to the door of his Connecticut mansion.

  Corporations Are Real, Shareholders Are Fictions

  This view gets it backwards. Corporations may be invisible, but they are quite real. Corporations own real property, enter real contracts, and pay real damages for committing real torts. They can live indefinitely, control more resources than many national governments, and thrive, weed-like, in the harshest locations and climates. By contrast, “the shareholder” is fictional. Shareholders seem more real than corporations because when we think of shareholders, we are not actually thinking of shareholders at all. We are thinking of human beings: fragile biological organisms who may happen to own, among their many different assets, shares of stock.

  The standard shareholder primacy model judges corporate performance from the perspective of something that does not exist: an entity whose only goal is to maximize the market price of the shares of a single company. In reality, even institutional investors like pension funds and mutual funds practice diversification. Their portfolios include shares in other companies, corporate bonds, preferred stock, real estate, and other types of investments as well. Moreover, these institutions themselves exist to serve the interests of their human beneficiaries, who often have their own investments in homes, real estate, and bank deposits. Indeed, for many beneficiaries their biggest investment is in their own human capital: their health, education, and earnings from employment. And humans, whether they hold stocks directly or through mutual and pension funds, are not just investors. They are also consumers who buy products, citizens who pay taxes, and organisms that breathe air and drink water.

  External Costs Are a Problem for Universal Owners

  This basic insight underlies an important intellectual challenge to shareholder value thinking: the idea of the “universal owner” or “universal investor.” Shareholder value thinking looks at the world from the perspective of a Platonic investor whose only asset is equity shares in one firm (say, BP) and whose only purpose and desire in life is to raise today’s price for BP shares by any means possible. But this Platonic shareholder does not exist. Real human beings own BP’s shares, either directly or indirectly through pension and mutual funds, and real human beings care about much more than just whether BP stock rises. They also want to protect the value of their other investments, keep their jobs, lower their tax bills, and preserve their health. They are to, a greater or lesser extent, “universal owners” with stakes in the economy, the community, and the planet.

  Consider someone who owns not only BP stock, but also holds BP bonds; owns shares in other oil companies; owns a beach home on the Florida Panhandle; has a job in the Gulf tourism industry; and values his own human capital, including his good physical health and social connections in a thriving coastal community. By skimping on safety corners, BP may have given this investor several years of above-average share performance. But by causing an enormous oil spill in t
he Gulf, BP’s risk-taking imposed much greater “external costs” on the investor’s other interests. As a result of the Deepwater Horizon disaster, the U.S. government imposed a moratorium on exploratory drilling in the Gulf that idled not only BP’s operations but those of other oil companies as well. The spill hurt the value of BP bonds, which were downgraded in the disaster’s wake. The value of beachfront property in the Gulf declined, and its tourism and fishing industries suffered. The Gulf ecosystem was harmed, and its ability to provide healthy seafood and safe recreation degraded.

  BP provides only one example of how companies can “create” shareholder value through strategies that impose larger external costs on universal investors. There are many others. For example, a software company like Microsoft or Oracle might increase profits by buying out or destroying its rivals, thus gaining monopoly power that allows it to raise the price of its products. Unfortunately, if its shareholders are also software consumers, those monopoly profits come from the shareholders’ pockets. A Verizon or Hewlett-Packard might raise its share price by cutting employee wages or health benefits, or simply cutting employees, but when American companies embrace this approach en masse, American investors who are also employees suffer. GE may lobby for legal loopholes to avoid paying corporate taxes, but when corporations pay no taxes, humans must either pay more taxes, or go without government services.

  Finally, it is well understood that the shareholders of a target company in a takeover or merger typically see their wealth increase when they receive a premium over the original market price for their shares. But numerous studies have also shown that, even as the shareholders of a target company receive a premium, the shares of the bidding company, which is typically much larger, often lose value.125 As a result, the gains to the shareholders of acquired firms in mergers and takeovers can be outweighed by larger losses to acquiring firms’ shareholders. One study has calculated that the net results, for shareholders as a class, of all corporate mergers from 1980 to 2001 was an overall loss in stock market value of $78 billion.126 Thus a hyperactive merger market may benefit undiversified shareholders who hold stock only in targets, while destroying value for universal owners.

  Why Universal Owners Don’t Act Like Universal Owners

  Recognizing that “shareholder” is a fictional noun, and that unrelenting pressure to increase stock price can drive corporations to do things that harm the real people who own their shares, naturally raises some difficult questions. In particular, why do so many diversified investors seem blind to their own interests as universal owners? Why do they lobby so hard for individual corporations to do something, anything, to raise share price, even when this harms the value of their other assets and interests?

  The answer has to do with structural factors that limit the information available to most individual investors and that create counterproductive incentives for many of the institutional investors that are supposed to represent individual beneficiaries’ interests. Consider first the plight of retail investors, typical “mom-and-pop” shareholders. Most have relatively small, diversified investment portfolios, meaning they are likely to hold only very small amounts of stock in any particular corporation. This makes most retail investors rationally apathetic. It simply doesn’t make economic sense for them to put much time or effort into finding out what’s going on at any of the particular companies in which they hold shares. Instead, they focus their attention on information that is simple, easy, and cheap to obtain: stock price. As a result they usually don’t know when a company is externalizing costs onto their other interests. (How many BP shareholders were aware of the risks BP was taking in the Gulf?) They assume a rising share price must translate into a personal benefit, ignorant of the damage being done to other parts of their universal portfolio.

  What about institutional investors, especially the mutual funds and pension funds that many individuals rely on to manage their investments for them? Proponents of the universal investor idea, most notably business professors James Hawley and Andrew Williams,127 have argued that even if individual shareholders are not in a good position to understand or protect their own universal interests, pension funds and mutual funds have the potential to act as stewards for universal owners. After all, because these funds aggregate contributions from many individual beneficiaries, pension and mutual funds control large investment portfolios. The California state pension fund CalPERS, for example, currently manages more than $200 billion in investment assets.128 This means that a pension or mutual fund may acquire a large enough stake in a particular corporation to overcome rational apathy, and justify spending time and money on acquiring and analyzing the information necessary to understand how that corporation’s business strategy affects the value of the stocks, bonds, real estate, bank loans, and other investments in the fund’s portfolio. Finally, mutual funds and hedge funds are supposed to act as fiduciaries for their individual beneficiaries. This concept might be read broadly enough to include protecting beneficiaries’ interests not only as investors in the fund’s portfolio, but also as customers, employees, homeowners, and biological organisms dependent on their environment.

  Yet even if pension and mutual funds are better positioned to protect universal investors’ interests than retail investors are, they are still unlikely to prove particularly effective stewards for universal investors. First, it is important to recognize that the idea that a pension or mutual fund might protect not only its beneficiaries’ financial interests in the fund’s portfolio, but also their outside interests in such matters as continued employment, adequate health care, lower taxes, and a clean environment, is—to put it mildly—legally untested. Thus we can expect most mutual and pension fund managers to err on the side of caution and manage their portfolios according to the well-established and accepted fiduciary goal of maximizing the value of the portfolio alone.

  Second, the lack of information and rational apathy that makes individual investors poor guardians of their universal portfolios also makes the beneficiaries of pension and mutual funds poor judges of whether their portfolio managers are doing a good job stewarding their universal interests. Just as retail investors default to the cheap, easy strategy of judging corporate performance by whether share price went up or down yesterday, pension and mutual fund beneficiaries judge the performance of fund managers according to whether the value of the fund portfolio went up or down yesterday.

  Fund managers accordingly have reason to avoid obvious “rob-Peter-to-pay-Paul” investing strategies that harm the overall value of the portfolios they manage. For example, a fund manager whose portfolio includes both stock in the target and stock in the bidding company in a proposed merger may have a more-jaundiced view of the supposed benefits of the merger than an undiversified shareholder who holds stock in the target alone. But fund managers have little to lose and much to gain from supporting corporate strategies that raise the stock prices of the firms they hold in their portfolios, even when those same strategies harm their beneficiaries’ outside interests. We should not be surprised to see a pension fund manager invest in corporations that cut costs by outsourcing jobs to China and India—even if many of the jobs that are outsourced belong to the employees contributing to the pension fund.

  How Hedge Funds Harm Universal Owners

  If these structural obstacles were not enough, pension and mutual fund managers’ ability to act as stewards for universal investors is being challenged today by another powerful force: the rise of hedge funds. Hedge funds are largely unregulated investment pools that are managed by professional traders on behalf of wealthy individuals, foundations, university endowments, and even some pension and mutual funds. They are now estimated to control nearly $2 trillion in investments.129 And unlike retail investors or pension and mutual funds, hedge funds tend to avoid diversification. Indeed, an activist hedge fund may hold as few as only two or three different securities in its portfolio.

  This means that the manager of an undiversified hedge fund—who
se human capital also is bound up in his portfolio’s performance—comes as close as any living entity can to the Platonic ideal of the undiversified shareholder who cares only about the price of a single company’s equity. As a result, hedge fund managers’ interests and universal owners’ interests often clash. A hedge fund manager will agitate long and hard for business strategies that raise the price of the shares of the few companies he holds, even if other companies’ shares suffer as a result. He will pressure companies to accept extreme risks that raise stock price, even if this hurts bond valuations. If he can afford concierge medical care and a private jet, he will happily push for corporations to raise share price by cutting employee health benefits and polluting the environment. (If the beaches on the Gulf of Mexico are soiled by oil, he’ll fly to the Bahamas for the weekend.)

  Consider, for example, the standard “investing” strategy of activist hedge fund manager Carl Icahn. Icahn is famous for acquiring a substantial position in a particular stock, then using his new shareholder status to demand the company’s board put the firm on the auction block and sell it off to the highest bidder (at which point Icahn becomes an ex-shareholder). Among other triumphs, he recently succeeded in pressuring Motorola to sell itself to Google. But on the rare occasion when Icahn has found himself owning stock in a company that wanted to make its own acquisitions—that is, when he is a shareholder in the bidding company that pays a premium, not the target that receives it—he has protested mightily, and worked to block the sale.130 Clearly, Icahn does not believe the mergers and acquisitions merry-go-round benefits investors as a class. But he is not interested in the wealth of investors as a class. He is interested only in his own wealth.