Corporations, Shareholder Primacy, and the Decline of Long-Term Investment

Lynn Stout discusses the origins of the misguided belief that corporations are owned by their shareholders in her book The Shareholder Value Myth. She argues that corporations are entities that have a legal existence and identity that is separate from that of its shareholders. The idea that shareholders "own" the corporation is a myth, but one that many wished to believe was true; and over time it effectively became true. The notion of shareholder primacy contributed the constraint that the corporation’s goal was to increase the wealth of its shareholders. The idea took root because it was popular with conservative economists, the public, the press, corporate reformers, shareholders, and even corporate executives.

The objective of shareholder primacy was to provide mechanisms whereby corporate leadership could be constrained to act in the best interests of the corporation and its shareholders. The metric by which executives would be judged was the shareholders share value.

It was assumed that the corporation and its shareholders would have common purpose in insuring the economic health of the enterprise. This assumption has turned out to be false. Therein resides a dilemma that can only be resolved by shattering this myth of shareholder supremacy.

Most people who actually invest in company shares do so through mutual funds or via pension plans. These people tend to be long-term investors who envisage their wealth increasing via the overall growth in the economy, rather than worrying about the specific activities of a particular company.

"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."

This is the type of shareholder people had in mind when they swallowed the shareholder primacy concept.

What type of investment environment have shareholders provided for corporations today?

"....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. By 2010, the average annual turnover for equities listed on the U.S. exchanges reached an astonishing 300 percent annually, implying an average holding period of only four months."

How can four months and long-term be in any way consistent?

The major players in the markets are mutual funds, pension plans, and hedge funds. One might think that pension plans and mutual funds that generally represent investors with long-term goals would themselves be focused on long-term performance of companies, but that would be a mistake. Pension plans have a desperate need for a rate of return on investment that is difficult to attain in current markets. This leads them to indulge in the more extreme investment tactics such as investing in hedge funds, or investing like a hedge fund themselves. Mutual funds and hedge funds have investors with long-term goals, but short-term memories.

"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."

What is a short-term investor looking for when he/she purchases shares?

"The short-term investor who expects to hold for only a few months or days wants to raise shares today and favors strategies like cutting expenses, using cash reserves to repurchase shares, and selling assets or even the entire company."

A hedge fund can exert a powerful influence on a company if it decides to invest enough to control a significant fraction of the shares. Stout refers to a study of activist hedge funds by Bill Bratton of the University of Pennsylvania. In his 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."

Nowhere in that list is there anything to do with the health of the company.

In a volatile market such as exists today, failure to meet set goals can generate large market responses. This puts considerable pressure on company executives.

"One recent survey of 400 corporate finance officers found that a full 80 percent reported that 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."

The concept of shareholder supremacy, coupled with the current nature of shareholders, has introduced a number of perverse incentives into the system. The extreme focus on share price, and the coupling with executive compensation, has contributed to risky and unwise decisions being made. Rather than holding executives accountable it has tempted them to do foolish things.

Where does all this lead? It leads to a dysfunctional economy. We discussed some of the issues in Corporate Profits and Wages: Karl Marx Would Be Smiling. Included there was reference to a study issued by the Federal Reserve Bank of New York that suggested that

"....executive incentives may even be driving the business cycle by their effects on investment."

Stock markets seem to have become disconnected from their original goal of raising equity for investment purposes. Instead they seem more like giant casinos where many high stakes and low stakes games are available for play. Money churns and the players have an exciting time, but there is little benefit to the economy or to society.

Businesses seem to recognize that becoming a public corporation is something to be avoided if at all possible. This issue was discussed in Are Public Corporations Becoming Obsolete? Companies tend to go private if they can. Private partnerships were once the typical business form; they may regain that status again.

Has the US form of capitalism come to a dead end? Something has to change. Let’s hope it is a change for the better.