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In 1976 Michael Jensen and Dean William Meckling of the Simon School of Business at the University of Rochester discovered a cure in need of a disease, publishing an article that posited that, since managers had an incentive to feather their own nests rather than return value to the real owner of a company the shareholders, that the sole goal of a company should be to maximize the return to shareholders.

At first blush that seems rather logical, but just remember that Mitt Romney's company, Bain Capital, was designed for the sole purpose of "Maximizing Shareholder Value", damn the consequences to the people whose lives, and livelihoods, he destroyed. And many of The 10 Worst Economic Ideas of 2011 also have an attraction to many people in spite of the damage they have been shown to cause.

These simple ideas, while exciting to the 1% and the Republican spin machine that enables them, are slowly rotting our capitalist system from the core.

In Forbes, Steve Denning notes:

Maximizing shareholder value turned out to be the disease of which it purported to be the cure. Between 1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33%. CEOs earned more for their shareholders for steadily less and less relative compensation. By contrast, in the decade from 1980 to 1990, CEO compensation per dollar of net earnings produced doubled. From 1990 to 2000 it quadrupled.

Meanwhile real performance was declining. From 1933 to 1976, real compound annual return on the S&P 500 was 7.5%. Since 1976, Martin writes, the total real return on the S&P 500 was 6.5%

Meanwhile incomes for ordinary Americans are stagnating.
Imagine an NFL coach holding a press conference on Wednesday to announce that he predicts a win by 9 points on Sunday, and that bettors should recognize that the current spread of 6 points is too low. Or picture the team’s quarterback standing up in the postgame press conference and apologizing for having only won by 3 points when the final betting spread was 9 points in his team’s favor.
Oh you're laughing at that very concept?
While it’s laughable to imagine coaches or quarterbacks doing so, CEOs are expected to do both of these things.
…notes Roger Martin in Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL.

Denning asks you to:

Imagine also that the coach and his top assistants were hugely compensated, not on whether they won games, but rather by whether they covered the point spread. If they beat the point spread, they would receive massive bonuses. But if they missed covering the point spread a couple of times, the salary cap of the team could be cut and key players would have to be released, regardless of whether the team won or lost its games.

Suppose also that in order to manage the expectations implicit in the point spread, the coach had to spend most of his time talking with analysts and sports writers about the prospects of the coming games and “managing” the point spread, instead of actually coaching the team. It would hardly be a surprise that the most esteemed coach in this world would be a coach who met or beat the point spread in forty-six of forty-eight games—a 96 percent hit rate. Looking at these forty-eight games, one would be tempted to conclude: “Surely those scores are being ‘managed’?”

Suppose moreover that the whole league was rife with scandals of coaches “managing the score”, for instance, by deliberately losing games (“tanking”), players deliberately sacrificing points in order not to exceed the point spread (“point shaving”), “buying” key players on the opposing team or gaining access to their game plan. If this were the situation in the NFL, then everyone would realize that the “real game” of football had become utterly corrupted by the “expectations game” of gambling. Everyone would be calling on the NFL Commissioner to intervene and ban the coaches and players from ever being involved directly or indirectly in any form of gambling on the outcome of games, and get back to playing the game.

To paraphrase Martin, what would lead a coach to do the hard, long-term work of getting his team to the Super Bowl when he could simply choose to work on simply beating the point spread instead? Even he had bonuses tied to reaching the playoff or Super Bowl, that bonus would pale in comparison to the size of the bets he could make wagering on his team. Thankfully the major sports leagues long ago banned that sort of gambling (see Alex Karras and Pete Rose).

But Denning's example is real. That esteemed coach who met or beat the point spread in forty-six of forty-eight games? Former General Electric CEO Jack Welch.

During the heart of the Jack Welch era GE met or beat analysts’ forecasts in forty-six of forty-eight quarters between December 31, 1989, and September 30, 2001—a 96% hit rate. Even more impressively, in forty-one of those forty-six quarters, GE hit the analyst forecast to the exact penny—89% perfection. And in the remaining seven imperfect quarters, the tolerance was startlingly narrow: four times GE beat the projection by 2¢, once it beat it by 1¢, once it missed by 1¢, and once by 2¢.
During Welch's 20 years at the helm of GE the company grew in market value from $14 billion to $484 billion. But in 1981 GE revenues were $12 billion and profit was $1.6 billion, by 2001 they had grown to only $130 billion and $12.7 respectively. Now 790% profit growth is nothing to sneeze at, but is it worth a 3400% rise in market capitalization? Welch himself realized this:
On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy…your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal…Short-term profits should be allied with an increase in the long-term value of a company.
Whoa, let me read that again: your main constituencies are your employees! You wouldn't know that from looking at the current Republican war on workers. You wouldn't know that from the way Mitt Romney treated the people he employed:
Cost-cutting became a mantra inside the company. After his employer, DuPont, was bought by Dade, William T. Mowrey, a field engineer, said his generous pension plan was replaced by a 401(k); his salary was cut by $1 an hour, costing him $2,000 a year in income. When he filed for overtime, he said, his new bosses refused to pay it. “They were just trying to milk as much out of us as they could,” he said.

Cindy Hewitt, a human resources manager, had been instructed to persuade about a dozen…workers to move to Miami, where Dade had another plant.

Not long after the workers arrived, the company said it would close that factory, too. Ms. Hewitt tried to help several workers return to Puerto Rico, but she said Dade insisted that they first repay thousands of dollars of moving costs. “They were treated horribly,” she said. “There was absolutely no concern for the employees. It was truly and completely profit-focused.”

Peter Drucker noted this in his seminal work The Practice of Management:
There is only one valid definition of a business purpose: to create a customer.
This concept should be remembered by everyone. Customers are what create jobs and put people to work. Customers are what create economic growth. A company without customers is always going to lay people off.

Martin suggests that:

companies should place customers at the center of the firm and focus on delighting them, while earning an acceptable return for shareholders
He highlights the credo for Johnson & Johnson which orders the company's responsibilities as Customers, Employees, Community, then Shareholders.

I have no problem with an America where some people through their hard work and great ideas can become rich. But focusing on short-term shareholder value while ignoring customer experience and giving excessive money to CEOs for managing Wall Street instead of managing the business is crazy.

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Comment Preferences

  •  Tip Jar (16+ / 0-)

    Teh stoopidTM, it hurts. Buy smart, union-printed, USA-made, signs, stickers, swag for everyone: Get your We are the 99% Yard Sign.

    by DemSign on Thu Dec 29, 2011 at 11:49:39 AM PST

  •  No Problem If the Company is Under the Governance (3+ / 0-)
    Recommended by:
    lcrp, G2geek, ahumbleopinion


    1968 was just about the economic high water mark for the people as a whole. It's the period when the rich had the smallest share of family wealth and the people had the biggest.

    Unions were large, media were journalistic, individuals were extremely heavily taxed on new income at the high end so businesses didn't offer huge compensation, and businesses were taxed more so they were able to afford to spend more of those pretax dollars on suppliers, wages, benefits, and reinvestment in the company's long-term growth.

    Maximizing shareholder value under civilized government may well be a fine idea.

    It wasn't until several years later that we began decivilizing the US government, and then the economi gusher-up and bleeding dry of the mainstream began.

    I have a real REAL hard time with a country that lets people get too rich too fast. That's what brought us to this point.

    We are called to speak for the weak, for the voiceless, for victims of our nation and for those it calls enemy.... --ML King "Beyond Vietnam"

    by Gooserock on Thu Dec 29, 2011 at 12:31:04 PM PST

  •  In the book "23 things they didn't tell you about (5+ / 0-)

    Capitalism" Chapter 2: Companies should not be run in the interests of their owners

    Gasoline made from the tar sands gives a Toyota Prius the same impact on climate as a Hummer using gasoline made from oil. ~ Al Gore

    by Lefty Coaster on Thu Dec 29, 2011 at 12:35:06 PM PST

    •  Especially when the top managers own so much (0+ / 0-)

      of the company that they can manipulate it to maximize their income at the expense of other shareholders and stakeholders.

      “when Democrats don’t vote, Democrats don’t win.” Alan Grayson

      by ahumbleopinion on Thu Dec 29, 2011 at 01:49:21 PM PST

      [ Parent ]

      •  In his book Martin advocates… (1+ / 0-)
        Recommended by:

        …that we change the law to eliminate:

        the use of stock-based compensation as an incentive. This doesn’t mean that executives shouldn’t own shares. If an executive wants to buy stock as some sort of bonding with the shareholders or for whatever other reasons, that’s just fine. However, executives should be prevented from selling any stock, for any reason, while serving in that capacity—and indeed for several years after leaving their posts. Stock based compensation is a very recent phenomenon, one associated with lower shareholder returns, bubbles and crashes, and huge corporate scandals. In 1970, stock based compensation was less than 1 percent of compensation. By 2000, it was around half of compensation. For the last 35 years, stock-based compensation has been tried. It had the opposite effect of what was intended. We should learn from experience and discontinue it.

        Teh stoopidTM, it hurts. Buy smart, union-printed, USA-made, signs, stickers, swag for everyone: Get your We are the 99% Yard Sign.

        by DemSign on Thu Dec 29, 2011 at 02:08:18 PM PST

        [ Parent ]

    •  erm (0+ / 0-)
      Companies should not be run in the interests of their owners

      Why would anyone want to be an owner then?

    •  Thom Hartman likes to point out that in the early (0+ / 0-)

      days of this country a corporation had to be run in the public interest. The owners would be allowed to profit but after the charter expired (typically 20 years) unless the corporation could show they had a compelling public interest the corporation was dissolved and the the assests distributed to the creditors/shareholders.

      Compassionate Conservatism is letting all the bridges collapse so you won't have to live under one after losing your home when they cut off your unemployment insurance.

      by ontheleftcoast on Fri Dec 30, 2011 at 12:32:12 PM PST

      [ Parent ]

  •  This was big for Milton Friedman too. (1+ / 0-)
    Recommended by:

    Who rots in hell while burning every second for eternity, chasing Ayn Rand around a desk.

    WTF!?!?!?! When did I move to the Republic of Gilead?!

    by IARXPHD on Thu Dec 29, 2011 at 12:51:41 PM PST

  •  the core of the problem in simple arithmetic: (2+ / 0-)
    Recommended by:
    DemSign, chmood

    What do you have to do in order to maximize the value of any one variable in an equation?

    Answer: minimize the value of all the other variables.

    Example:  X + Y + Z = 4.  Maximize for X.  

    Result:  4 + 0 + 0 = 4.  The value of Y and Z must be set to zero.  

    (Strictly speaking that example ignores negative numbers and so on, but at least serves to illustrate.)

    If the goal is to maximize shareholder value, then it necessarily follows that all other variables have to be minimized: driven toward zero.  So we see, with impacts on workers, customers, the economy at-large, and the ecosystems on which everything else depends.  

    That's the fatal flaw in the system: it drives itself to its own destruction.  

    And yet there does appear to be one other variable in the equation, whose value is at least "balanced" with shareholder value: that being executive compensation.  

    The cure is equally simple.   (Simple to say, more difficult to implement in legislation & regulation & corporate practices.)  Remove the idea of maximizing for one variable, and substitute optimizing for a number of variables.   These can be spelled out: employees, customers, the economy at-large, ecology.  There are theoretically (chaos theory: attractors) many sets of conditions under which a company can function with a number of variables optimized.  Then the goal of management should be to find the sets of conditions that work best for each company.  

    "Minus one vote for the Democrat" equals "plus one vote for the Republican." Arithmetic doesn't care about your feelings.

    by G2geek on Thu Dec 29, 2011 at 12:59:07 PM PST

    •  Not true in general. (2+ / 0-)
      Recommended by:
      debedb, chmood

      The kinds of systems we're taking about aren't linear functions. The relationship in general of one parameter to others isn't zero sum.

      Why is your metaphor bad? Because it covers the real problem with "maximizing shareholder value". In cybernetic systems, in general, it is true that driving a parameter to an extreme value loses you flexibility.

      If you get massively tall, or fat, or tiny, all your other parameters have fewer possible values: your heart must be a certain size, your veins and arteries are pushed to unusual values.... You lose flexibility, because the extreme value isn't compatible with most other  parameter combinations. It's an entropy type problem.

      An organization that maximize a single value, rather than optimizing over a range of values, is following the path of a cancer -- they're eating themselves alive by maximizing one parameter of the system and thereby decreasing overall flexibility.

      Read Gregory Bateson about these issues, back when biology was still a scientific field rather than a grab bag of techniques for developing pharmaceuticals.

      •  apparently you didn't see where I said that.... (1+ / 0-)
        Recommended by:

        ... "There are theoretically (chaos theory: attractors) many sets of conditions under which a company can function with a number of variables optimized."

        I could have gone down the road explaining nonlinear dynamics and attractors and combinatorial math, but that would have lost the vast majority of readers.  Political communication works best where it's as simple as possible.  

        Alternately I could have gone down the road with analogy to biological systems and ecological niches and natural selection, but that would have been a long digression.

        I may already have made those mistakes in another comment referring to entropy gradients and potential differences, but at least I didn't go down the trail about dissipative structures in that one! :-)

        "Minus one vote for the Democrat" equals "plus one vote for the Republican." Arithmetic doesn't care about your feelings.

        by G2geek on Thu Dec 29, 2011 at 02:16:08 PM PST

        [ Parent ]

  •  dividends vs. growth of share price (1+ / 0-)
    Recommended by:

    It used to be that companies were valued by shareholders according to their dividends: the distribution of profits to shares.   For example if you held 100 shares of XYZ Inc. and they issued a dividend of $10 per share, you collected $1000.  

    Then something changed, and companies began to be valued according to their anticipated growth in share price.  At this point dividends didn't matter quite so much.  Instead, if you bought 100 shares of XYZ corporation for $5,000, you would be seeking to sell those 100 shares for $6,000 to obtain your $1,000 in profit on your investment.  

    The subtle but significant difference is that the latter method favors a kind of "gambling" approach to investment, and ultimately leads to "microsecond trading" where computers and software try to wring out every last drop of value from even the slightest movement in share prices.  In that situation, average investors, even day traders with their hands on their keyboards in real time, are inevitably shortchanged.  

    Both a dividend and a change in share price can be seen as an "entropy gradient" or "potential-difference between two points," by analogy a voltage between two terminals on a battery.  The difference of potential between the two points is what enables energy to be harvested for actual use: when the battery is fully charged you can connect it to a device that uses the flow of electrical current, for example a flashlight bulb.  

    Stock dividends are set by boards of directors, at levels that enable companies to retain some of their profit for uses such as replacing obsolete plant & equipment, hiring workers, and so on.  By analogy this is like partially discharging a battery but keeping some of the charge in it: which, as it turns out, is necessary in order to obtain the largest number of cycles of recharging and discharging the battery.  

    If a company distributes all of its profit to its shareholders, it can't invest in its own future.  By analogy this is like fully discharging the battery before recharging it: which, as it turns out, is harmful to the battery and reduces the number of times the battery can be discharged and recharged.

    The task of the Board of Directors is to see to it that the "battery" of corporate profit isn't "discharged" so deeply at each cycle that the company can't invest in its own future continuity.  

    Now if you switch over to a "growth of share price" model, what you have is a situation where the Board of Directors loses control entirely, to a potentially unlimited crowd of people who are trying to wring every iota of value out of moves in share price.  Not just upward moves either: upward or downward will do, so long as there is a change over time, the greater and more rapidly the better.  

    The result of this is similar to packing a pile of damp sand around the battery (each microsecond-trader is a grain of damp sand): the electrical current flows through the water in the sand, little to no electrical current is available to light the flashlight bulb, and meanwhile the battery gets deeply discharged and may not be possible to recharge.  

    Use whatever analogy you like, having to do with the capture of energy across entropy-gradients, and the result is the same: the simple physics tells us that when you capture all of that energy at any particular point, no more is available beyond that point.  

    "Minus one vote for the Democrat" equals "plus one vote for the Republican." Arithmetic doesn't care about your feelings.

    by G2geek on Thu Dec 29, 2011 at 01:33:35 PM PST

    •  But the important point is… (2+ / 0-)
      Recommended by:
      G2geek, marykk

      …that when markets took to "maximizing shareholder value" was right around the same time that they stopped funding pensions funds, started moving towards the speculation of stock price over paying dividends, and started paying compensation in the form of stock.

      Teh stoopidTM, it hurts. Buy smart, union-printed, USA-made, signs, stickers, swag for everyone: Get your We are the 99% Yard Sign.

      by DemSign on Thu Dec 29, 2011 at 02:24:56 PM PST

      [ Parent ]

      •  strong correlation, may even be causal. (1+ / 0-)
        Recommended by:

        The way I see it is: a bunch of dissipative structures (in this case parasitic and predatory managers, microsecond speculators, etc.) crowded around every possible entropy gradient (changes in share price: down as well as up), capturing all of the available energy (money) for themselves and leaving nothing behind.  

        "Minus one vote for the Democrat" equals "plus one vote for the Republican." Arithmetic doesn't care about your feelings.

        by G2geek on Thu Dec 29, 2011 at 02:31:06 PM PST

        [ Parent ]

  •  A sharehold puts his, her, or its money into (0+ / 0-)

    shares with the objective of obtaining the largest possible value for the investment.  If the CEO pursues any other objective, he will be replaced by the shareholders.  If the CEO can maximize shareholder value with fewer, uneconomical customers; fewer employees; and higher profit products and that's what a majority of the shareholder's want, that's what he's going to do.  When the CEO maximizes shareholder value, he keeps his job.  That's just the way it works.

    Certainly, various investors have various definitions of shareholder value.  Some may value the corporation's having employees, without regard to profit or the dollar value of the shareholdings.  Some may value having customers, without regard to whether all of the customers are profitable.  Some may value the corporation's offering products which are not the most profitable.  If an investor has an investment objective other than maximizing the value of its shares, it can find an investment which suits its objective.  But the shareholders of most corporations have the objective of seeing the dollar value of their shares increase, because, unlike the corporation, which may have perpetual life, the shareholders and the CEO's need to pay for today's food and today's Bentleys today.

    •  Again… (1+ / 0-)
      Recommended by:
      Cassandra Waites

      …it used to be that people bought stocks and expected to be paid dividends. The stock price could be utterly stagnant, but if it paid dividends regularly the initial investment would compound magically. But that's long term thinking.

      In the short-term world speculators want the stock to double or triple overnight like Charles Ponzi paying interest.

      Teh stoopidTM, it hurts. Buy smart, union-printed, USA-made, signs, stickers, swag for everyone: Get your We are the 99% Yard Sign.

      by DemSign on Thu Dec 29, 2011 at 02:31:52 PM PST

      [ Parent ]

    •  You said: (0+ / 0-)
      If the CEO pursues any other objective, he will be replaced by the shareholders.

      True in theory, but not in practice.  Look at the compensation packages that CEO's have, and you'll see that they need not fear being removed by shareholders because of the golden parachutes.  Furthermore, most metrics for CEO performance can be gamed by the CEO and CFO.  Play a few games with the balance sheet, and it can look like a company is experiencing tremendous growth which then triggers rewards for the CEO.  Meanwhile that same company could be taking on butt loads of debt and laid off 30% of its employees.  But that's not the CEO's problem.

      Having a policy does not mean receiving care. -- Tzimisce

      by Miggles on Thu Dec 29, 2011 at 02:49:31 PM PST

      [ Parent ]

  •  It's baked into the system. (2+ / 0-)
    Recommended by:
    SquirrelWhisperer, chmood

    Nearly a century and a half ago, in Capital Vol I, Marx quotes T.J. Dunning in a footnote:

    Capital eschews no profit, or very small profit, just as Nature was formerly said to abhor a vacuum. With adequate profit, capital is very bold. A certain 10 per cent. will ensure its employment anywhere; 20 per cent. certain will produce eagerness; 50 per cent., positive audacity; 100 per cent. will make it ready to trample on all human laws; 300 per cent., and there is not a crime at which it will scruple, nor a risk it will not run, even to the chance of its owner being hanged. If turbulence and strife will bring a profit, it will freely encourage both. Smuggling and the slave-trade have amply proved all that is here stated.

    If you don't like it, dump capitalism.  This relentless pursuit of maximum profit is the very core of capitalism; it couldn't exist without it.  If you (the capitalist) can get the most profit by pleasing your customers, that's what you'll do.  If you can get it by beating your customers senseless and selling their children on the black market, that's what you'll do.

    The politics of direct action is based, to a certain degree, on a faith that freedom is contagious. - David Graeber

    by An Affirming Flame on Thu Dec 29, 2011 at 02:19:19 PM PST

  •  It's not so much maximizing shareholder value as (1+ / 0-)
    Recommended by:

    it is to maximizing it over the short term at the expense of the long term.  In Germany the unions (as in machinists, secretaries, etc) have seats on the board of directors so at least any decisions made by the company are made with the long term interests of the company being given strong consideration.

    Having a policy does not mean receiving care. -- Tzimisce

    by Miggles on Thu Dec 29, 2011 at 02:40:13 PM PST

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