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 incomes for ordinary Americans are stagnating.
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%
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.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).
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.
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.Peter Drucker noted this in his seminal work The Practice of Management:
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.”
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 shareholdersHe 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.