In his latest letter (link), GMO's James Montier destroys the concept of shareholder value maximization or SVM, which, as defined by Friedman in 1970 is roughly as follows: “There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits..." As an aside, Montier is anything but a fan of Milton: 'It is quite staggering just how many bad ideas in economics appear to stem from Milton Friedman. Not only is he culpable in the development of SVM, but also for the promotion of that most facile theory of inflation known as the quantity theory of money. Most egregiously of all, he is the father of the doctrine of the “instrumentalist” view of economics, which includes the belief that a model should not be judged by its assumptions but by its predictions."
And while the full letter covers many topics, not the least of which is corporate obsession with buybacks, which as we warned back in 2012 would soon be the only game in town thanks precisely to the same failed Federal Reserve policies that were meant to boost the economy but merely ended up benefiting the 1% and is therefore directly leading to the record wealth disparity and middle-class destruction which everyone - even the Fed - has finally noticed, there is one point that bears emphasis: the plunge in S&P500 corporate lifespans to record lows.
From the collected evidence on the psychology of incentives, it appears that when incentives get too high people tend to obsess about them directly, rather than on the task in hand that leads to the payout. Effectively, high incentives divert attention away from where it should be.
One of the other features that stands out as having changed significantly between the era of managerialism and the era of SVM is the lifespan of a company and the tenure of the CEO. Both have shortened significantly.
In the 1970s, the average lifespan of a company in the S&P 500 was 27 years (already down massively from the 75 years seen in the 1920s!). In the latter half of the last decade, the lifespan of a corporate in the S&P 500 had declined still further to a paltry 15 years.
In parallel to this trend, the average tenure of a CEO has fallen sharply as well. In the 1970s, the average CEO held his position for almost 12 years. More recently this has almost halved to an average tenure of just six years. It is little wonder that CEOs may be incentivized to extract maximum rent in the minimum time possible given the shrinkage of their time horizons (not independent of the shrinkage in time horizons for investors perhaps).
How can one explain this unprecedented collapse in corporate viability? Simple: in Montier's words, upper-management is merely focused on maximizing its own compensation, virtually at any cost, up to an including encumbering the corporation with record amounts of debt and using the proceeds to boost equity value, which in turn leads to a direct surge in executive compensation. To wit:
From the mid 1980s onwards, equity issuance has been net negative as firms have bought back an enormous amount of their own equity (and geared themselves by issuing debt – a massive debt for equity swap). One of the most common raison d’êtres for stock markets that gets offered up is that they are providing vital capital to the corporate sector – the evidence suggests that this is nothing more than a fairy tale. Far from providing capital to the corporate sector, shareholders have been extracting it from corporates.
This is also one of the main reasons provided by Montier why SVM has gone so horribly wrong.
... what went wrong? I think one of the most obvious candidates concerns the pay of CEOs. When one casts even a cursory glance over Exhibit 4 (CEO median pay) the increasing dominance of stock-related pay becomes obvious. During the era of managerialsim, the vast majority (i.e., over 90%) of the total compensation for CEOs came through salary and bonus. In the last two decades one can see the increasing dominance of stock-related pay. In the last decade some two-thirds of total CEO compensation has come through stock and options.
This has certainly aligned managers and shareholders à la Jensen and Murphy, but doesn’t seem to have generated the kind of impact that one might have expected. At least two reasons for this stand out. Firstly, as is now well known, options aren’t the same thing as stock. They give executives all of the upside and none of the downside of equity ownership. Effectively they create a heads I win, tails you lose situation.
In addition, incentives don’t always work in the way that one might expect (yet more evidence of the law of unintended consequences). Economists tend to have complete faith in the concept of incentives, driven by their obsession with a very specific definition of rationality. However, the evidence on the way incentives work may surprise you (and recently raises questions for many economists).
And here is the CEO "incentivization to extract maximum rent in the minimum time possible" in one chart:
Is there any wonder why the most powerful entities in the US - corporations - and rather their chief executives, have been so enthralled and supportive of central bank money printing? After all, how much of the exponential rise in executive pay, most of it tied to stocks and options, would have been possible had central banks not backstopped not only the financial system, but the equity tranche in the S&P 500? It also shows why in a day of low yields, corporations have been so happy to issue every more loans and use the proceeds to directly serve as the primary bidder of stocks to ever higher valuations; valuations which as Montier explains are far above where intrinsic values suggest buybacks make corporate sense.
... if one were feeling charitable, one might choose to suggest that there just weren’t many new investment opportunities, and thus this return of capital was a perfectly reasonable thing to do. If this were the case, one might hope that the buybacks were done at prices that were below intrinsic value (since this would have genuinely improved the lot of shareholders). However, as Exhibit 14 shows, this hasn’t been the case. When market valuations were high (prior to the financial crisis) a record number of buybacks were conducted. Conversely, at the market lows, firms were hardly doing any buybacks at all. As Warren Buffett said in his letter to shareholders back in 1999, “Buying dollar bills for $1.10 is not a good business for those who stick around.”
The obsession with returning cash to shareholders under the rubric of SVM has led to a squeeze on investment (and hence lower growth), and a potentially dangerous leveraging of the corporate sector.
Again, all topics we have covered in the past.
Montier's conclusion: SVM, buybacks, and all other derivatives of the unprecedented capital misallocation resulting from 6 years of global QE is directly to blame for record wealth inequality - again, something we have said is the case for a little over 5 years!
To see how this is related to the rising inequality that we have seen it is only necessary to understand who benefits from a rising stock market (i.e., who gets the “benefits” of SVM and its buyback frenzy). The identity of this group is revealed in Exhibit 15. The top 1% own nearly 40% of the stock market, and the top 10% own 80% of the stock market. These are the beneficiaries of SVM.
Another reflection of the role of SVM in creating inequality can be seen by examining the ratio of CEO-to-worker compensation. Before you look at the evidence, ask yourself what you think that ratio is today and what you think is “fair.” A recent study by Kiatpongsan and Norton (2014) asked these exact questions. The average American thought the ratio was around 30x, and that “fair” would be around 7x.
The actual ratio is shown in Exhibit 16. It turns out the average American was off by an order to magnitude! If we measure CEO compensation including salary, bonus, restricted stock grants, options exercised, and long-term incentive payouts then the ratio has increased from 20x in 1965 to a peak of 383x in 2000, and today sits somewhere just short of 300x!
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The role of SVM in declining labour share should be obvious, because it is the flip-side of the profit share of GDP. If firms are trying to maximize profits, they will be squeezing labour at every turn (ultimately creating a fallacy of composition where they are undermining demand for their own products by destroying income).
[W]e need to think about the broader impact of policies like SVM on the economy overall. Shareholders are but one very narrow group of our broader economic landscape. Yet by allowing companies to focus on them alone, we have potentially unleashed a number of ills upon ourselves. A broader perspective is called for. Customers, employees, and taxpayers should all be considered. Raising any one group to the exclusion of others is likely a path to disaster. Anyone for stakeholder capitalism?
Sadly no. Because nobody seems to mind: after all there are such epic distractions on TV as Ferguson, Bill Cosby and, of course, Dancing with the Stars. So for now at least, the Ponzi that enriches only very, very few continues, and remember: there has never been a revolution on an uptick. However, if Bill Gross is correct, those days may be finally coming to an end.
What happens then will be the biggest, and likely most lethal, "mean-reversion" in history.