Monday, January 23, 2017

The Dumbest Idea In The World Leads To Slower Corporate Growth And Inequality

Jack Welch, the former CEO of General Electric called the corporate goal of maximizing shareholder value (MSV) the dumbest idea in the world.  This article explains why corporate executives subscribe to the idea and some of the consequences of the dumb idea.  It is great for the CEO but terrible for economic growth; it is also a major contributor to the growth in income inequality.  The quote below from the article provides a good summary of the consequences:

The stock-price manipulation involved in massive buybacks—and the resulting exorbitant executive pay—are thus not just moral or legal problems. The consequences of MSV and share buybacks are a macro-economic and social disaster: net disinvestment, loss of shareholder value, diminished investment in innovation, destruction of jobs, exploitation of workers, windfall gains for activist insiders, rapidly increasing inequality and sustained economic stagnation. Stock buybacks are thus a financial bonanza for stockholders and senior managers, but they destroy economic value for society.

MSV might be a good idea if the intent was to maximize long term shareholder value.  Instead it has been used to maximize short term stock prices for several reasons.  CEO's want to get the payback from investments during their tenure which averages around seven years.  There are also less risky and easier ways to manipulate the short term stock price.  Cost cutting by shifting jobs to lower wage locations and lower wages for local employees works well because labor compensation is around 60% of costs in the typical corporation.  Its also easier to increase the stock price with stock buybacks which reduce the number of shares outstanding.  That, of course, improves the earnings per share ratio which ordinarily increases the stock price.

Its easy to understand why CEO's subscribe to the dumbest idea in the world if one looks at how they are compensated.  CEO's in F500 corporations receive 82% of their compensation in the form of stock options.  When they cash in their options and sell their stocks they are taxed at the capital gains rate which is much lower than the tax on wage income.  That is also one of the reasons why they reward shareholders dividends.  They are also taxed at a much lower rate than wage income.  Between 2006 and 2015 public firms spent $3.9 trillion on stock buybacks. That was 54% of their net income.  They also spent 37% of their net income on dividend payouts.

CEO's also have to protect themselves from corporate raiders who target firms that are not rewarding shareholders at the level that the corporate raiders would like.  The goal of the raiders is to divest assets and extract value for themselves.  It is not surprising that firms listed on the stock exchange invest only 3.7% of their assets.  Privately held firms invest 6.8% of their assets.  Large corporations are also job destroyers instead of job creators as they like to claim.  Corporations in business longer than five years are net destroyers of jobs. 

Large corporations have also found ways to avoid taxes by retaining their profits earned overseas instead of investing them in the US.  Congress has proposed that we allow corporations to return the $2 trillion of profits held overseas by eliminating or cutting the tax on profits held overseas.  Those in Congress who favor this plan should look at what executives at Cisco said that they would do with the returned profits.  They would use the funds to finance stock buybacks, make dividend payouts and engage in merger and acquisition activity.

There are a small number of firms that reject the MSV goal in favor of the notion that the main purpose of firm is to attract and retain customers.  Amazon is one of the good examples of this practice.  It has grown very fast and its stock price has grown with its rapid growth. Amazon invests in technologies and services that create new business opportunities and delight customers.  The two charts below do a nice job of contrasting the short term MSV strategy with the goal of customer addition and expansion.

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