October 2, 2018

The Shareholder Value Delusion

Sometimes a really bad idea can gain a foothold in a large population and spread like a virus. Over the centuries, there have been many: the eerie threat of witchcraft, the deep danger of religious heresy, the revealed presence of secret Communists in the U.S. State Department. These widely shared psychoses are dangerous and often highly destructive.

A current version of such a mania is the truly destructive notion that the first responsibility of U.S. corporations is to their shareholders.

Like all bad ideas, this bogus principle had one of John Maynard Keynes’ “defunct economists” as its author. That economic thinker was the University of Chicago’s Milton Friedman.

Friedman was later strongly seconded in a 1976 Harvard Business Review article by Michael Jensen and William Meckling.

As the late Lynn Stout, in her book The Myth Of Shareholder Value observed, the idea was based upon a misreading of the law and has produced consistently poor outcomes.

The legal gaffe was based upon the case of Dodge v. Ford Motor Company. As Stout explains, Dodge v. Ford is routinely cited as the legal authority for the idea that corporate law requires directors to maximize shareholder value. But what that case was really about was the duty a controlling majority shareholder (Henry Ford) owed to the minority shareholders (the Dodge brothers) in a closely held company…
an entirely different matter.

The poor outcomes have been tracked. Stout reports that business school dean, Roger Martin, calculated that between 1933 and 1976 (the year that Jensen and Meckling published their article), shareholders who invested in the S&P 500 enjoyed real compound average annual returns of 7.5%. After 1976, this average dropped to 6.5%. Since the early 1990’s, the picture has grown darker. After the run-up from 1992 to 1999 (remember the dot-com bubble?), shareholder returns have been a shabby 3.4%.

OK, so returns have been in decline.

What else has the shareholder value delusion wrought?

Well, it seems logical to believe that any public corporation devoted to the concept would behave in the following manner:

It would actively buy back its shares to drive the price up (an
activity that was illegal prior to 1982)

It would regularly issue dividends to it shareholders – even
at the expense of investments in plant, equipment and

It would reward senior executives with stock options and
grants to ensure their devotion to the cause.

And, of course, this is exactly what has been happening. In 2018, the Fortune 500 companies are expected to buy back over $800 billion of their own shares, up 51% from 2017. (Remember how Trump’s tax bill was going to bump up the average worker’s pay by $4,000+? This is where that money really went.)

Interestingly, over the five years through 2017, the 353 companies that spent significantly on buybacks underperformed the market on average.

Of course, money spent on buybacks is money NOT spent on the kind of projects that enhance competitiveness and innovation and drive longer-term success.

And that’s where the real problem lies.

This behavior – driven by a mistaken idea – is the financial equivalent of eating your seed corn. When it’s gone, there’s nothing left to eat and no new crops to plant.