The Shareholder Value Fallacy

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Jack Welch, the celebrated CEO of GE from 1981-2001, was named the “Manager of the Century” by Fortune in 1999.  Jack was a master at maximizing shareholder value, hitting analysts’ forecasts to the penny 89% of the time between December 31, 1989 and September 30, 2001.  During his tenure at GE, Jack grew the market value of the company from $14 billion to $484 billion.

Welch became the poster child for Shareholder Value theory, a theory that was initially put forth by the Noble Prize winning Economist Milton Friedman in his book Capitalism and Freedom in 1962 and later popularized in his 1970 NY Times Magazine article, “The Social Responsibility of Business is to Increase its Profits.”  The basic premise is that company executives are agents of the owners of the company, the shareholders, and as such must do everything in their power to maximize the returns on investment.  Friedman stated, “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits.”  He called executives who pursue more holistic strategies, “unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades.”

Unfortunately, Friedman’s theory gained in popularity and was further expounded upon by a couple of professors at the University of Rochester in 1976.  CEOs began to receive large amounts of stock to couple their interests with those of the shareholders.  Consequently, executive compensation skyrocketed all the while company returns slowed.  In his book, Fixing the Game, Roger Martin writes “between 1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33 percent. 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.”  Deloitte found that between 1965-2009, the rate of return of invested capital of US firms actually declined by a staggering three quarters.

Fast forward to 2014 and I see so many companies that have lost sight of their values because of their constant pursuit of hitting quarterly numbers.  The current system is sick and in my mind, is in desperate need of examples of companies that prove that being virtuous is in fact good business.  Certainly there are some executives that are bucking the trend, such as Paul Polman, CEO at Unilever.  Polman is so focused on the long-term that he no longer issues quarterly profit reports and refuses to give analysts earnings guidance.  Polman recently stated “we have to bring this world back to sanity and put the greater good ahead of self-interest.”  Even Jack Welch seemed to come to grips with the fallacy in a 2009 interview with the FT in which he said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… Short-term profits should be allied with an increase in the long-term value of a company.”

Shareholder Value theory has so infiltrated our current system of capitalism that it will undoubtedly take some time to undo the damage, but what better reason for values-based businesses to pursue restoration instead of extraction.

Photo Credit: 1la

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2 Responses

  1. Joel
    | Reply

    John Thompson, Microsoft Board Member and leader of the company’s Search Committee for a new CEO had this to say after Satya Nadella was named as Steve Balmer’s resplacement:

    “The fact that we chose to do a very public external search was as much for our investors as it was for anyone else. [We wanted] to make sure that we had done the best possible job we could of surveying the landscape and picking the leader that we thought would do the most to create real value for shareholders.”

    Just another example of a large, publicly-traded company focusing exclusively on shareholders.

  2. Joel
    | Reply

    Opportunist shareholders must embrace commitment by Martin Wolfe in the Financial Times

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