As the world negotiates the second year of the “deepest, broadest and most dangerous financial crisis since the 1930’s”, 1 there is a growing realisation that the economic landscape of the future is going to be radically different from the one we have grown accustomed to over the past three decades. To get some idea of how things might change, the UK’s Financial Times has garnered the views of some of the greatest minds of our time in the fields of economics and finance.
In a series of essays published in a recent FT supplement, four Nobel economics laureates, a former chairman of the US Federal Reserve, a former UK chancellor of the exchequer and a number of luminaries from the worlds of academia and finance expressed their views on the future of capitalism. Reading through the essays, it is apparent that we stand at the brink of significant change. In the same way that the financial crisis of the 1930’s triggered doubts about the future of capitalism and led to the rise of socialism and communism, this crisis is also likely to have far-reaching consequences.
As Martin Wolf, chief economics commentator of the FT puts it: “Today, with a huge global financial crisis and a synchronised slump in economic activity, the world is changing again. It is impossible at such a turning point to know where we are going. In the chaotic 1970s, few guessed that the next epoch would see the taming of inflation, the unleashing of capitalism and the death of communism.
What will happen now depends on choices unmade and shocks unknown. Yet the combination of a financial collapse with a huge recession, if not something worse, will surely change the world. The legitimacy of the market will weaken. The credibility of the US will be damaged. The authority of China will rise. Globalisation itself may founder. This is a time of upheaval.”
In trying to predict the future, most commentators have looked to the recent past in an attempt to identify the major factors which precipitated the current crisis. The seeds of the financial crash have been raked over in countless articles and media reports, and are generally well known by now.
Major culprits include the “easy money” generated by trade surpluses in China, Germany and the oil-rich countries which were invested mainly in US assets; low interest rates; financial institutions that didn’t manage risk, and regulators who didn’t police the activities of the banks as they should have.
Toss in frenetic financial innovation, complex financial instruments that too few people understood, huge levels of household borrowing and bubbles in asset prices, and the picture is pretty much complete.
These factors are common knowledge. What is not as well known is that many commentators are now singling out another factor: the concept of shareholder value maximisation. The case against SVM is concisely spelt out by Francesco Guerrera, finance and business editor of the Financial Times in the US: “Long-held tenets of corporate faith – the pursuit of shareholder value, the use of stock options to motivate employees and a light regulatory touch allied with board oversight of management – are being blamed for the turmoil and look likely to be overhauled.”
SVM was popularised in the early 1980s by Jack Welch, legendary CEO of General Electric who led the company between 1981 and 2001. Since then, the goal of rewarding shareholders by increasing profits and share prices on a quarterly basis has become a firmly established goal for companies around the world. The concept of SVM spawned an industry in itself, as consulting firms rushed to offer their own brand of “Value-Based Management” and value-adding metrics such as EVA, CFROI, and ROCE became part of the corporate lexicon.
While SVM as a concept is in line with the basic economic model of how companies should organise themselves, the question now being asked is whether it should be the sole guiding principle for corporate action. Should executives single-mindedly aim to increase the share price of their companies even in the short run?
It appears that the problem with SVM is that it has become a goal in itself. There is nothing wrong with corporate behaviour that sets out to deliver quality products or services to satisfied customers via well-motivated employees. This will usually result in higher profits and higher share prices. But, it is important to note, such increased share prices are measures, not causes, of business success. If this crisis has revealed anything, it is that efforts to increase share prices in the short term do not guarantee stable or secure earnings. SVM has put the cart before the horse.
SVM is also based on the premise that capital markets are efficient, and that share prices reflect only the present value of all future profits. However, the price bubbles of the past decade or so have shown that in the short term, and sometimes over surprisingly long periods of time, capital markets can be remarkably inefficient.
In such times, individual investors are tempted to maximise their short-term returns by following the herd and buying into ever-rising markets. These markets are not driven by expectations of future profits, but by human emotions such as euphoria, greed and fear. However, when euphoria and greed give way to fear and the bubble bursts, the entire herd loses out.
Share option schemes have also contributed to an unhealthy focus on short-term share prices. Although agency theory says that executives should be incentivised to act in the interests of the shareholders by growing the share price, the short vesting periods of some share option schemes (typically three years) can lead to disaster.
Executives will naturally attempt to maximise the share price during the vesting period, because doing so maximises the value of their share options. However, the temptation to do so by “gaming” the share price is exceedingly strong, leading to short term gains which are too often reversed once the options have been exercised.
It is believed that this type of incentive may have encouraged managers in the banking industry, for instance, to take dangerous, short-term business risks. By the time the consequences of their actions became apparent, they had taken the money and run.
The lesson to be taken from the failures of SVM is that good business results are inevitably the result of long-term relationships, based on trust, which are developed between managers, employees, customers and suppliers. In the future, this must be understood by managers and directors and clearly communicated to shareholders as well. Shareholders must allow and even encourage a longer-term focus, and give up their obsession with short-term results.
If this happens, company profits should become more stable and more sustainable in the long run. The share price will improve over time, securing more value for shareholders than could be achieved by a short-term focus on price maximisation. So, while SVM may be dying, long-term shareholder value creation may just be coming into its own.
1. Martin Wolf, page 8, Financial Times supplement on The Future of Capitalism, issued with the FT of 12 May 2009.