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Investing, CEO pay and the economy

2014-12-04 07:24:33

No value

Dec 3rd 2014, 13:02 by Buttonwood

DO companies exist merely to generate economic returns to their owners? The

concept of "shareholder value" suggests this should be their primary focus. But

in a hard-hitting note, James Montier of GMO, the fund management group,

suggests this is "The World's Dumbest Idea".

As Mr Montier argues, the shareholder value concept arose in part as a way to

get round the agent-principal problem - that executives will run firms for

their own benefit, rather than for that of their owners. The idea goes back to

Adam Smith who wrote that

being the managers rather of other people's money than of their own, it cannot

well be expected that they should watch over it with the same anxious vigilance

with which the partners in a private copartnery frequently watch over their

own......Negligence and profusion, therefore, must always prevail, more or

less, in the management of the affairs of such a company.

In the 1980s, the worry was that executives were too focused on their own perks

(jets, pensions etc) and on empire-building. From this arose the idea that

executive pay should be linked to the share price, in the form of options. And

what has been the result? Mr Montier defines the era of "managerialism" as from

1940-1990 and the sharehoder value era as the period since then. (One could

argue with this timing, although he claims the results are robust as to the

timing of the cross-over.) Real returns were slightly higher in the era of

managerialism and much higher if one focuses on earnings growth rather than

valuation. (A share price increase can either be the result of earnings growth,

or the market placing a higher value on a given level of earnings. Such higher

valuations can be transitory.)

So shareholder returns haven't gone up in the era of "shareholder value". CEO

pay has, though. Hard to believe but CEOs got by in the 1970s on $1m or so;

their total remuneration has grown eightfold in real terms since then. The

focus on the share price has led to an unhealthy concentration on meeting the

short term earnings per share target; surveys have shown that executives will

reject a project with a positive rate of return if it damages the ability to

meet the next quarter's eps. Money has been returned to shareholders (in the

form of buy-backs) while business investment has declined; as a proportion of

GDP, it is still lower than at any time in the 1947-2007 period.

CEOs can be forgiven for pursuing a "get rich quick" strategy; since the 1970s,

the average tenure of a CEO has fallen from almost 12 years to six. Why would

they care about long-term value? And while buy-backs may return money to those

shareholders who take advantage of them, they may damage long-term investors;

the peak for buy-backs was in early 2008, just when the market was about to

crash. As Warren Buffett has said, this was the equivalent of buying dollar

bills for $1.10.

So the whole concept should really be renamed "CEO value"; they have been the

main beneficiaries. And all this has led to growing inequality; two-thirds of

those in the top 0.1% of earners have been executives or those working in

finance. And that trend, which has spilled out to the rest of the developed

world, is leading to the growing anger of voters and the resistance to

globalisation which may eventually cause even more damage to business and

investors.