“The World’s Dumbest Idea” by James Montier of GMO.

Anyone interested in the question of shareholder value will I think find this paper by James Montier interesting.

The focus of the paper is to explore problems with elevating Shareholder Value to be the primary objective of a firm. Many companies are trying to achieve a more balanced approach but the paper is still useful background given that some investors appear to believe that shareholder value maximisation is the only valid objective a company should pursue. The paper also touches on the question of how increasing inequality is impacting the environment in which we operate.

While conceding that the right incentives can prompt better performance, JM argues that there is a point where increasing the size of the reward actually leads to worse performance;

“From the collected evidence on the psychology of incentives, it appears that when incentives get too high people tend to obsess about them directly, rather than on the task in hand that leads to the payout. Effectively, high incentives divert attention away from where it should be”

The following extracts will give you a sense of the key points and whether you want to read the paper itself.

  • “Let’s now turn to the broader implications and damage done by the single-minded focus on SVM. In many ways the essence of the economic backdrop we find ourselves facing today can be characterized by three stylized facts: 1) declining and low rates of business investment; 2) rising inequality; and 3) a low labour share of GDP (evidenced by Exhibits 7 through 9).” — Page 7 —
  • “This preference for low investment tragically “makes sense” given the “alignment” of executives and shareholders. We should expect SVM to lead to increased payouts as both the shareholders have increased power (inherent within SVM) and the managers will acquiesce as they are paid in a similar fashion. As Lazonick and Sullivan note, this led to a switch in modus operandi from “retain and reinvest” during the era of managerialism to “downsize and distribute” under SVM.” — Page 9 —
  • “This diversion of cash flows to shareholders has played a role in reducing investment. A little known fact is that almost all investment carried out by firms is financed by internal sources (i.e., retained earnings). Exhibit 13 shows the breakdown of the financing of gross investment by source in five-year blocks since the 1960s. The dominance of internal financing is clear to see (a fact first noted by Corbett and Jenkinson in 1997”— Page 10 —
  • “The obsession with returning cash to shareholders under the rubric of SVM has led to a squeeze on investment (and hence lower growth), and a potentially dangerous leveraging of the corporate sector” — Page 11 —
  • “The problem with this (apart from being an affront to any sense of fairness) is that the 90% have a much higher propensity to consume than the top 10%. Thus as income (and wealth) is concentrated in the hands of fewer and fewer, growth is likely to slow significantly. A new study by Saez and Zucman (2014) … shows that 90% have a savings rate of effectively 0%, whilst the top 1% have a savings rate of 40%…. ultimately creating a fallacy of composition where they are undermining demand for their own products by destroying income).” —Page 13 —
  • “Only by focusing on being a good business are you likely to end up delivering decent returns to shareholders. Focusing on the latter as an objective can easily undermine the former. Concentrate on the former, and the latter will take care of itself.” — Page 14 —
  • “… management guru Peter Drucker was right back in 1973 when he suggested “The only valid purpose of a firm is to create a customer.”” — Page 14 —

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

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