“Our theories of shareholder value maximization and stock-based compensation have the ability to destroy our economy and rot out the core of American capitalism.”
– Roger L. Martin, Dean of the University of Toronto’s Rotman School of Management, Fixing the Game
We live in a world of two markets.
The Real Market: the world in which we live and breathe; this is a world where factories are built, products are produced and consumed, revenues are earned, expenses are paid, and real dollars of profit appear on a company’s bottom line.
The Expectations Market: the world in which shares of listed companies are traded for prices determined by investors’ expectations of future company performance – in other words, the stock market.
“What would lead a CEO to do the hard, long-term work of substantially improving real-market performance when he/she can choose to work on simply raising expectations instead?” Good point.
Martin continues, “Even if he/she has a performance bonus tied to real-market metrics, the size of that bonus now typically pales in comparison with the size of his/her stock-based incentives. Expectations are where the money is. And of course, improving real-market performance is the hardest and slowest way to increase expectations from the existing level.”
Since the 1970’s, capitalism has been inundated with fraudulent behavior. 2001-2002 represented an influx of accounting scandals…Enron, WorldCom, Tyco, Global Crossing, and Adelphia quickly come to mind. In 2005-2006, we encountered an era of options backdating scandals. And, more recently, the subprime mortgage crisis of 2007-2008. Why? Managers began acting in desperation, embodying a “whatever it takes” attitude in order to increase expectations.
“A pervasive emphasis on the expectations market,” writes Martin, “has reduced shareholder value, created misplaced and ill-advised incentives, generated inauthenticity in our executives, and introduced parasitic market players. The moral authority of business diminishes with each passing year, as customers, employees, and average citizens grow increasingly appalled by the behavior of business and the seeming greed of its leaders.”
In 1976, Michael Jensen and Dean William Meckling (Simon School of Business) wrote an article for the Journal of Financial Economics: Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure, in which they examined the principal-agent problem, broadly defined as management’s pursuit of selfish interests at the expense of shareholders. To mitigate the principal-agent problem, the academics contended, companies must entice executives to act with shareholder value maximization as first priority. As Forbes astutely noted, “The article performed the old academic trick of creating a problem and then proposing a solution to the supposed problem that the article itself had created…unfortunately, as often happens with bad ideas that make some people a lot of money, the idea caught on and has even become the conventional wisdom”.
According to Martin, principal-agency theory “had the unfortunate effect of tightly tying together two markets: the real market and the expectation’s market”. And low and behold, since 1976, we have seen a deterioration of corporate performance in tandem with a massive boom in executive compensation.
Between 1960 – 1980, CEO compensation (per dollar of net income) for the largest publicly traded American companies fell by 33 percent. Yet, from 1980 – 1990, CEO compensation per dollar of net income DOUBLED. And from 1990 to 2000, it more than quadrupled.
Martin relates capitalism to the NFL. (In fact, the book title in its entirety reads: “Fixing the Game: Bubbles, Crashes, and What Capitalism can Learn from the NFL”) In the NFL, the “real market” consists of teams playing on the field. Real touchdowns and real field goals are scored. The expectations market? Gambling. Sports bets are placed based on gamblers’ expectations of future performance – sounds familiar.
“But unlike American capitalism, the NFL looked thoughtfully at the relationship between the real game and the expectations game and identified a serious danger…they clearly saw that the pressures of the expectations game could do serious damage to the real game…they have enforced a strict separation between the real market and the expectations market…exactly the opposite of the way we have managed it in business”. Martin asserts in his book that the NFL has operated with a long-term goal of customer satisfaction, and a focus on the real market, while post-1976 capitalism has largely concentrated on short-term profits – attempting to maximize shareholder value to the detriment of customers.
To “fix the game”, Martin proposes that companies eliminate stock-based compensation (or at the very least bind compensation to a long-term performance metric beyond the tenure of a CEO), re-align boards of directors, and most importantly, shift focus away from shareholders, placing greater emphasis on society.
Martin views the world through a harshly critical eye, essentially denoting managers greedy and investors foolish. Although a bit extreme, Martin is not alone in his assertion that shareholder value maximization should not be a company’s first priority. Does shareholder value maximization have the ability to “destroy our economy and rot out American capitalism”? I don’t know that I would choose those exact words. In fact, I would contend that consideration of stakeholders and shareholders need not be mutually exclusive. Apple, Google, and Unilever are three prominent examples of companies which have successfully created value for both shareholders and society.