Shareholder value & innovation

Shareholder value, said Jack Welch, “is the dumbest idea in the world.” I was reminded of this by Tim Worstall’s reply to Liam Byrne’s demand to “reject once and for all the tired and increasingly flawed orthodoxy of shareholder value.” Tim says:

Increasing income, and/or wealth, is driven by technological advances that lead to greater productivity. And only societies which have had some at least modicum of that shareholder capitalism have ever had that trickle-down which drives the desired result.

This, however, overlooks an important fact – that shareholder-owned firms (in the sense of ones listed on stock markets) are often not a source of technological advances. Bart Hobijn and Boyan Jovanovic have pointed out that most of the innovations associated with the IT revolution came from companies that didn’t exist (pdf) in the 70s. The stock market-listed firm is often not so much a generator of innovations as the exploiter of innovations that come from other institutional forms – not just private companies but the state (pdf) or just men tinkering in garages.

This fact seems to have become more pronounced in recent years. David Audretsch and colleagues show that innovative activity has come increasingly from new firms rather than listed ones. And Kathleen Kahle and Rene Stulz show that listed companies today are older, less profitable and more cash-rich than those of years ago. They say:

Firms’ total payouts to shareholders as a percent of net income are at record levels, suggesting that firms either lack opportunities to invest or have poor incentives to invest.

There are, of course, many possible reasons for this lack of investment. One might be that outside shareholders are so short-termist that they discourage firms from investing (though personally I doubt this). Alternatively, they might be too ill-informed to distinguish between good and bad projects and so often err on the side of caution.

A third possibility is that both investors and bosses have wised up to a fact pointed out by William Nordhaus – that innovation yields only scant profits because these get competed away*. It might be that Schumpeter was right: innovations tend to come from over-optimism and excessive animal spirits and that the listed firm, in replacing buccaneering entrepreneurs with rationalist bureaucrats, thus diminishes innovation.

From this perspective innovation is against the interests of the shareholder-owned firm, as it threatens their market position: the creative destruction of which Schumpeter wrote is by definition bad for incumbents. It’s no accident that the most successful stock market investor, Warren Buffett, looks not for innovative firms but ones that have “economic moats” – some kind of monopoly power that allows them to fight off potential competition.

Tim might therefore be taking too optimistic a view of shareholder capitalism: shareholder value might now be a restraint upon technological advances more than a facilitator of them**.

I don’t say this merely to criticise Tim, but to highlight a mistake made by many of capitalism’s cheerleaders – that they fail to see that the threat to a healthy economy comes not so much from lefties with silly ideas (or perhaps even from presidents with them) but from capitalism itself. For many reasons – of which the pursuit of shareholder value is only one – capitalism has lost some dynamism. In underplaying this, capitalism’s supporters are making the mistake of which Thomas Paine accused Edmond Burke: they are pitying the plumage but forgetting the dying bird.

* Apple is a counter-example here: Steve Jobs genius was not so much in fundamental innovations as in the ability to create products so beautiful that they had brand loyalty and hence monopoly power.

** The strongest counter-argument here might be that the prospect of floating on the stock market (often at an inflated price) incentivises innovation by unquoted firms.

Comments

[Tim Worstall]

"The strongest counter-argument here might be that the prospect of floating on the stock market (often at an inflated price) incentivises innovation by unquoted firms."

Well, yes. For I'm not using shareholder capitalism to mean publicly listed firms. Just ones with capitalist shareholders who make out like bandits if they get it right.

[Patrick Kirk]

State funded research is a huge source of innovation and a lot of commercial innovaation is based on basic research that came from governemnt programs. Someone who articulates this far better than me is http://marianamazzucato.com/the-entrepreneurial-state/

Shareholder based companies are great vehicles for commercialising this research but as you say, they have a poor record of coming up with innovation themeselves.

[Dave Timoney]

One cultural change since the 80s has been the tendency for innovators to systematically use large firms as launchpads. In other words, they don't tinker in the garage so much as develop a skunkworks within the corporate host and then decamp on the promise of VC funding and an eventual IPO. Back in the day, the instinct was to stay and convince rather than go solo as soon as an idea was monetisable.

This may reflect a growing corporate inability or uninterest in exploiting new ideas that springs from shareholder value, though the tendency to get employees to sign restrictive covenants on IP rights suggests otherwise, so perhaps it is more a reflection of the decline in corporate loyalty and the rise of promiscuous employment (the flip-side of precarity).

Of course, these are more effects than causes. The underlying dynamic is probably the shift from physical to intellectual capital - i.e. less plant, more patents. The problem is that this may also be masking an accelerated shift from productive to distributive activities, which would explain sluggish productivity. An example of the distributive trend is the growth of talking shops and vapid consultancy - something that Liam Byrne seems well versed in.

[Blissex]

Fairly reasonable arguments: large businesses are mostly good at incumbency, rather than innovation; and incumbency is quite difficult indeed, few businesses become incumbents, and not many remain incumbent over time. W Buffett quote appropriate.

As to S Jobs and design engendering brand loyalty, he himself said that he wanted Apple to be the BMW of its own market, and fair point.

But Apple should have been a small success, a Bang&Olufsen size company. It has become big for another reason: its business model currently relies entirely on the debt boom created by the BoJ, the FOMC, and the BoE.

The reason is that mass-market Apple products are indeed the BMWs of their market, with BMW-like prices, like an iPhone for £500. So it should be a profitable but niche product, not a mass-market one. But many of the people who could not find £500 to cover an unexpected bill yet buy iPhones, and that's because they effectively get £500 of instant credit when they open a mobile phone account, to be repaid over two years by a large chunk of the monthly fee. That's a bit of an aside though.

[Luis Enrique]

if the stock market is useful because it's how private investors (entrepreneurs, VCs etc.) realize their investments in innovation, and behave in a way to maximize their sale price at IPO, then they are still concerned with shareholder value. So whilst I think it's interesting and important that listed firms are not often innovators, I don't think it quite knocks down idea that creating shareholder value has a role in innovation.

[Luis Enrique]

sorry for just re-stating your strongest counter argument!

[aragon]

How do you avoid mentioning Clay Christensen in the article?

Read This article, at Forbes, which links to the capitalists dilemma (Harvard Business Review).

http://www.forbes.com/sites/stevedenning/2014/05/23/clayton-christensen-are-investors-bad-for-business/#512541622b88

Then this one.

http://www.forbes.com/sites/stevedenning/2017/01/08/resisting-the-lure-of-short-termism-how-to-achieve-long-term-growth/#6113df8d3ab9

MSV = Maximising Shareholder Value

"Meanwhile workers wages have stagnated for decades. Since the advent of MSV in the 1980s, the benefits of productivity gains have flowed to shareholders, including the executives, not to workers who created those gains."

[...]

"The consequences of MSV and share buybacks are a macro-economic and social disaster: net disinvestment, loss of shareholder value, diminished investment in innovation, destruction of jobs, exploitation of workers, windfall gains for activist insiders, rapidly increasing inequality and sustained economic stagnation. Stock buybacks are thus a financial bonanza for stockholders and senior managers, but they destroy economic value for society."

[...]

"so society is learning that much of 'the talent' it thought were adding value have in fact been extracting value for themselves."

Financialisation leads to neo-feudalism.

So yes, Maximising Shareholder Value, a religion in business, is a really dumb idea. As are several other conventional theocratic views.

Sorry, I couldn't resist.

p.s.
Venture Capitalists don't innovate they back sure things e.g. commercialisation of public research.

[aragon]

I have just read the Liam (There is no money left) Byrne article.

"That is why we are seeking to launch a new kind of debate in the hope of finding a new kind of consensus. The sooner we find it, the sooner we can reject once and for all the tired and increasingly flawed orthodoxy of shareholder value and trickle-down economics that took shape with such force nearly 50 years ago."

R.O.F.L.

http://www.forbes.com/sites/stevedenning/2014/06/17/why-the-worlds-dumbest-idea-is-finally-dying/#4e8fd40b4ef8

"You could note that in the period 1978 to 2013, while the rates of return on assets and invested capital in US firms declined by around 75 percent, CEO compensation increased by an astonishing 937 percent, while the typical worker’s compensation grew by a meager 10 percent."

They can agree on neo-liberalism, while accepting it doesn't work?

https://www.theguardian.com/politics/2017/jan/10/jeremy-corbyn-calls-for-maximum-wage-law

Implemented as a 100% tax on all income, not such an idiotic idea?

Attacking economics...
So many dumb ideas...
So little time...

[Kaleberg]

One thing that has changed is that corporate taxes are much lower than they were back when large companies were more innovative. With a 90% personal rate and effective 50% corporate rate, it wasn't worth just paying out big salaries and dividends as opposed to increasing the value of the company. Also, there has also been a lot less anti-trust enforcement, so there are a lot fewer big companies and much less competition between them. We used to see major industrial laboratories at companies like IBM, AT&T, Xerox, Polaroid, RCA and others. The closest thing we have seen lately is Google, and Google is shutting down its research labs as unprofitable.

The old industrial research laboratory did have a lot of payoffs. Xerox, originally Halide, developed dry copying. Polaroid developed instant photography. It is hard to justify those laboratories these days. Large companies are under no threat of breakup, like Standard Oil, if they dominate the industry and lead to technological stagnation. Taxes are so low, it makes much more sense to pay $50M to the CEO than on a 200 man research lab.

Xerox, of course, did a lot of amazing research, but corporate management had no clue as to how to develop it, so xerographic computer printers and point and click computers were sold by others. Canon grabbed the printer market and Apple grabbed computers.

For small firms, it still makes sense to innovate. If nothing else, you can sell out to big firm. It's not as if you can dominate the market. You have to do something well to compete.

[aragon]

The Innovators Dilemma at Kodak.

http://lens.blogs.nytimes.com/2015/08/12/kodaks-first-digital-moment/

"The main objections came from the marketing and business sides. Kodak had a virtual monopoly on the United States photography market, and made money on every step of the photographic process. If you wanted to photograph your child’s birthday party you would likely be using a Kodak Instamatic, Kodak film and Kodak flash cubes. You would have it processed either at the corner drugstore or mail the film to Kodak and get back prints made with Kodak chemistry on Kodak paper.

It was an excellent business model."

Tim and Chris a fan of Unicorns or Cockroaches?

Billion pound companies with no revenue vs small companies with organic growth?

http://uk.businessinsider.com/cockroach-tech-startups-unicorns-venture-capital-2016-4

"London-based Powa Technologies raised at least $225 million in debt and equity over the last three years and at one point claimed to be worth $2.7 billion. But the payments business went bust in February, with debts of $16.4 million and just $250,000 in the bank."

http://arstechnica.com/science/2017/01/theranos-downfall-due-to-elaborate-4m-conspiracy-investor-says/

"It’s been a rough couple of years for Elizabeth Holmes, CEO and founder of the now-floundering blood-testing company Theranos. The biotech company went from a promising golden child of Silicon Valley, at one point valued at $9 billion, to a disgrace that put patients in harm's way with tens of thousands of inaccurate blood tests. It had one of its two diagnostic labs shut down by federal regulators, it lost high-profile business partners, and it now faces a mountain of lawsuits. Holmes herself has been banned from the blood-testing industry (pending an appeal)."

https://www.bloomberg.com/features/2016-zenefits/

"Zenefits was everything Silicon Valley loved wrapped up in one company. It had a visionary founder. It tackled a stodgy industry ripe for disruption. The recurring commissions gave it a steady stream of revenue from the start. And Zenefits was the first in the health insurance software space, the Uber to its future competitors’ Lyft. The potential for greatness is what allowed Zenefits to expand from 15 employees to 1,600 in three years; raise $580 million in three fundraising rounds; and become one of Andreessen Horowitz’s biggest investments. Last year it was valued at $4.5 billion, which made it, in Valley parlance, a “unicorn” several times over."

https://www.theguardian.com/technology/2016/oct/06/theranos-lab-closures-walgreens-centers-layoffs-elizabeth-holmes

"Theranos is not the only Silicon Valley company to have doubt cast upon its core science. Former employees said that San Francisco-based vegan food company Hampton Creek, which markets itself as a technology company, exaggerated how advanced its technology was. More recently Bloomberg reported that the company had been engaged in an alleged undercover buyback campaign, where members of staff were tasked with buying up jars of Hampton Creek’s eggless mayonnaise product Just Mayo. The US justice department has since opened up a criminal investigation into whether the company committed fraud."

https://www.cbinsights.com/research-unicorn-companies

There is a pattern to the industries, Internet or Healthcare related.

Tulip Bulbs do not get a look in!
http://www.bbc.co.uk/culture/story/20160419-tulip-mania-the-flowers-that-cost-more-than-houses

[Blissex]

«The Innovators Dilemma at Kodak.»

That companies have an "Innovators Dilemma" is a myth that is very popular, and that's unfortunate, because there is a much better insight.

It is *executive teams* that have, or rather don't have, an Innovators Dilemma:

* By the time they get to executive positions they are middle aged and close to retirement.

* Their main vested interest is to asset strip the company as fast as possible while they are in power before they retire.

* If the incumbent company has some kind of "market lock" like Kodak or IBM had, this means that their strategy is entirely predictable: cut investment and depreciation as much as they can, raise the prices on their existing product lines, and award themselves fantastic bonuses from the cashflow thus generated by booking "profits" that largely consist of asset stripping the company's "goodwill".

* Because the goal is to maximize cashflow and booked profits by minimizing investment, there is a continuous drive towards higher margin, upper market, branded products.

* The incumbent's strategy opens up a huge "pricing umbrella" for would be competitors that are prepared to compete on price and novelty, even if quality is inferior.

* After the "executive team" retires, the company "profits" fall dramatically, and the cashflow to generate new investments and develop new products is further reduced to boost them to avoid a takeover. Bankruptcy follows.

Put another way rather than companies having an innovator dilemma, executive team have a no-innovation determination.

That sequence is most typical of one-product line technology companies (and that's why W Buffett does not invest in them), where the founding generation in their 30s becomes 25 years the vulture generation that asset strips the company bare by shedding existing low price product lines, moving upmarket and stopping investing in new products. Many such companies have lasted around 25 years because of this lifecycle.

The only cases where companies survive is when they are so large and have lasted so long that they have many divisions at different stages of their executive team lifecycle, so that when some division in the no-innovation asset stripping phase of their executive team lifecycle, some other division is ramping up in the innovative asset-building phase, and it all averages out.