Yves here. While this article has a lot of good observations and provides some new information, I quibble with a few things. First, the piece conflates investment with innovation. Opening a new plant or taking a successful regional product national will require investment but neither qualifies as innovation.
Second, he doubts that companies are so short term oriented as to deter them from investing. I wrote about how companies were under-investing in 2005. The fixation with meeting quarterly earnings targeta is a significant culprit. I’d been hearing for some time that McKinsey was having great difficult in getting its clients to invest in attractive projects, even ones that had a payback of less than a year, because they didn’t want to take the earnings hit. And anyone with contacts in Corporate America has heard of related types of dysfunctional behavior: freezing hiring, maintenance, and other expenses till after the end of the quarter; pressing clients to place bigger orders even though all the company is doing is cannibalizing future demand, and of course, accounting games, which look great until they become so significant that analysts notice. Andrew Haldane has confirmed the corporate short-term bias by documenting how they use excessively high discount rates to evaluate capital commitments, which discourages investment in projects with longer-term payouts, like infrastructure and innovations.
We’ve also discussed at length why maximizing shareholder value is counterproductive. As John Kay has stressed, when companies try to “maximize shareholder value,” they don’t succeed:
Oblique approaches are most effective in difficult terrain, or where outcomes depend on interactions with other people. Obliquity is the idea that goals are often best achieved when pursued indirectly.
Obliquity is characteristic of systems that are complex, imperfectly understood, and change their nature as we engage with them…
Obliquity gives rise to the profit-seeking paradox: the most profitable companies are not the most profit-oriented. ICI and Boeing illustrate how a greater focus on shareholder returns was self-defeating in its own narrow terms. Comparisons of the same companies over time are mirrored in contrasts between different companies in the same industries. In their 2002 book, Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras compared outstanding companies with adequate but less remarkable companies with similar operations…in each case: the company that put more emphasis on profit in its declaration of objectives was the less profitable in its financial statements.
Finally, when I was at McKinsey in the stone ages of the 1980s, it was widely recognized that smaller companies were more innovative than big ones; the firm tried regularly to come up with ways to help its big dinosaurs become more nimble. The belief at McKinsey was that scale itself was a problem, that bigger institutions have more specialized roles and much more rigidity (more routinization, more bureaucracy).
By Charles Dillow, an economics writer at the Investors Chronicle. He blogs at Stumbling and Mumbling and is the author of New Labour and the end of Politics. Follow him on Twitter at @CJFDillow. Originally published at Stumbling and Mumbling; cross posted from Evonomics
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 increasinglyfrom 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.
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“Oblique approaches are most effective in difficult terrain, or where outcomes depend on interactions with other people. Obliquity is the idea that goals are often best achieved when pursued indirectly.”
Congrats, you have highlighted a trade secret held by experts in nonlinear optimization. The saying is: you can’t go there from here. So whenever optimization (such as profit maximization) has to happen over an irregular landscape (often multidimensional, not just 3D as Earth landscapes) the process is multi-step (cannot go in straight-line, 2 steps) and so it happens that often times you take steps that move you in the opposite direction (less profit) of your final destination (maximum profit), but that was a necessary step to avoid a salient non-linearity (an obstacle).
We have automated these processes substantially so algorithms do their own thing and we just wait for them to arrive. But often algos think they have finished but just got stuck in a local maximum that is not the global maximum, so we need to test them by starting from different points (different initial values) and check whether they arrive at the same maximum.
What you describe as the short term behavior of firms to show the rapidest result to shareholders is equivalent to getting stuck in a local maximum for not being able to look at the whole landscape and find the global maximum.
A further complication of certain system such as markets is that the multidimensional landscape is not fixed, it is dynamic so the global maximum moves at a certain speed because the landscape changes its shape as a result of the actions of its agents and other forces.
A corollary in the political realm. Purists, extremists, hardliners, those that cannot accept to move in a direction that goes against the principles of the political movement, cannot win in the big game. Being able to violate the principles some times in the search of the maximum (power) will best achieve the practical realization of those principles. I call this the cynical corollary.
Your last point is why Labour currently struggles in the UK. No-one can argue that Corbyn doesn’t have principles, but the leader sometime needs to look past the principles to get the job done. Which is why I say he would be good Ideologue-in-chief for Labour, but crap leader.
Thank you, Vlade.
It’s getting bad isn’t it?
Corbyn has more sympathisers / supporters in the City than one can imagine.
Sounds like we should catch up over a coffee someday :) Or a glass of wine given your provenance..
Thank you, Vlade.
I would be delighted to and am happy for Yves to pass on my e-mail address.
Speaking of my provenance, it’s the tropics, so may be rum, too :-).
Best wishes.
Thank you, Yves.
You may be heartened to hear that Haldane has privately encouraged formation of a “people’s investment trust” focused on value and sustainability. This will launch in the spring. My former manager and I, who both know and have worked with Haldane and are big fans of the guy we hope will be governor of the Bank of England, are amongst the founders. It was my former manager who drove this project to fruition.
On a related note, you may be following the decline of Pearson. Investor short-termism and poor management since the departure of the founding family have wrecked a firm that, two decades ago, had the potential to be what Bloomberg is. (NB a friend and former employer of Bloomberg told me that Symphony is eating Bloomberg’s lunch. Bloomberg is scrambling to find fin tech firms it can buy and use to reinvent itself or close them, so that no competition emerges.) GEC (UK, not US) was similarly destroyed in the 1990s.
I can attest first hand to this resistance to anything that may jeopardise short-term revenue streams. I’ve worked in innovation groups in a number of large companies. Resistance to bringing innovations to market is strong even when the innovation program is, at least superficially, supported at the highest levels. The ONLY time I’ve seen large companies be at least mildly successful at this is when there is some KPI that mandates that at least x% of revenue in the verticals must come from products released within the last year or two. Of course, even then, verticals like to play games with this allocation.
The resistance remains despite the vast numbers of companies training employees on the latest fads for innovation like “Design Thinking.” (this was called “customer-centric design” back in the 80s). Today all over the world, 100s of 1000s of workers are badly applying methodologies they learned in a 3-day workshop (or they read a book!) to come up with creative ideas typically divorced from the business context, and therefore doomed.
At the same time, the big consultants continue to push for innovation projects because there’s so much pull from their clients. McKinsey bought a design agency called Lunar a few years back, Accenture bought Fjord… BCG, KPMG, EY… all bought design agencies specialising, at least in part, in helping companies innovate. Two friends have a very lucrative consulting practice helping to teach creativity to corporate and even governmental clients. I know from several sources that most of their projects end shortly after they consulting gig ends. Other projects that remain alive become so distorted that they no longer resemble the original ideas. In this way, Yves is right to challenge the article author’s definition of innovation. What gets labeled “innovation” by many companies are simply incremental improvements to existing products.
One small hope is that many companies are recognising that service innovation – how a product is delivered, supported, renewed, etc. — can sometimes bypass the hurdles of cost of capital and short-termism. These, however, hardly provide a sustainable advantage.
Haldane has also influenced the new business secretary, Greg Clark, and the industrial strategy unveiled a couple of days ago.
To be honest, I don’t see that industrial strategy delivering the goods. Apart from Legal & General (an insurer), Hermes (an asset manager) and the soon to be launched People’s Investment Trust (hopefully, it won’t be the pits :-)), the City is not interested. Also, is it too late to reindustrialise and rebalance the UK economy from consumption and invest for the long-term? Is the damage done terminal? It feels so.
Yves’ former employer, MacKinsey, studied UK manufacturing for the government a few years ago. Apart from the likes of Rolls Royce and British Aerospace / BAe Systems, there is little UK-owned that can survive a “f the EU, we’re going global” Britain.
On this (economy), here’s a good link http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2017/01/brexit-the-rights-consistent-error.html
Basically, the argument could be boiled down to:
There is no evidence that “freed of EU shackles”, UK companies would want to jump and start exporting mightily, because there’s no evidence that the UK companies want to export but can’t right now.
I’d add to that that Germany managed to turn itself into an export powerhouse in EU, with regulations even stronger than UK (yes, it had the help of in effect undervalued currency, but there was time when pound was at parity with EUR and it still did zilch for exports)
Thank you, Vlade. Spot on!
In 2009 – 10, I worked on a government and City initiative to identify regulatory impediments (e.g. Basel III’s treatment of trade finance and AML) to trade, alternative sources of SME finance, mentors for entrepreneurs etc. It was banks’ way of heading off structural and remuneration reforms. It soon dawned on us that UK PLC is in no fit state to compete. With regard to manufacturing, the average size of a firm was an entity employing a dozen people, so a workshop. There was also little interest in export, “too much hard work, more than my life / job’s worth, too much aggro”. The local monoglots don’t help, either.
Thank you, Vlade.
The way that the UK and some other countries mess up their devaluations makes me question my support for currency flexibility as a safety valve. The 30% devaluation of Sterling over 2008 – 9 made no difference to UK exporters, but it did make my long distance relationship with a woman in Zurich very expensive :-).
Many thanks, Vlade.
Just a couple of observations.
In the referendum campaign, Minford said that Brexit would herald the end of manufacturing in the UK. He thought that was good, but could not think of what would replace such activity.
I went to a well known public school, a preparatory or private school (sic) to readers outside the British Isles. In the sixth form (last two years to readers outside the UK), pupils had lectures etc. from business as we thought about careers and further education. It was interesting to see presentations by representatives of manufacturing so poorly attended. I remember a particular one by British Aerospace. The upper class pupils were not bothered as they had connections, private incomes etc. The middle class wannabes would not be seen dead anywhere near manufacturing lest their social class be questioned.
A few years later, Tory minister Peter Lilley self deprecated about being on social security and in trade to guffaws at his party’s conference.
I have a meeting with agents from the DOJ further to our DPA soon, so I must dash :-) or :-(.
John Kay’s assertions are excellent although I like to think about the same issues in different terms. Instead of using obliquity I use the term by-product. When a particular output (company profits, individual happiness) is the result of complex interactions, those outputs can be considered as by-products. By-products cannot be selected as goals, even worse as Kay explains, when you select them as goals those become almost impossible to achieve because your decission making process becomes too complex and error prone. It all ends in frustration. If you select happiness as a goal you almost certainly will end being quite unhappy and frustrated. It’s better to focus on easier well-defined goals that you can achieve, and it will make you, as a by-product, happy!!
Except that so many people spend their lives trying to figure out what goals they should focus on so that they could get happiness as a by-product that they fail to actually get and start moving towards any of those.
Once you realise happiness is a by-product, and necessarily short lived, you can move on or give up. As, you know there are three kinds of people, those who know mathematics and those who don’t.
I was looking into innovation at companies quite some time ago, and the problem I saw is that the large companies prefer (for organizational and political reasons) revolutions to evolutions.
But revolutions more often fail than succeed (and then they succeed, they usually bring in something else than what the original revolutionaries intended), especially the large “innovative” projects.
Japanese kaizen, which is often given as an example is evolution in practice – but to do evolution well, you have to be able to drop your ego quite a bit, which is not easy for a lot of westerners (and even fewer americans).
The real purpose of the modern neoliberal ideology is the provide intellectual cover, while a small elite steal all the economic gains of society.
Until that changes, we are not going to see any real changes.
Most executives today know they are only going to be there for a short time. So they maximize short term profits, even at the expense of long term ones.
https://www.washingtonpost.com/business/economy/businesses-focus-on-maximizing-shareholder-value-has-numerous-costs/2013/09/05/bcdc664e-045f-11e3-a07f-49ddc7417125_story.html
Very disturbing.
Bill Lazonick has a great article on this one too:
https://hbr.org/2014/09/profits-without-prosperity
One other matter I should draw to the attention of readers is that McKinsey and other management consulting companies may seem like the “good guys”, but in practice, they are a very, very big part of the problem today. A lot of the outsourcing was done with management consulting. They are about as bad as finance and part of Michael Hudson’s “parasites”.
Until society is fundamentally re-oriented to benefit people as a whole rather than a small elite though, I think that this will continue.
When your multi billion dollar tech firm decides that your project needs to move to a room with no cubes or offices, but with espresso, Foosball, and couches, they have finally realized that innovation matters but it’s too late to do anything meaningful.
“Innovation theater”.
It’s like when western manufacturers were trying to cope with the success of the Japanese in the 80s — by imposing morning calisthenics and sushi in the cafeteria because the Japanese did those things.
It is important to realize who the “shareholders” are to whom companies are beholden. These are chiefly institutional investors: government pensions and the 1% of universities that own half the endowments. In this sense, the “markets” are driven by government money, and government tax favored money. How can markets almost totally dependent upon the government even be called capitalism? Free markets need lots of people making market decisions, not a few fund managers working for government pensions and universities. Individual investors required for a market have been out of this manipulated game a long time.
Clarifying, thank you.
I don’t know about US, but in the UK, the companies are run by directors. The directors are (to again quote excellent John Kay on this) “accountable to shareholders, but responsible to – and for – all stakeholders”. The law says that the directors should “to promote the success of the company”. That is not the same as to “maximize shareholder value”, or even close.
Just for clarification – not that they often behave that way.. But in theory, they could be held responsible, if someone cared enough.
I wonder where Michael Porter’s “Competitive Strategy” falls in the influences on the lack of innovation? In my 35 years in Wall Street finance, I am unaware of another more influential theory, or one more widely accepted as uncontested conventional wisdom by investment bankers, corporate strategists, and investment research analysts. I don’t believe an MBA curriculum that would be considered legitimate if it didn’t have section on Porter. This theory concludes that the ultimate and single most dominant corporate strategy regardless of industry is the minimization of costs. It is easy to imagine that a capitalist absorbing Porter’s conclusions would simply conclude that corporate strategy boils down to the use of power to marginalize labor and suppliers at every turn.
Thanks, Yves. Reading Naked Capitalism has made me more aware of the scammy side of so-called shareholder value. In fact, it often is a slogan used to cover dubious management decisions. As a long-term free lance, I have IRAs and an SEP and so on. When the proxies show up, they show terrible management decisions and lots of self-aggrandizement. Nokia regularly puts enormous stock buy-backs on the proxy. Maybe Nokia management could have done more R&D instead. Walgreens Boots is a mixture of managerial delusion and enormous salaries and grants of stocks (when the board’s not suffering from Louis XIV complications like private-airplane rentals and domestic partnerships). And so on. As a practical matter, articles like this and NC’s stress on innovation and equity mean that I check the “no” box when confronted with this managerial foolishness. Ironically, managers paid with enormous stock grants, supposedly to ensure loyalty, end up having an interest in inflating the value of the stock. What could go wrong?
Another long-time freelancer here.
And, as for those terrible management decisions, they’re the sort that would kill a freelance business in short order. Yet these big, dumb companies can keep going on. And on. And on.
I think we should hire ourselves out as management consultants. Waddya think, DJG?
1. Once I put the corporate jet(s) into mothballs, I won’t be popular.
2. Also, even when I was a free lance (I took a job a year ago), I wore a necktie to meetings. That was scary for those inside the institutions, although helpful in getting better service at restaurants.
3. I would never allow any of the pampered executives to fly first class or to stay on floors of hotels that require an Exclusive Key Card for entry. It is amazing, though, how much opposition one can engender by taking away even the silliest of privileges.
To compensate, but not as compensation, I’d encourage gifts of chocolate or wine at year-end holidays. Also, cashews.
That’s about all you and I have to know about the mgt-consultant biz.
To be honest, there is nothing new here. This has been a problem for all time. Two critical experiences.
First, early in my business career, before management consulting and time on Wall Street, I worked in corporate planning for the fourth largest steel company in America. The US industry was decimated at the end of the 70s. The real reasons were that innovative process technologies were created in the US but were implemented in Japan and by US mini mills, not by the big steel companies. Big steel’s internal calcification preempted the implementation of their own innovations and led to their demise.
I am currently the CFO for a nascent, innovative financial services company that will solve the greatest issue that insurance companies have. It uses entirely different methodologies than the traditional industry (think index fund vs. active management). One would think that the traditional industry that regularly and openly advocates for innovation would embrace our business. Au contraire. Further, the PE funds that say this is exactly what they want in an investment (patented business methods, massive market, significant competitive advantages and much higher profitability) would capitalize the firm. Again, nope. Their business, which a few have admitted to us, is about fees for the GP not returns for the LPs.
The bottom line is all systems are designed to prevent innovation, which in my experience happens in all spheres from outsiders. That is why I say there is really nothing new here.
Yves, a timely post. I have a strategy / new offering development role within a Fortune 500 company. The specific business unit I support has been quite successful this year (definitely a broad-based effort, but my role (withholding comment on its occupant) was a valuable one), but other adjacent business units, without support from roles like mine severely under-performed, mostly because they’d been starved of roles like mine to develop new offerings (sales people were so desperate for evolution and innovation around what they were selling they started independently approaching other companies to form strategic partnerships and license technology– indicative they weren’t being properly supported). Rather than recognize this and bulk up strategy / new offfering development resources where needed, the company has frozen hiring and promotions while (of course) keeping aggressive 2017 targets. I liken it to management “starving the horse upon which its riding” but still expecting to win the race. Einstein’s definition of insanity also comes to mind. Disillusioned, and in anticipation of this year’s results and likely subsequent wave of newly unemployed streaming from company, I’m now looking for opportunities elsewhere.
As an aside, and probably too out there, but have you ever considered adding some type of jobs board to the site as a way to generate more revenue for the blog? I’m a daily reader of site and would love to discuss opportunities that other readers may have, as their presence here is probably a good leading indicator of potential working relationship (“do the right thing”, “think about the long-term”, “don’t bs”, etc). Could be a way for this blog and site to have an even broader impact in the world–
Regardless, thanks as always for the best news site on the web.
Well.. if you consider Well Fargo’s strategy as “innovative” then you can conclude that shareholder value drives “innovation”.
How many times, as a society, do we need to learn Kalecki’s profit equation before it sinks in?
Yves hits the major weaknesses of this piece at the start. I would say they are not “quibbles,” but rather hamstringing misconstructions that lead to baseless conclusions.
First off, “innovation” cannot be said to be having any problems at all, given that information technology (itself innovating at red-shift rates) has endowed us all with new tools for exponential breakthroughs in every single field of human activity except, maybe, shaving. That’s not just technical innovation: it includes innovation in psychology, especially in management psychology and consumer psychology, both embodied in the big data blob and in crowd-sourcing of all kinds. Now you may not not like that “innovation,” and you might think it is not a “healthy economy”: but that is a political call. There is no denying that it is “innovative.”
Leaving aside that its premise is wrong, the whole article goes kittywhompus in the conclusion: “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.”
Wow what a straw man. Capitalism is a big tent. Broadly speaking, capitalism disseminated the vast majority of “innovation” since about 1400, and essentially all innovation since 1700. Capitalism did not arise to innovate, but to develop, produce, and profit from innovation; it evolved by choosing and disseminating “innovative techniques” time and again. Whether the innovations are good or not falls out in the market, and so far, nobody has found a better laboratory to test new ideas than a well-regulated market. Marx himself was a “cheerleader of capitalism” for those very reasons. He thought capitalism was the best thing ever—yet—and he hoped that still better things would be achieved under a coming stage of social evolution. And, that may be, but we have not seen it as yet.
So what is new here is wrong, and what is old here is known; the value added is in the commentary from Yves on obliquity, which is always interesting, and in the moral lesson, which, if true, is edifying conservatism: do good things and you will profit; seek profit only and you will end up in the bazaar. Back to Clifford Geertz’s Peddlers and Princes for some great anthropology on that lesson.
maybe the reason some public companies dont invest (at least today) is that they dont see the reason to. their sales arernt growing (even apple is shrinking) and if they wanted innovation they can buy the companies that do it, cheaper with less risk (once there is some value to the ‘innovation’ anyway). but the ‘shareholder’ theory is just a way to make the companies short sighted. because innovation and investment are inherently risky (see Ford and in $800 million loss this quarter driven in part because of cancellation of a plant). do some big public companies invest in the future products today? yes. but they have to be looking long term. are there many of them? almost none, not quite, but close. or at least innovation that has some public good to it (look back to the first computers, back in the 40s and 50s, today’s maybe be much larger, faster, but they are still basically the same. we may use them in ways that never were imagined. but was the innovation the original idea and creation of the computer, or was is the changes after the fact that made it a high impact innovation? and based on that, have we really innovated much since the 70s-90s? and considering the original purpose of the computer was aiming cannons, and that was basically paid for by the government, is the current innovation drought because the government has cut back on that? and MR T in charge of T land, will that get worse?
So, basically the whole thesis is a rough comparison of the role of private vs public capital in the pursuit of shareholder value through innovation and then you end up your thesis with ” … capitalism has lost some dynamism”.
Lol, talk about pivoting mastery. Where is the contribution of social capital to this argument? How does any of this proves or disproves that capitalism is dead? Did I miss that or the dog chewed on it?