The Business Roundtable – a body representing the chief executives of America’s largest companies – announced in August an updated statement on the purpose of a corporation. In broad terms, the statement articulated a shift away from shareholder primacy towards a more stakeholder-oriented vision. Advocates of the move welcomed the recognition of issues such as employee welfare and environmental impact, while critics lamented the apparent downgrading of shareholder interests.
But commentators largely missed the key point: companies will disappoint both stakeholders and shareholders unless the underlying problem of short-termism is addressed. The widespread assumption that corporate activity is today mostly driven by a focus on long-run shareholder value is mistaken. In practice, many corporate leaders are instead focused primarily on short-run share price maximisation.
The fundamental problem to be addressed is therefore not one of broadening the perspective of CEOs away from a narrow focus on shareholders. Rather, it is to address the incentive problem, afflicting the entire investment chain, that results in an obsession with short-term share price performance rather than long-run value creation.
Share price myopia
Today’s crisis of capitalism originates not in the boardroom but in the capital markets, and is a result of the agency issues that arise from a highly intermediated financial system. In the modern publicly listed corporation, shareholders typically stand a number of steps removed from company management. For example, in the case of a pension fund, the end saver’s interests are represented by a group of trustees; those trustees usually delegate the management of the assets to an external asset manager (often further intermediated by a fiduciary manager); and the asset manager builds a portfolio and engages with company management in line with their mandate. Agency issues exist at every stage in this chain, but arguably the critical principal-agent problem arises in the relationship between the trustees and the asset manager.
Facing the challenge of assessing a manager’s ability, trustees typically employ market cap benchmarks to measure the ongoing success of a strategy. However, this creates an incentive for managers to herd around the benchmark and engage in performance-chasing activity to control the risk of short-term benchmark underperformance. Trustees themselves also engage in procyclical decision-making, tending to hire managers after strong performance and fire managers after poor performance. And the clearest example of procyclical behaviour comes from momentum and trend-following strategies that exploit the performance-chasing activity of asset owners and managers for private gain, while amplifying price trends and exacerbating asset mispricing.
With an asset management industry so obsessed with short-term performance, it is hardly surprising that CEOs engage in strategies designed to maximise share prices over the short term. Reinforcing this dynamic, remuneration arrangements that are heavily skewed towards equity-based compensation ensure that CEOs are financially rewarded for actions that boost share prices.
Finance theory must share the blame for this share price myopia. In particular, a paper by Michael Jensen and Kevin Murphy published in 1990, titled “CEO incentives: it’s not how much you pay, but how”, made a forceful argument in favour of remuneration structures that link CEO pay to shareholder wealth. When combined with the idea that share prices are an accurate reflection of the fundamental worth of a company – as embodied in the efficient market hypothesis – the natural conclusion is that CEO pay should be closely linked to share price performance. CEO pay in the US exploded during the 1990s, with stock options quickly becoming the largest share of total remuneration.
However, if share prices can depart substantially from fair value, then the argument in favour of equity-based compensation breaks down. Indeed, in the presence of mispricing, CEOs are incentivised to maximise share prices and simply become another procyclical participant in the system. When executives act with the sole intention of inflating stock prices, this will often be at the expense of long-run value creation. As a result, short- and long-run shareholder interests come into conflict, rendering the concept of shareholder value – when abstracted from time horizon – meaningless. Given the nature of executive incentives, the resolution of this conflict will often favour the short-term over the long-term.
Reconciling shareholder and stakeholder concerns
An excessive focus on share price maximisation is often viewed as a side-effect of the shareholder primacy ideology. The natural corollary of this view is that there needs to be a levelling of the playing field in order to place stakeholder concerns on a par with shareholder interests. This line of thinking places shareholders and stakeholders in opposition to one another and ignores the importance of time horizon.
While it is true that shareholder and stakeholder interests may come into conflict over the short term, their interests are in far greater alignment over the long term. For example, a company that seeks a short-term boost to its bottom line by cutting employee benefits, will suffer from a demotivated workforce and will lose talented staff in the long term. Similarly, a company that squeezes its suppliers for short-term gain, puts at risk its ability to meet customer demand over the long term. In both cases, actions which ignore the value and importance of a company’s stakeholders also undermine the goal of delivering long-term returns to shareholders.
This is to argue that over the long run, shareholder concerns coincide to a large extent with stakeholder concerns. Put differently, well-run businesses that are focused on long-run value creation will generally not exploit their employees, suppliers, customers or wider society. This is especially true given the power of social media to shine a spotlight on corporate behaviour that is deemed to undermine their social license to operate.
The best way to align shareholder and stakeholder interests is therefore to ensure that CEOs are incentivised to deliver long-term value – to customers, shareholders and wider society – rather than seeking to maximise the share price over the short term. This will require a re-setting of relationships along the investment chain and a re-thinking of executive compensation practices.
Extending the investment horizon
An essential precondition for long-term thinking to prevail in boardrooms is for long-term thinking to predominate across the asset management industry. This will only happen if asset owners demand asset management strategies that focus on long-term value creation rather than short-term benchmark outperformance.
A first step in this direction would be for asset owners to recognise the incentives that drive share price myopia across the asset management industry and to counteract their effects. This could include an overhaul of the traditional approach to manager monitoring – with the aim of deterring performance-chasing – as well as a re-framing of the mandate given to asset managers.
From a regulatory perspective, the goal of policymakers should be to foster an asset management sector that is focused on identifying and nurturing sustainable business models. A move in this direction could include an explicit recognition of the damage done by short-horizon strategies that respond primarily to price trends with little concern for business fundamentals.
Returning to the Business Roundtable statement, the shift from shareholder primacy towards a more stakeholder-oriented vision is likely to benefit neither shareholders nor stakeholders unless the underlying disease of short-termism is treated. An excessive focus on share prices by investors and CEOs inflicts long-term damage on shareholders and wider society. Conversely, extending the horizon of asset managers and corporate leaders could benefit shareholders and stakeholders alike. Regulatory interventions will still be required to curtail the negative effects of monopoly power and certain systemic externalities, but a greater focus on long-run value creation in the capital markets – instigated by long-horizon asset owners – could help restore trust in the financial system and deliver meaningful benefits to society.