Growth in the US is weak. Wages are stagnant, corporate earnings growth is anemic, and consumer spending is wobbly. The Great Recession has been over for years, but it certainly doesn’t feel like it.
New research suggests that a specific feature of American corporations is to blame: an obsession with delivering short-term returns to shareholders while ignoring the future of the business.
“One factor contributing to sluggish economic growth is short-termism, a corporate philosophy that prioritises immediate increases in share price and payouts at the expense of long-term business investment and growth,” write researchers at The Roosevelt Institute (RI).
The way RI tells it, American companies have developed a disease that causes them to elevate one element of their business structure before any other: the shareholder.
After a few decades of shareholder primacy, during which companies neglected other parts of their businesses, like workers and R&D, the American economy is starting to show how badly its been hurt. You see, shareholder primacy sucks money away from places where it could be a more productive engine of growth and throws it into the ocean of the market, where it mostly just jostles about in the ebb and flow of stock trading.
The thing is: The American corporation wasn’t always this way. There was a time when it took on a more holistic approach to its function in society.
“The purpose of corporations used to be to innovate, creating universities, building railroads, designing self-driving cars, and looking into commercial space transport,” Lynn Stout, a professor at Cornell Law School and the author of “The Shareholder Value Myth,” said in a recent interview with Marketplace. “These are really big long-term projects … and what corporations are supposed to do.”
But ideas and practices have changed, and now we have a problem on our hands.
A few points from The Roosevelt Institute before we go on:
- From 2003 to 2012, S&P 500 companies used 54% ($2.4 trillion) of their earnings for stock buybacks.
- From 2009 to the end of 2013, corporate investments rose by $400 billion.
- But those investments were dwarfed by shareholder payouts, which increased by $740 billion.
- During that same period, companies borrowed $900 billion. (It’s worth noting that companies with the highest dividend payouts and share repurchases also tend to borrow the most.)
- Since the 1980s, companies have invested less than 10 cents of each borrowed dollar.
“In other words, the financial system is no longer an instrument for getting money into productive businesses, but has instead become an instrument for getting money out of them,” the RI researchers write. “The sector overall is now predicated largely on seeking rents through payouts rather than increasing profits through growth.”
“A comparison of similarly situated public and private firms shows that public firms invest substantially less and are also less responsive to changes in investment opportunities. Public firms are responsible for roughly two-thirds of all non-government R&D expenditures in the United States; however, research suggests almost half of managers would reject a profitable investment if it meant missing an earnings forecast,” the RI researchers write.
RI’s point is that money that could be spent on R&D or higher wages (which would encourage consumption) is just sitting in the stock market getting chomped on by high-frequency traders, tossed around in the slushy moves of big mutual funds, and waiting to be chum for hedge fund managers.
‘But Linette, that’s what companies are for.’
Now I know what you’re thinking: Everything you’ve learned from watching CNBC’s Joe Kernen bloviate about the merits of capitalism tells you that companies were only created to hand money back to shareholders. And you’re sure of that.
Unfortunately for you, that isn’t how it has always been.
In the first half of the last century, two professors, Adolph Berle of Columbia University and Merrick Dodd of Harvard Law, duked it out over whether companies lived for shareholders. Berle took the side of shareholders, and Dodd took a more holistic approach.
“The business corporation,” Dodd said in a 1932 issue of the Harvard Law Review, is “an economic institution which has a social service as well as a profit-making function.”
In other words, Dodd argued that corporations are supposed to enrich the economy, provide workers with a decent wage and purchasing power, and create high-quality products. This was known as the “managerialist view,” and it basically won out through the 1960s. Even Berle eventually capitulated.
Then in the 1970s, as the stock market was going through lean times, members of what we know as the Chicago school of free market economic theory dug up the old idea of shareholder primacy and put it back to work.
Noted economist Milton Friedman wrote in The New York Times Magazine in 1970 that a corporation’s only “social responsibility of business … [is] to increase its profits” for shareholders who “own” the corporation.
And that was that. We’ve been running with putting shareholders first ever since. Problem is, it seems we’re running with it right off a cliff.
For your consideration
Michael Pearson, the former CEO of Valeant Pharmaceuticals, had a singular focus on showing growth in his company so that the market would reward it with a rising stock price. His pay, after all, was tied to that stock price.
And so he slashed R&D to single digits, instead spending money on acquisitions to grow the company. He once said that the unfortunate thing about curing cancer was that there was no money in it. And his philosophy on drug pricing was to charge as much as the market could bear. As a result, he drove the price of two lifesaving heart medications up hundreds of percentage points.
On this, Pearson was unapologetic. In 2014, he explained that when it came to Valeant’s management, “there’s only one metric that really counts, and it’s total return to shareholders.”
“We’re just going to be focused on what’s best for shareholders,” he said.
Of course, this massive effort to only increase Valeant’s stock price led the company down a dark path — and when reports surfaced that within its business it had a secret pharmacy that was bypassing insurers (and other poor governance), the outcome was the exact opposite.
The company’s stock price lost 90% of its value. No one wins.
And there are less egregious cases all around us. Consider the differences between two incredibly well-known companies, Apple and Amazon.
Apple’s stock has lost about a quarter of its value over the last year, despite a bunch of stock buybacks at the urging of former shareholder and billionaire investor Carl Icahn.
Analysts all over Wall Street will tell you it’s an innovation issue. It needs another billion-dollar product, and no one sees one coming down the pipeline. Back in November, though, Bloomberg gave Apple a big pat on the back for spending 3.5% of its $233 billion revenue on R&D. Meanwhile, its peers spent far more; Google spent 15% of its $66 billion revenue on R&D, and Facebook spent 21% of its $12.5 billion revenue on it.
Apple’s capability to spend was much greater, but it held off, and now it doesn’t have a magic product to wow Wall Street or its customers.
On the other hand, you have Amazon CEO Jeff Bezos, who has consistently denied shareholders profits in order to reinvest in his business. Now, through that constant reinvestment, Amazon has found itself on the cutting edge of not just e-commerce, but also the cloud computing it developed. For that, analysts at Oppenheimer have slapped a $938 price target on its stock. It opened at $726 on Wednesday.
We don’t have to take this
There are ways to solve the problems caused by an overemphasis on returning profits to shareholders, and RI lists several of them.
It suggests that we can break the link between stocks and CEO pay. We can make sure that companies don’t pay out shareholders before they fill their pension coffers to ensure employees who’ve served them have retirement funds. We can lower the number of shares companies can repurchase at a time. We can limit the amount of debt companies can use to pay back shareholders. Those are just a few ideas.
And none of this should be taken to imply that shareholders don’t have things to say. Activist hedge fund managers representing the voice of shareholders can be good for companies. Private equity, which can use leveraged buyouts to purchase companies that need to be reconstructed, can be a force of good, too.
But when any of this is taken too far, it sucks the life out of our economy and puts money where regular people can’t touch it, keeping them from driving our economy forward. We have to realise we have a problem.
“The Price of Profits,” our series with Marketplace, looks at what happens when profits become a company’s product. For more, visit priceofprofits.org.
Disclosure: Jeff Bezos is an investor in Business Insider through his personal investment company Bezos Expeditions.