David
 James
 Brunner

HBS professors Gary Pisano and Willy Shih have an interesting article (“Restoring American Competitiveness“) in the July 2009 issue of the Harvard Business Review discussing the plight of the American economy.  They argue that American business has lost the capability to innovate in many important high-tech industries by outsourcing production to Asia and decreasing investment in research and development (R&D).  This process has been continuing for several decades, and the damage is reflected by average weekly wages that have been stagnant for almost thirty years, as well as by a trade balance in high-tech products that has been in deficit since 2002.  Pisano and Shih assert that there are strong complementarities between manufacturing capabilities, design capabilities, and innovation.  Consequently, although the strategy of specializing in “high-value-added design and innovation” while outsourcing capital-intensive manufacturing tasks to low-cost providers may be attractive in theory, it proves difficult or impossible in practice.

Pisano and Shih then offer a few proposals for policy-makers and managers about how to improve the situation.  Unfortunately, I find the proposals unconvincing.  With respect to government, they first recommend to “reverse the slide in the funding of basic and applied science”.  It turns out, however, that U.S. federal funding for basic research has almost tripled since 1980, while funding for applied research has nearly doubled.  According to the data that Pisano and Shih provide in the article, funding has declined only slightly since 2003, after a dramatic rise that began in 1998.  Although raising investment in basic and applied science is probably a good idea, it’s hard to understand how this can be a solution to the problems identified in the article, since these problems developed despite dramatic increases in the level of federal research funding (in real dollars).  Next, Pisano and Shih recommend that government “focus resources on solving ‘grand challenge problems’” and “let ailing giants dies” (they refer specifically to auto companies).  I don’t object to either of these proposals, but, again, I find it hard to understand how they will reverse three decades of deterioration in America’s high-tech innovation capabilities.

Pisano and Shih’s recommendations for managers are similarly unsatisfying.  First, they suggest that companies “make capabilities the main pillar of your strategy”.  My colleague Brad Staats explains that a capabilities-oriented approach to management entails recognizing the interdependencies between different parts of the business. If managers understand these interdependencies and incorporate them in strategic decision-making, perhaps they will not outsource activities that are crucial to long-term competitive advantage. It’s a nice idea, but Harvard Business School professors (notably Bob Hayes) have been making similar arguments at least since the 1980s.  It seems to me that we need to dig deeper and consider the factors that have discouraged or prevented managers from following this obviously sound advice.

Next, they recommend managers “stop blaming Wall Street for short-term behavior”, because managers can escape Wall Street’s pressure for short-term results if they send a clear, consistent message that they intend to focus on the long term.  Although it’s nice to think that frequent incantations about long-term focus can keep Wall Street at Bay, I’m skeptical.  A long-term strategy can take ten or twenty years to pay off, and few CEOs are sufficiently secure in their positions to ignore criticism from stock analysts and business journalists obsessed with short-term results.  And activist investors eagerly pounce on companies when their stock prices dip, so CEOs take a long view at their peril.  Even leaving these problems aside, most senior executives will be inclined to pursue strategies that pay off by the exercise date on their multi-million dollar stock option packages.

The other recommendations for managers–”recognize the limits of financial tools”, reinvigorate basic and applied research”, “collaborate”, and “create technology-savvy boards of directors”–all sound like nice ideas, but again it’s unclear why companies that have steadily cut R&D and outsourced the foundations of their innovative capabilities would heed these appeals.  Certainly similar appeals have been made since the problems became apparent in the 1980s.

My take on the problem, informed by the work of professors Mary O’Sullivan (Wharton) and William Lazonick (University of Massachusetts), is that the America’s problems will require major changes in the institutions of American capitalism, as opposed to the relatively minor adjustments proposed by Pisano and Shih.  In an insightful article, O’Sullivan and Lazonick describe the way that the shareholder value maximization ideology has lead companies to shift from retaining earnings and reinvesting them for long-term growth, to downsizing the corporation and distributing profits to shareholders.  The shareholder value ideology is reinforced by executive compensation tied to share price (stock-linked compensation), and by the danger of becoming the target of a hostile acquirer or an activist investor (the “market for corporate control”).  Together, stock-linked compensation and the market for corporate control create strong incentives for managers to focus on short-term shareholder returns: increase the share price and reap multi-million dollar rewards, or let the share price wilt and risk losing one’s job.  Until we change these incentives, I doubt that companies will begin to make the kind of investments that Pisano and Shih advocate.

William Lazonick makes the case against stock buybacks in the latest issue of BusinessWeek.  In his article “The Buyback Boondoggle“, He argues that companies spend huge sums of money on buybacks that they could have invested in innovation and employment.  From the article:

The amount of money spent on buybacks is staggering. From 1997 through last year, 438 companies in the Standard & Poor’s 500-stock index spent $2.4 trillion on them. In 2007, as profits soared, the average buyback bill for each was about $1.2 billion—a record amount. And faced with a dramatic drop in their combined net income in 2008, these companies trimmed buyback spending, but not proportionately: The buyback-to-profit ratio, which was already unprecedented in 2007, more than tripled in 2008, from 0.90 to 2.80.

He further observes that buybacks helped weaken major American firms to the point that they required government bailouts when the economy deteriorated:

If bailed-out General Motors (GM) had banked the $20.4 billion distributed to shareholders as buybacks from 1986 through 2002 (with a 2.5% aftertax annual return), it would have had $35 billion in 2009 to stave off bankruptcy and respond to global competition.

And the bailed-out banks? Eight of the biggest spent a total of $182 billion on buybacks from 2000 to 2007. That reduced their ability to cover their bets on derivatives, exacerbating the crisis they created in the first place.

At the heart of the issue is the conflict of interest between shareholders and management, on one hand, and other corporate stakeholders such as employees, customers, suppliers, local communities, and nations, on the other.  Shareholders have limited liability, so they can profit by extracting as much money from companies as possible during good times, even to the point of taking on debt to pay dividends–a common private equity practice.  If the companies subsequently go bankrupt, the shareholders have already pocketed their profits.  The greater the likelihood of bankruptcy, the greater the incentive for shareholders to take money out.

A more subtle problem is that shareholders have difficulty quantifying and verifying the value of long-term investments, so they prefer short-term investments or cash distributions.  Thus managing for shareholder value becomes managing for the short term, leading to underinvestment in innovation, human capital, and organizational capital.

As Lazonick points out, executive compensation in the form of stock shares and options create incentives for senior managers to buy back shares, since buybacks both distribute cash to shareholders and increase demand for shares.

In the article, Lazonick proposes banning share buybacks, but this won’t solve the problem of short-termist incentives embedded in executive compensation linked to stock price.  So how about limiting the value of stock grants and options to 5% of base salary for employees of publicly traded companies?

Over the last several decades, maximizing shareholder value has become widely accepted as the duty and legitimate purpose of business managers.  Many scholars propounded this ideology, and probably none more forcefully than Milton Friedman.  In a well-known article in the New York Times Magazine in 1970, he argued that “The Social Responsibility of Business is to Increase its Profits“.  In his book From Higher Aims to Hired Hands, Harvard Business School professor Rakesh Khurana describes how this view replaced a conception of the business manager as a steward of the public interest responsible for skillfully balancing the interests of corporate stakeholders to sustain the enterprise and create value for society.  William Lazonick and Mary O’Sullivan provide a complementary perspective.

Unfortunately, while maximizing shareholder value squares nicely with neoclassical economic theory, it can cause serious problems in practice.  In my research project on Public Interest Capitalism, we link shareholder value maximization to inequity, short-termism and underinvestment, and deterioration of social capital.  In a nutshell, there are three fundamental problems with relying on shareholder value maximization as the criterion for corporate management.  First, market incentives (hence profit) may correlate only slightly or even negatively with social welfare (on this point, see David Grewal’s book Network Power).  Second, markets can impede innovation (Mary O’Sullivan provides the details in Contests for Corporate Control).  Third, by reducing the purpose of the company to generating as much profit as possible for a diffuse external constituency, shareholder value maximization decrease the identification of employees to organizational goals, thereby hindering learning and efficient operation.  For a different but complementary perspective, see Simons, Mintzberg and Basu’s ”Memo to: CEOs“.

Fortunately, it appears that the shareholder value maximization movement may have run its course–albeit after bringing the global economy to the brink of collapse.  A group of MBA students at Harvard Business School, concerned about business ethics and inspired by Rakesh’s work, have started MBA Oath, a movement to professionalize management.  The New York Times has the story: “A Promise to Be Ethical in an Era of Immorality“.  This is a very encouraging development.