Tag Archives: shareholder value maximization

Outsourcing, incentives, and "Restoring American Competitiveness"

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.

Applying Public Interest Capitalism to the health insurance industry

Former health care executive Wendell Potter has been calling attention to how health insurance companies increase shareholder value at the expense of their customers and the broader public interest.  Potter left an executive post at CIGNA to become a senior fellow at the Center for Media and Democracy.  His descriptions of how insurance firms short-change their customers and cynically manipulate the political process to serve there masters on Wall Street are a powerful indictment of the shareholder value maximization ideology.  Potter’s interview with Bill Moyers, below, is well worth watching.

Wendell Potter interview with Bill Moyers from YouTube

From a Public Interest Capitalism perspective, one of the most interesting characteristics of the interview is that neither Moyers nor Potter ever questions the ideology of shareholder value maximization–Milton Friedman’s doctrine that a company exists only to make as much money as possible for its shareholders.  So we have only two choices: healthcare managed by greedy corporations who will (metaphorically) throw their customers under the bus to boost profits, or healthcare managed by the government.  Although I have nothing against healthcare managed by the government, my research on Public Interest Capitalism suggests another possibility: restructuring capitalism so that corporations seek to balance private profits and the public interest.

The idea of such enlightened corporate management may seem far-fetched, and it is far-fetched when economic institutions create overwhelming incentives for management to increase shareholder value regardless at any social cost.  But these incentives can be changed.  We could start by prohibiting compensation linked to share price (stock options and stock grants) in publicly traded companies.  Capping executive compensation at a multiple of the compensation of the lowest-paid employee–perhaps forty times–would probably help, too, by limiting the ability of senior executives to profit personally from abusive tactics.  Then limit dividends and voting rights to shareholders who have owned shares for at least five years, thereby reducing the influence of activist investors and hedge funds while protecting the legitimate interests of long-term shareholders.  Requiring that insurance companies disclose, in a standard and easy-to-understand format, performance metrics related to patient satisfaction, recision rates, and so forth would help the public identify abusive firms.

In light of our shareholder-oriented corporate governance institutions, it’s easy to understand why health insurance companies behave the way they do.  Institutions determine whether we can cooperate productively, or whether we slip into wasteful and socially injurious redistributive conflicts, as in the case of the American health insurance industry.  But just because we have developed pathological institutions doesn’t mean that managers necessarily want to behave this way–Potter obviously did not–or that we have to stand idly by as these institutions wreak havoc on our healthcare system and our government.  As Nobel-prize-winning economist Douglass North points out in his book Institutions, Institutional Change, and Economic Performance, institutions are “humanly devised constraints that shape human interaction”.  Humans devised them, and humans can change them.

From hired hands to higher aims?

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.