Shareholder Value Maximization: The World’s Dumbest Idea?

James Montier, member, asset allocation team, GMO

The CFA Institute European Investment Conference is a focused, interactive conference for Europe’s leading investment professionals. The 2016 CFA Institute European Investment Conference will bring portfolio managers, analysts, chief investment officers, and CEOs together in Amsterdam on 7–8 November.

If you agree with the economist John Maynard Keynes that “ideas shape the course of history,” then you ought to agree that the history of modern business and finance has been shaped by one influential idea: that the job of a company’s management is to maximize shareholder value. But according to James Montier, a distinguished investment professional and behavioural finance writer, shareholder value maximization is “a bad idea.” He believes it has not added any value for shareholders and has contributed to such major economic and social problems as short-termism and rising inequality.

Montier made his case against shareholder value maximization when delivering the closing keynote address at the 2014 European Investment Conference in London, a video of which can be viewed below. In his characteristic iconoclastic style with a generous use of ironic humour, Montier labeled shareholder value maximization, the way Jack Welch, the former CEO of GE, had once described it in 2009, as “the dumbest idea in the world.”

An Academic Opinion without Much Evidence

Montier said that the idea of shareholder value maximization didn’t come from businesses but rather originated as an opinion in academia and was unsupported by much evidence. It is most directly traced to an op-ed written by economist Milton Friedman in 1970. Over the years, academic research papers on the subject, such as those by Michael C. Jensen and William H. Meckling (PDF) and Jensen and Kevin J. Murphy (PDF), have made it inseparable from the alignment of incentives. That is, top management of companies should be offered financial incentives (e.g., stock ownership and call options) to align their interest with maximizing the stock price.

The idea of shareholder value and incentives then worked its way into practice. Montier gave the example of Business Roundtable (BRT), an association of CEOs of major US companies. He said that in 1981, the mission of BRT referred to making quality goods and services, earning a profit, and building the economy, but by 1997, it became firmly focused on shareholder value.

Failing Shareholders

Montier claimed that shareholder value maximization has failed the shareholders — its intended beneficiaries. Despite enormous increases in compensation of CEOs and a rising proportion of financial incentives through stock ownership and options, shareholders are not better off. To illustrate this point with a case example, Montier compared the return performance of IBM, which switched its focus to shareholder value maximization, to that of Johnson & Johnson, which retained its credo (PDF) emphasizing responsibility to customers, employees, and communities. Montier showed that during 1971–2013, the stock of Johnson & Johnson had indeed outperformed that of IBM.

Widening his analysis, Montier asserted that during 1940–1990, what he called “the managerial era,” the annual real return to shareholders in listed equities was 7%. After the 1990s, during “the shareholder value maximization era,” it was also about 7%. But, he added, when adjusted for changes in valuation independent of shareholder value maximization, isolating yield and growth, the return in the shareholder value maximization era lags by about 2 percentage points.

What Went Wrong?

Montier said that financial incentives for management that were meant to maximize shareholder value did not work because of a flawed understanding of how human beings respond to incentives. Under the mantra of shareholder value maximization, CEOs are now being paid more than ever before and about two-thirds of that compensation is in the form of stock ownership and stock options. Call options, which only pay off if stock prices rise, encourage short-term gaming by CEOs rather than long-term value creation. More importantly, as research from behavioural finance shows, when incentives become large, those being incentivized become obsessed with the incentives themselves and lose sight of what the incentives are meant to achieve. Montier believes that rather than focusing on the long-term prosperity of their businesses, CEOs are focusing on how much more money they can make if they can game the system.

Instead of observing reality and deducing their theories from what they see, Montier claimed, economists supporting shareholder value maximization tried to fit available facts to their opinions about incentives and human behaviour. Montier quoted President Ronald Reagan: “An economist is someone who sees something happen in practice and wonders if it’d work in theory.

A Cause of Short-Termism and Inequality

Montier contended that shareholder value maximization and financial incentives are a direct cause of short-termism and inequality. The life-span of an S&P 500 company has decreased from more than 26 years in 1971–1976 to close to 15 years in 2005–2010, and the average tenure of CEOs has shrunk from 10 years to six years. Private companies, not subject to the same short-termism pressures, invest more than public companies, and CFOs of listed companies are willing to forego projects with positive net present value to make quarterly earnings targets. From “retain and reinvest,” companies have moved to “downsize and distribute.” It is hard to argue that companies do not have ample investment opportunities available to them in the real economy, but many companies are instead buying back shares, often at record high prices.

Connecting short-termism with its effects on society and economy, Montier pointed to “three stylized facts”:

  1. Business investment as a percentage of GDP is declining.
  2. There is rising income inequality in society (PDF), and the share of income of business executives and financiers has increased dramatically.
  3. Labor is losing its share of GDP.

Short-termism and inequality hurt our societies and economies, Montier said. There are fewer new projects and jobs because companies are preoccupied with meeting quarterly earnings targets. There is also less spending in the economy, slowing down our economic growth, as those who spend a higher proportion of their income have a lower share of income.

Montier believes that our world would have looked different if instead of maximizing shareholder value and enriching themselves with exorbitant and problematic incentives, those managing companies were required to focus on running their businesses, producing quality goods and services, treating customers and workers fairly, and creating shareholder value as a by-product, not as an objective.

If you liked this post, consider subscribing to the European Investment Conference blog.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

This entry was posted in News, Speakers and tagged , , , . Bookmark the permalink.

20 Responses to Shareholder Value Maximization: The World’s Dumbest Idea?

  1. Graham Clark says:

    Good article thank you…. As Charlie Munger referred to in “The Psychology of Human Misjudgment” a case of ‘Incentive caused Bias’.

  2. As Montier concluded his case against shareholder value maximization, CFA Institute conducted an instant digital poll of conference delegates, mostly seasoned investment professionals, to get their view. Here are the results.

    How sound or flawed is the idea and practice of shareholder value maximization?
    Both the idea and its practice are largely sound (5%)
    The idea is largely sound but the practice is largely flawed (58%)
    Both the idea and practice are largely flawed (31%)
    Undecided (6%)

    • Very interesting results. Shame about the technical problem – it would have been really interesting to know what the audience thought at the start. But, as you say, this is not a new debate for seasoned professionals.

      The idea that SVM theory is good but the practice flawed seems to me a bit like saying communism is fine in principle, it’s just that it gets let down by (all) the practitioners! Surely after 30 years plus of experimenting with “aligning pay”, we should be authentic – ethical to use the language of the #FutureFinance – and stop clinging to the excuse that we can distinguish between “good” theory and “bad” practice! What we experience today is the theory in practice!

      The bigger question – which warrants another session/event – is what should replace this flawed theory? And what can investors do to be less a part of the problem? It’s interesting Jim made no reference to the ESG debate at all. Perhaps we could usefully join the dots. And this is in both directions – eg do SRI fund managers do anything different about the short-termism challenge?

  3. Pingback: Saturday links: penny stock punishment | Abnormal Returns

  4. Panskeptic says:

    Another poisoned flower from Milton Friedman. That man did a lot of damage.

  5. Pingback: What Really Grinds my Gears | the yinzer analyst

  6. Vivek says:

    I’m agree with the article but i think if ‘Maximization Shareholder’s wealth’ is not getting first priority. Then at what level and factors, company is successful in arousing its further investors to invest in its company ?

    • Vivek

      Thanks for visiting our blog and sharing your comment.
      As I understand, shareholders are be offered a return, the problem is with “maximization” and the singular focus on SVM.

  7. Mthokozisi Nkomazana says:

    SVM should never take centre stage of the business, l believe that if a business entity can focus on sustainability and contuinity, growth and corporate social responsibility, then, SVM will be reaped as a ripe fruit when the time is due.

    It is funny how business tend to talk much about ethics, but in practice the only objective they are concerned with is enrinching the owners rather than the lives of low income earners and the community at large, and subsequently the economy at large.


  8. Pingback: Shareholder Value Maximization: The World’s Dumbest Idea? | The Big Picture

  9. Pingback: 10 Weekend Reads | The Big Picture

  10. Jarno says:

    Very good read, thank you

  11. Pingback: Week In Review | Prudent Trader

  12. kwame Brooks says:

    Very interedting reading. If businesses are more rounded in their focus and contribution to society and the various contributors that have been sactificing to faciliitate their survival, then it SVM automatically follows.Business should focus on value creation through the provision of goods and services that advances the standard of living of the society.

  13. Robert Steiner says:

    This article and presentation were terrific. Is there any way to get a copy of the Power Point deck from Mr. Montier’s presentation? He used some very competlling charts and graphs I would love to share with my colleages. Thank you.

  14. Peter M.J. Gross says:

    Thanks for your comment, Robert.

    Unfortunately, a copy of Mr. Montier’s presentation is not available for distribution.

  15. Azo Napoli says:

    I have just found out about the Shareholder Value Maximization issue, despite being an avid NYT reader for the past 8 years… (obviously I am not an economist). My question however is this: this seems to be an ultra important issue defining the very character of modern capitalism in the most critical manner along with the real life conditions of our very own lives.. How on earth is it possible that we are not discussing this ALL day and ALL night on news media (even sophisticated media like nyt or wapo seem clueless of the issue) instead of being so utterly fixated on things like the repeal of the Glass-Steagall act? Obviously the G-S act was a contributing factor but this incentive design is going to be responsible for the collapse of the system sooner or later if things continue like that. Do u think I am getting the picture right?

Leave a Reply

Your email address will not be published. Required fields are marked *