Other commentators – Page 3 – Escondido Framework

Time to bury Milton Friedman?

Milton Friedman got a name check twice in today’s FT, on the letter’s page and in an article by Philip Delves Broughton on the facing comment page. What was it that Keynes said about defunct economists?*

The first reference was in a letter from Philip G Cerny, Professor Emeritus of Politics and Global Affairs, University of Manchester and Rutgers University, writing in response to Jo Iwasaki who was calling for moral leadership to prevent behaviour like that revealed in the VW Dieselgate:

“The first mandatory prerequisite for company executives is maximum profitability, whether for the company as a whole or shareholders in particular, as Milton Friedman and others have so successfully argued. Culture comes a long way behind, and only comes into play if it actually contributes to profitability. In other words, there is an inherent structural conflict between profitability and the kind of moralistic behaviour Ms Iwasaki wishes to prescribe.

“On the contrary, there is in fact a deep culture of profitability that prevents other sorts of cultural values from working. Only factors outside the company — whether government regulations, the courts, consumer rebellion, strong public interest pressure groups or exposure to scandal (as with Dieselgate) — can be effective, and only then if they do not seriously dent profitability. That’s capitalism.”

The shortcoming in the Friedman perspective on which Cerny relies is the failure to understand that the primary driver for the company executive is self interest, rather than corporate profitability. Corporate profitability is a driver of behaviour only to the extent that it affects self interest. Self interest is a function of lifestyle preferences, reputation enhancement, job security, bonus targets and personal moral compass. The challenge facing boards and investors, and indeed all those with an interest in how the company behaves, is how to align the interests of executives with their own.

The second reference to Milton Friedman is more insightful and comes in Philip Delves Broughton’s column, which is titled “American business is the master, not victim, of globalisation: If businesses saw more value in investing in US workers, they could have done so”.

Delves Broughton addresses the prospects for bring offshored jobs back to the United States, as promised by Donald Trump. Referring to Steve Jobs telling Barak Obama in 2011 that the jobs manufacturing iPhones wouldn’t be coming to the US anytime soon, he notes that manufacturing jobs are increasingly disappearing as automation takes over, and that Shenzen is way down the learning curve and now delivers quality that Apple would struggle to find in the US. However, the principle point of the article is that

“….the best US companies had become brilliant at managing across borders and directing resources to where they generate the highest returns. They weren’t victims of globalisation. They were its masters and had become less and less American.”

Delves Broughton continues later in the article:

“If one accepts Milton Friedman’s argument that a corporation’s sole responsibility is to its owners, then one cannot find fault with these multinationals. They plant their flag where the money is. Their shareholders don’t want them playing the “Star Spangled Banner” in the boardroom. And while they may not directly be investing in American workers, they are generating returns for US investors who can reallocate their capital as they see fit. Mr Trump has done precisely this with his own business, investing in property deals far beyond US shores.

“But this is a fragile argument and Mr Trump is gleefully smashing it to pieces. He knows you cannot respond to stagnant wages and economic insecurity among the working and middle classes with the crystalline logic of a Nobel-winning economist. And he is threatening to perp walk before the press any companies that disappoint him.”

Offshoring in order to harness skills and low cost labour has probably generated greater benefits overall for the US population as a whole, as a consequence of lower prices, higher quality and, for that matter, returns to shareholders. But Delves Broughton is right to challenge the shareholder value orthodoxy that is an expression of the Milton Friedman view of the world. One of the consequences of this way of looking at, and describing capitalism has been the increasing inequality in US society that has fuelled American populism and landed the US, to say nothing of the wider world, with President Trump.

We can only hope that the resilience of American society and politics can withstand four years of a Trump presidency. US companies face a challenging time, notwithstanding the appointment of representatives of large corporations to cabinet posts and promises of tax breaks, as the government tries to deliver on its promises to the rust belt. One way of understanding their plight is to reflect on an excessive focus on the “crystalline logic of a Nobel-winning economist” (while, at the same time, being complicit in the way that top managers were being rewarded by boards composed of their peers at everyone else’s expense) and not paying sufficient attention to the wider constituencies, particularly employees, suppliers and the political world.

*”The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” The General Theory of Employment, Interest and Money (1936), Ch. 24 “Concluding Notes” p. 383-384

Highlights from October 2016 Harvard Business Review

My two picks from the latest Harvard Business Review relate to two Escondido Framework themes: the way that executive teams have been the beneficiaries of the misunderstanding by shareholders (or, rather, their representatives on remuneration committees) of what motivates them and how the relevant market relationships work; and the need to think about employees as customers.

An article titled “Compensation, the case against long-term incentive plans” reviews the work of Alexander Pepper, set out in his book “The Economic Psychology of of Incentives: New Design Principles for Executive Pay (Palgrave Macmillan 2015). Pepper documents how pay for performance incentives, and Long Term Incentive Plans in particular, fail to work as proponents expected. The four reasons are summarised as follows:

Executive are more risk-averse than financial theory suggests
Executives discount heavily for time
Executives care more about relative pay
Pay packages undervalue intrinsic motivation

HBR’s review of Pepper’s work, in its Idea Watch section, comes not long after news broke in London on 22^nd August that Woodford Investment Management was to scrap all staff bonuses, based on the belief that ‘bonuses are largely ineffective in influencing the right behaviours.’

The second article of interest is an article by Cheryl Bachelder, CEO of fast food franchise Popeyes: “How I did it…… The CEO of Popeyes on treating franchisees as the most important customers”. It’s not so much the lesson expressed in the article’s title that excites me, but an extract in the middle of the text that takes the message a stage further, recognising staff as customers:

At one point in my career, I was touring restaurants to talk to team members about the importance of serving guests well. I met a young man who was not excited about my “lesson”. He asked who I was. “I’m Cheryl,” I said. “Well Cheryl,” he said, “there’s no place for me to hang up my coat in this restaurant, and until you think I’m important enough to have a hook where I can hang up my coat, I can’t get excited about your new guest experience program.” It was a crucial reminder that we are in service to others – they are not in service to us.

Timeless themes in Galsworthy’s “Strife” (1909)

My mother in law and I have resolved the problem of the deadweight loss of Christmas (Joel Waldfogel, American Economic Review, December 1993) by giving each other a night out at the theatre, accompanied by her daughter/my wife. Whether last night’s trip to see “Strife” at the Chichester Festival Theatre was her gift to me or mine to her doesn’t matter, it was a great production and my first exposure to John Galsworthy’s insightful exposure of the fallacy of mindless short term focus on shareholder value, the importance of recognising the constraints on the firm of public opinion, and the pressures on the trade union to serve its long term interest over the pressures of the interested parties in the immediate dispute. Furthermore, themes on hand around corporate governance, the tension between external directors and a dominant shareholder chairman, and on the other (in the context of the current junior doctors’ dispute and the tensions within the British Medical Association) between the professional leadership of the trade union and the intransigent leader of the local workers’ committee, have a resonance in 2016 every bit as powerful as they may have had when the play was first performed in 1909.

Wikipedia provides a useful synopsis:

The action takes place on 7 February at the Trenartha Tin Plate Works, on the borders of England and Wales. For several months there has been a strike at the factory.

Act I

The directors, concerned about the damage to the company, hold a board meeting at the home of the manager of the works. Simon Harness, representing the trade union that has withdrawn support for the strike, tells them he will make the men withdraw their excessive demands, and the directors should agree to the union’s demands. David Roberts, leader of the Men’s Committee, tells them he wants the strike to continue until their demands are met, although the men are starving. It is a confrontation between the elderly company chairman John Anthony and Roberts, and neither gives way.

After the meeting, Enid Underwood, daughter of John Anthony and wife of the manager, talks to her father: she is aware of the suffering of the families. Roberts’ wife Annie used to be her maid. She is also worried about the strain of the affair on her father. Henry Tench, company secretary, tells Anthony he may be outvoted by the Board.

Act II, Scene I

Enid visits the Roberts’ cottage, and talks to Annie Roberts, who has a heart condition. When David Roberts comes in, Enid tells him there must be a compromise, and that he should have more pity on his wife; he does not change his position, and he is unmoved by his wife’s concern for the families of the strikers.

Act II, Scene II

In an open space near the factory, a platform has been improvised and Harness, in a speech to the strikers, says they have been ill-advised and they should cut their demands, instead of starving; they should support the Union, who will support them. There are short speeches from two men, who have contrasting opinions. Roberts goes to the platform and, in a long speech, says that the fight is against Capital, “a white-faced, stony-hearted monster”. “Ye have got it on its knees; are ye to give up at the last minute to save your miserable bodies pain?”

When news is brought that his wife has died, Roberts leaves and the meeting peters out.

Act III

In the home of the manager, Enid talks with Edgar Anthony; he is the chairman’s son and one of the directors. She is less sympathetic now towards the men, and, concerned about their father, says Edgar should support him. However Edgar’s sympathies are with the men. They receive the news that Mrs Roberts has died.

The directors’ meeting, already bad-tempered, is affected by the news. Edgar says he would rather resign than go on starving women; the other directors react badly to an opinion put so frankly. John Anthony makes a long speech: insisting they should not give in to the men, he says “There is only one way of treating ‘men’ — with the iron hand. This half-and-half business… has brought all this upon us…. Yield one demand, and they will make it six….”

He puts to the board the motion that the dispute should be placed in the hands of Harness. All the directors are in favour; Anthony alone is not in favour, and he resigns. The Men’s Committee, including Roberts, and Harness come in to receive the result. Roberts repeats his resistance, but on being told the outcome, realizes that he and Anthony have both been thrown over. The agreement is what had been proposed before the strike began.

Missing from the synopsis are some of the more subtle themes in Galsworthy’s text, including the recognition by Harness of the reality facing the company (that it will not survive if the strike continues and the men’s jobs are on the line) irrespective of Roberts’ concern for a wider struggle against “Capital”, John Anthony’s arguments about the primacy of the bottom line and his duty not to compromise, and the concern of the majority of the directors of the company for public opinion (and their personal reputations).

Linear programming and the theory of the firm – flashback to the 1950s

Exposure to linear programming while doing my MBA at Stanford informed the model of the firm that I described first in May 1980 in a paper for Steve Brandt’s seminar on strategic management and developed into a core component of the Escondido Framework. So when I was told recently about Robert Dorfman’s “Application of linear programming to the theory of the firm” (Berkeley, 1951) and a collection of essays from a 1958 symposium at the University of Michigan edited by Kenneth E Boulding and W Allen Spivey titled “Linear programming and the theory of the firm” (New York, 1960), I thought I should take a look.

Both titles engage somewhat futilely in trying to extend the application of linear programming beyond its useful limits, and swamp the conceptual opportunity of applying a way of thinking about organisational problems with multiple constraints with the desire to created mathematical analytical models under conditions that are necessarily massively complex, non-linear, and dynamic.

Dorfman’s final chapter, on “Assumptions, Limitations, and Possibilities” highlights the limitations of the techniques that he explored in the previous chapters, particularly in relation to the static conditions under which the analysis might be undertaken, the challenges of coping with a dynamic and multi period condition, and with uncertainty. He effectively gives up: “There is little reason to hope that linear programming, or any other simple formulized technique will be able to comprehend this entire problem”. This probably still applies even in an age of massive computing power and ability to capture and interrogate “big data” that Dorfman could never have imagined. He did acknowledge that at the time of writing his book that “linear programming emphasises the physical inter-relationships of productive processes almost to the exclusion of the demand side”. My memory of studying linear programming at the Stanford Graduate School of Business in 1979 is that in this respect at least the commercial applications of linear programming had moved on the in following few decades. Ultimately, however, Dorfman retreats back into an assumption that linear programming could be best applied to managing and optimising internal processes, accepts that the practical applications will be limited in the short term, but remained hopeful, that “economists can rely on the mathematicians, the electronicists, and the statisticians to provide a practical tool.”

The final two essays in Boulding and Spivey’s collection move beyond the descriptions in the earlier essays of the mathematics of linear programming and how they might be applied to the activities of the firm. Interestingly in the context of a book about the application of linear programming, both end up focussing on the difficulty defining the objective function for the firm, arguing that firms seek to more than just maximise profits.

C.Michael White’s essay “Multiple Goals in the Theory of the Firm” reviews the thinking prevailing at the time about the various goals for the firm, both within the scope of profit maximisation (eg in relation to time horizons, to strategic considerations such as discouraging competitive market entry, and in relation to public relations). He cites AG Papandreou, suggesting that he had pointed out that “profit is simply one possible ranking criterion in a broader system of preference-function maximisation. Under perfect competition, profit is the only ranking criterion consistent with survival. In the absence of perfect competition the long-run survival of the a firm may be achieved best (or at least as well) through the maximisation of goals other than profit.”

White addresses the issue of the survival of the firm “The firm as a social and economic organization, like many other organisms, has a compelling urge to survive. More fundamental than the profit motive, the motive to survive is implicit in most decisions within the firm, though the possibility of organizational suicide should not be ruled out”. He later observes “Survival, including the consequent homeostasis concept (Boulding, Reconstruction of Economics, New York, 1950) is seldom an explicit primary goal of a firm but instead provide a pervasive set of limitations on other goals including profit.” However, White fails, surprisingly in an essay in a book about linear programming to close the loop that is embedded in the Escondido Framework model of the organisation as the occupying the virtual space bounded by its market interfaces with customers, capital, labour, other suppliers etc. But he goes some way in this direction, for example identifying later in the paper that “In most instances financial objective are evidenced as additional constraints on other objectives.

White’s summary is as good a description of the objective of the firm as any I have come across since embarking on this project in 1980: “The goals of firms represent a wide array of alternative objectives of which profit maximization is only one, although without doubt a most significant one. In those instances where firms strive to maximize profit all other aspects of the firm’s behaviour impose restrictions on this goal.” (He continues his summary by observing “The difficulty of estimating with accuracy the long-run prospects of a firm makes survival or homeostasis (when interpreted as a relative position within an environment) the most likely long-run objective.”)

Sherrill Cleland’s “A Short Essay of a Managerial Theory of the Firm” is an insightful attempt to move beyond what he describes as “the Traditional Firm”, a limited model developed from the work of Marshall, Chamberlin and Robinson in the 1930s and 1940s essentially seeing the firm as a passive respondent to conditions imposed by external markets for consumption, capital, labour, and materials, and the competitive industry structure. He describes how while economists were studying the operation of the market to understand the allocation process, businessmen were “developing a strong propensity to innovate in order to gain temporary monopoly control over market forces. As the businessman learned by doing, his propensity to innovate shifted to a propensity to monopolize and temporary monopoly became more permanent. The pattern of internal decision-making which he followed was designed to minimize the external constraints which had theoretically limited his decision alternatives. The initial managerial revolution, then, was an attempt by the businessman to control or influence the external forces (the product market and the factor market) that had been controlling and limiting him. That he was successful, and patently so, is evidenced by our antitrust laws. He wished to expand his field of choice, his set of alternatives, while simultaneously reducing the degree of uncertainty he faced.” He captures the different types of relationship with these external forces in the following figure, that distinguishes between those that the business accepts as given, those that provide a degree of restraint but are subject to influence, and the activities that the firm can reshape in response to its own decisions.

Cleland later proceeds develop his “Managerial Theory”, reflecting how the firm, operating in imperfect markets and consequently with options in terms of pricing and other parameters, is in a position to take choices about its internal operations, processes and outputs, and consequently is able to consider goals other than straightforward profit maximisation. He considers the possibility of satisficing behaviour, for example ensuring only that profit levels exceed the cost of capital and perhaps share the benefits of market power through spending on social responsibility programmes, and also minimax behaviour, for example by engaging in defensive pricing to secure long term contracts and thereby reduce uncertainty or discourage competitive entry.

Cleland further explores how decisions are made within the firm, and highlights to failure of traditional economic models of the firm to consider the role of the people within the firm, in particular the “manager-executive” in taking decisions, and in turn the way that the institutionalised processes, policies and procedures shape the way that decisions are taken, and the decision themselves. He also examines the firm as an information system, with flows both up and down the organisation, to provide the basis for decision-taking by managers and their execution of these decisions by subordinates.

In common with Dorfman, Cleland hopes that his essay is merely laying the foundations for further work, but I have been unable to establish whether he undertook further work in this field or whether this essay provided the foundation for the work of others. Nonetheless, a sentence in his closing paragraph about his “Managerial Theory” that deserves wider airing for its emphasis on “satisfactory profit” and the decision-making power of management: “The managerial theory of the firm considers the firm as an organized information system, intent upon a satisfactory profit level operating in an external and internal environment which allows the manager significant decision-making power.”

“Shareholder value ……. the biggest idea in business” – Really?

The Economist has published a useful analysis of the place of “Shareholder Value” in contemporary thinking about business and the firm (Shareholder Value: the enduring power of the biggest idea in business*, The Economist, 2 April 2016).

The article describes the evolution of the idea that the purpose of the firm is to maximise shareholder value, its primacy first in the Anglo Saxon world, but its pervasiveness today globally wherever commerce is practised. It also cites the objections to capitalism of a society that sees corrupt and failing businesses and widening social inequality.

It describes the challenges faced by Shareholder Value. The first that is it

“is a licence for bad conduct, including skimping on investment, exorbitant pay, high leverage, silly takeovers, accounting shenanigans and a craze for share buy-backs, which are running at $600 billion a year in America”

but the Economist then argues that these are essentially perversions of Shareholder Value:

“These things happen, but none has much to do with shareholder value. A premise of “Valuation” is that there is no free lunch. A firm’s worth is based on its long-term operating performance, not financial engineering. It cannot boost its value much by manipulating its capital structure. Optical changes to accounting profits don’t matter; cashflow does (a lesson WorldCom and Enron ignored). Leverage boosts headline rates of return but, reciprocally, raises risks (as Lehman found). Buy-backs do not create value, just transfer it between shareholders. Takeovers make sense only if the value of synergies exceeds the premium paid (as Valeant discovered). Pay packages that reward boosts to earnings-per-share and short-term share-price pops are silly.

“Outbreaks of madness in markets tend to happen because people are breaking the rules of shareholder value, not enacting them. This is true of the internet bubble of 1999-2000, the leveraged buy-out boom of 2004-08 and the banking crash. That such fiascos occur is a failure of governance and human nature, not of an idea.”

The second is the challenge of the stakeholder model:

“that firms should be run for all stakeholders, not just shareholders. In a trite sense the goals of equity-holders and others are aligned. A firm that sufficiently annoys customers, counterparties and staff cannot stay in business.”

The Economist then goes on to describe the difficulty finding an objective to replace shareholder value, including risk of potentially unintended consequences of placing too much emphasis on specific stakeholder, for example by protecting employment to the point that a company goes under. It then concludes that “For these reasons shareholder value—properly defined—will remain the governing principle of firms” but with the qualification that “shareholder value is not the governing principle of societies. Firms operate within rules set by others.”

The Escondido Framework turns a lot of this thinking on its head. Maximising shareholder valuation is not an absolute objective: rather the management of a company need to deliver sufficient shareholder returns, including the prospect of returns, to secure the capital the company requires and to satisfy shareholder that they would not be better off using such influence as they have in the financial instruments they hold to replace them with other managers. This is fundamentally no different to the task they face setting terms of employment to secure the necessary workforce, and designing products and services and setting prices to attract and retain customers. The Escondido Framework also argues that other, non-financially mediated markets have also to be considered, to keep regulators on-side and to maintain a favourable climate among the public at large who may ultimately influence the behaviour of governments or even do such perverse things as consequence of their alienation as to cast votes to leave a continental economic union that underpins the welfare of the economy.

One of the underlying conclusions of the Escondido Framework is that shareholder value is not the governing principle of firms. This is a descriptive not a normative statement. Firms are managed to keep shareholders of management’s backs. Inefficiencies in capital markets and corporate governance result in perverse and/or satisficing behaviours by managers in relation to shareholders, as evidenced by the lack of control of executive salaries and value destroying M&A activity. Firms that are successful in the long term in terms of market presence, satisfying customers and being places that employees report as attractive places to work, whose standing and reputation with the public helps reduce pressure for adverse regulation from government, happen also to be those who are successful in providing returns to shareholders over the long haul that attract long term investors who, like Warren Buffet, manage to generate superior returns. The deal works this way round, not the other way!

*The authors regrettably seem unaware that Jack Welch once described Shareholder Value as “the dumbest idea in the world” – see blog post 10th April 2010

John Kay: Shareholders think they own the company — they are wrong

At the risk of breaching copyright, John Kay’s column in today’s Financial Times needs reproducing in its entirety!

So whose is the business? No one’s, just like the river Thames

Stock exchange: Who owns shares in a company? A name is recorded on a share register and someone else makes a decision to buy or sell

Shareholders own the corporation, and the duty of the directors to maximise shareholder value follows from that. I have lost count of the number of times I have been told “that is the law”.

But it is not the law. Certainly not in America, as Lynn Stout, a professor at Cornell University Law School, has pointed out.

Shareholders in England have more rights — but even there, the obligation of a company director is to promote the success of the company for the benefit of the members. The company comes first, the benefit to the members follows from its success.

And English shareholders are definitely not owners. The Court of Appeal declared in 1948 that “shareholders are not, in the eyes of the law, part owners of the company”. In 2003, the House of Lords reaffirmed that ruling, in unequivocal terms.

Ownership is not a simple concept. The classic account of its meaning was given 50 years ago by another legal scholar, Tony Honoré.

Ownership, like friendship, has many characteristics and if a relationship has enough of them we can describe it as ownership.

If I own an object I can use it, or not use it, sell it, rent it, give it to others, throw it away and appeal to the police if a thief misappropriates it. And I must accept responsibility for its misuse and admit the right of my creditors to take a lien on it.

But shares give their holders no right of possession and no right of use. If shareholders go to the company premises, they will more likely than not be turned away.

They have no more right than other customers to the services of the business they “own”. The company’s actions are not their responsibility, and corporate assets cannot be used to satisfy their debts.

Shareholders do not have the right to manage the company in which they hold an interest, and even their right to appoint the people who do is largely theoretical. They are entitled only to such part of the income as the directors declare as dividends, and have no right to the proceeds of the sale of corporate assets — except in the event of the liquidation of the entire company, in which case they will get what is left; not much, as a rule.

There is a stronger case for asserting that a company is “owned” by its directors than there is for its shareholders. There is little doubt that if you explained to a Martian what earthlings mean by ownership and asked who owned a corporation, the Martian would point to the C-suite.

So who does own a company? The answer is that no one does, any more than anyone owns the river Thames, the National Gallery, the streets of London, or the air we breathe. There are many different kinds of claims, contracts and obligations in modern economies, and only occasionally are these well described by the term ownership.

It makes little sense even to ask who owns shares in a company. One name is recorded on a share register; someone else makes a decision to buy or sell; someone else decides how the shares are to be voted; and someone else benefits from the returns from the company’s activities.

It is not only possible today, but usual, for all these rights to be exercised by different people. And that is even before taking account of the complications introduced by stock lending.

As Charles Handy has written, when we look at the modern corporation, “the myth of ownership gets in the way”. Clear thinking about business would be easier if we stopped using the word.

Failing the marshmallow test

The BBC World Service is the insomniac’s salvation. If you are lucky, a background of talk radio helps you back to sleep. If you are luckier still, you stumble on a piece of quality programming that Auntie has chosen to share with the rest of the globe but not with its domestic listeners.

“In the Balance”, a business programme presented by Andy Walker at 03:30 GMT on Sunday 2nd November, included a first class discussion of short termism between Bridget Rosewell, Geoffrey Franklin and Richard Dodds, following an interview with John Kay that marked the second anniversary of the publication of his report for HM Government on short termism in equity markets.¹

The essential conclusion of the Kay report [reference needed] was that there is too much short termism in UK corporate life at the expense of addressing long term competitive advantage. The top management of quoted companies focus unduly on hitting 3 monthly targets, which are a poor measure of management competence, and have been rewarded accordingly. The 1990s featured attempts to align management incentives with the interests of shareholders, but the net result was that “many people who were quite incompetent made quite a lot of money”. Kay concludes that regulation is not the solution, but that a change in culture is required, but that it is hard to know how to do this, and harder still to measure progress.

Kay expanded on the culture change required and the inherent difficulties. He referred to the “marshmallow test”, an experiment with 4 year old children. Most, when presented with a marshmallow and told that if they wait 5 minutes before eating it they will be given a second one, will eat it right away. (A celebrated study of children subjected to the marshmallow found that those who exhibited a lower personal discount rate and exercised sufficient self control to win the second marshmallow – or maybe just had the insight to understand the challenge facing them – prospered more in later life). Andy Walker asked John Kay whether he was saying that executives simply need to grow up, to which Kay responded “a lot of company directors would fail the marshmallow test.”

In the ensuing discussion among the panellists, Bridget Rosewell blamed her profession (economists) for promulgating the view that all the information about the future prospects of the company is captured in the share price, and consequently many board level remuneration packages have been structured around movements in the share price, and the panel as a whole seemed to conclude that we have spent years telling people to focus on the wrong thing. Further, Rosewell also observed that “All markets exist in institutional contexts and cultural contexts.”

Is John Kay right? Undoubtedly yes. But the supplementary questions are more interesting: why do so many fail the marshmallow test; and what can we do about it?

There are probably could be three underlying reasons for the behaviour Kay describes.

One is that, notwithstanding the experimental data that suggests that people who come out on top in later life are those who as small children passed the marshmallow test, perhaps some of those who make it to the upper reaches of commercial organisations respond disproportionately to short term signals. (Or maybe, by the time that they have reached the upper reaches they are no longer capable or responding to anything other than short term signals?). This is not something that I have observed myself, but there may be some revealing academic research lurking in the nether regions of a business school somewhere that addresses the personality types of chief executives and points to this failing.

A second explanation could be that human timeframes and organisational timeframes may be intrinsically misaligned. “In the long run, we are all dead.” The career time horizon for a typical chief is only exceptionally longer than twenty years on first appointment. Even then, the time horizon within the specific appointment is only exceptionally more than ten – and probably for very healthy reasons including personal boredom thresholds and the benefit from time to time for a fresh set of eyes on a problem. Whether it is desirable is irrelevant, it is entirely reasonable for individuals to consider the rewards – both material and emotional – that will flow from what is deliverable and measurable within their own term of office. And although they may also be concerned for their own legacy in the role, they also have to reflect that they have little power to stop those who come after them frittering it away.

The final explanation relates to the institutional and cultural frameworks about which Kay and the “In the Balance” panellists agonised. The evidence here is compelling (although I would not go as far as Rosewell in condemning the argument that share prices capture all the information about a company – the point, for discussion in more depth elsewhere, is that the prices of traded financial instruments are corrupted because they also capture information about expectations about trader behaviour (in an economist’s version of Heisenberg’s Uncertainty Principle). Many management teams have been presented by academics, consultants, brokers, investment bankers, and journalists, arguably in error, that they must respond to and seek to affect short term share price performance, and the regulator environment has encouraged rather than discouraged this. Given that the possibility that the first of these three explanations holds true for some executives, and the probability that the second of these three explanations holds true for most, it is all the more pernicious that the we have aligned cultural and institutional frameworks in this way. Instead, we need to bend over backwards to create a culture and institutional framework as a counterweight to the possibility that personal discount rates – driven by hardwired human appetites and instincts – are higher than those of companies and organisations in general, and society overall.

So, who’s eaten my marshmallow?

¹ The Kay Review of Equity Markets and Long Term Decision Making, July 2012

“It’s 80% Dark Matter”

I attended the launch of “Collaboration Strategy: How to Get What You Want from Employees, Suppliers and Business Partners”, the new book by Felix Barber and Michael Goold of the Ashridge Strategy Management Centre. The book contains plenty of good material on structuring terms with the parties who you work with and aligning incentives. Reflecting the past service of both authors with the Boston Consulting Group, it has plenty to say about focusing on those activities in which you enjoy competitive advantage and outsourcing the others.

Publisher’s glass in hand, I was listening to Felix deliver a short lecture providing a synopsis of the themes of the book when someone¹ muttered in my ear: “they’re talking entirely about markets and financial incentives, but in reality it’s 80% Dark Matter”. This is a powerful metaphor and an important insight: we need to recognise that there is lot of dark matter out there in the economy and without it nothing works. Market forces and financial incentives alone do not explain how organisations, partnerships and collaborations operate and why we need them. Barber and Goold do acknowledge, buried deep in their text, that there may be more going on by commenting that they “don’t wish to downplay the importance of other approaches to motivating employees and other partners”. But, possibly reflecting lifetimes as consultants and academics, they convey in the book the impression that they don’t recognise the amount of Dark Matter that the system needs.

¹ David Pitt Watson, sometime managing director of BCG rivals Braxton Associates, Labour Party Finance Director, boss of the activist investment fund Hermes Focus and now social entrepreneur and responsible investment guru.

Strategy: a dialogue between desire and possibility

When someone as eminent as military historian Sir Michael Howard reviews a new book by a young former soldier by describing it as “a work of such importance that it should be compulsory reading at every level in the military” and (recognising himself that he is “really go[ing] overboard” ) that the book “deserves to be seen as a coda to Clausewitz’s On War” you know that you have to read it and that your expectations have been set very high.

Emile Simpson’s War from the Ground Up: 21st Century Combat as Politics deserves a much wider audience than just the military. It sparks ideas about analogies in other parts of life; the experience of a young officer in Helmand Province has meaning elsewhere.

One of his most powerful ideas is the recognition that we need to understand how our actions will be interpreted, and when then they can be interpreted in multiple ways they risk becoming ineffective:

To use an analogy, the market is an interpretive structure whose function is to impose a specific type of meaning, a price, on a product. When the market cannot allocate a price (which is one of its basic functions), its mechanism breaks down and it loses utility. This happened in the financial crisis of 2008, when many derivatives were so complex that the market could not price them. The market seized up its basic mechanism stopped working. When an action in war can be interpreted in a multitude of different ways depending on the prejudice of the audience, it is very hard to make armed force have political utility in a Clausewitsian conception of war: for a military outcome to set conditions for a political solution it needs to be recognised as such. (p.74)

But his comments on strategy are more powerful still:

Essentially strategy is the dialectical relationship, or the dialogue, between desire and possibility. At the core of strategy is inevitably the problem of whether desire or possibility comes first. Does one start with the abstract idea of what is desired, or should one commence by consideration of what is realistically possible? This is a chicken and egg situation.

The two should ideally be in perpetual dialogue, not just before but also during a conflict. Desire must be grounded in possibility; possibility clearly requires an idea in the first place which informs any analysis of possibility…..

Understood as dialogue between desire and possibility, strategy is as much the process that handles this dialogue as the output of the dialogue itself. (p.116)

“Shareholders do not own companies, nor do they own the assets of companies”

Six academics, from law schools and business schools in the US, UK, and continental Europe, have written a first class letter to the Financial Times today, printed under the headline “Acknowledge that companies remains separate legal entities”.

They take the Business Secretary to task for slipping into the trap of asserting, in the course of the controversy over bankers’ pay, that shareholders “own” banks.

Kent Greenfield and his colleagues write:

“….the notion that shareholders own companies is simply incorrect.

Shareholders do not own companies, nor do they own the assets of companies.

Shareholders own shares of stock – bundles of intangible rights, most particularly the rights to receive dividends and to vote on limited issues.

Unfortunately the erroneous notion….that shareholders own companies seems to have side tracked the discussion, and policy formation, around corporate governance leading to an inappropriate and ultimately counterproductive focus on shareholders.

…..companies are separate legal entities, without owners, and effective corporate governance involves the consideration of a variety of parties not, necessarily, shareholders.”

Signatories to the letter: Kent Greenfield (Boston College Law School); Andrew Johnston (University of Sheffield); Jean-Philippe Robé (Sciences Po Law School, Paris); Beate Sjåfjell (University of Oslo); Andre Spicer (Cass Business School); Hugh Willmott (Cardiff Business School)