Organisational purpose – Page 3 – Escondido Framework

Should customers have come first in the GKN battle?

I don’t disagree with Michael Skapinker often, but his commentary on the successful bid by Melrose for GKN in today’s Financial Times “Customers should have come first in the GKN battle” had me getting out a metaphorical red ballpoint to mark his homework.

It was a shame. He made such a good start, rehearsing points that he has made well in the past about shareholder value:

Whose interests should companies serve? For decades, the answer, particularly in the US and the UK, was shareholders’. Total stock market return, the argument went, was clear and measurable and it kept managers focused — until Jack Welch, former General Electric boss and one of shareholder value’s greatest champions, denounced it as “the dumbest idea in the world”.

That was in 2009. Mr Welch was not the only business chief to notice that the financial crisis had shredded the idea that if companies looked after shareholders, everything else would follow. Josef Ackermann, then-head of Deutsche Bank, said: “I no longer believe in the market’s self-healing power.”

A little later in his article, I also awarded him marks for citing the late Sumantra Ghoshal of London Business for arguing in 2005 that:

the people whose contribution should be recognised first were employees, who also took the biggest risks;

shareholders could sell their shares far more easily than most employees could find another job;

and employees’ “contributions of knowledge, skills and entrepreneurship are typically more important than the contributions of capital by shareholders, a pure commodity that is perhaps in excess supply”.

Not content with citing Sumantra Ghoshal with approval, Skapinker moved on later in the article, in the context of the intervention by the Tom Williams, chief operating officer of Airbus’s commercial aircraft division, about the need for long-term investment and strategic vision in the aircraft industry, to cite “the great” Peter Drucker for saying that

the purpose of business was to create a customer. Without that customer, there are no jobs for workers, no returns for shareholders and no strategic skills for nations.

All good stuff, and essentially consistent with Escondido Framework thinking, but Skapinker and others who were unhappy at the outcome of the bid seem to have missed the point about what was happening.

During the takeover battle, much was made of the heritage of GKN, whose origins lay in the founding of the Dowlais Ironworks in the village of Dowlais, Merthyr Tydfil, Wales, by Thomas Lewis and Isaac Wilkinson ion 1759. John Guest (whose name survives in the “G” of GKN – formerly Guest Keen and Nettlefold) was appointed manager of the works in 1767, and in 1786, he was succeeded by his son, Thomas Guest, who formed the Dowlais Iron Company. However, the links to the multinational automotive and aerospace components company of 2018 are slight and accidental.

The company acquired by Melrose consists of four major divisions: GKN Aerospace (Aerostructures; Engine Products; Propulsion Systems); GKN Driveline (Driveshafts; Freight Services; Autostructures; Cylinder liners; Sheepbridge Stokes); GKN Land Systems Power Management; PowerTrain Systems & Services; Wheels and Structures; Stromag); and GKN Powder Metallurgy (Sinter Metals; Hoeganaes). This is a collection of businesses that is the outcome of over a hundred years of acquisitions and disposals across the globe¹. At least at the parent company level, there is little to suggest the opportunity for much value creation from them all being part of the same corporate entity.

What business was GKN plc in? The management of a portfolio of business units, primarily in manufacturing but some in services, spread across a range of different industries and technologies serving a variety of different types and classes of industrial customers, many but not all being OEMs.

Who were the customers of the corporate entity, as opposed to the subsidiaries (which are the entities that interface directly with the purchasers of goods and services, with their employees, and with suppliers)? Perhaps the subsidiaries themselves, insofar that they derived value from the parent company and investment funds, in return for cash returned to the parent? Perhaps the employees of the subsidiaries, at least in so far as they were beneficiaries of a corporately administered pension scheme (that, incidentally, Melrose committed to topping up with an extra £1 billion)?

Much has been made, including by Michael Skapinker in his article, of the 25% of the shares that were in the hands of hedge funds and other short term speculators who had only bought them very recently in the hope of a quick return. Presumably they bought these shares from owners who were willing to sell at a lower price against the possibility that the Melrose bid failed and the share price under the existing management team would fall.

Melrose’s argument during the takeover battle was essentially that it is a management team with a record of successful managing corporate assets who would replace a management team that has been destroying value in its management of the GKN portfolio. The commitments Melrose made along the way to the customers for the GKN subsidiaries’ goods and services and to their employers (in part evidenced by the promises relating to the pension scheme), suggest that they are not old fashioned asset strippers, selling off assets as part of strategy to wind down wealth creating business units. Rather, they appear to understand the business that the GKN plc is currently in, which is managing a portfolio of businesses, adding value to those where it can, and selling those to which other companies can add more value.

If this is indeed the approach that Melrose takes, it will reflect a mindset in which the board thinks about the businesses within the portfolio as customers for the corporate centre, recognising that if there are other corporations that can provide individual business units with a better deal, let them go. And that will make it easier to keep their customers in the capital markets, to whom they have spent the last few months marketing themselves, happy, loyal, and committed.

¹ Wikipedia history of GKN plc since 1966

Revisiting Colin Mayer’s “Firm Commitment”

I first read Firm Commitment[1] when it was first published in 2013 and found the opening chapters – which include a well-constructed critique of the shareholder value paradigm – offered the tantalising prospect that Colin Mayer might be about to expound a theory similar to the Escondido Framework description of the firm occupying a solution space bounded by market interfaces. Unable to recall where his diagnosis of the failings of the modern firm and his prescription for addressing them departed from my own, I recently revisited his book.

Returning to Firm Commitment, I rejoiced again at much of the description in the early chapters of the shortcomings in the classical model of the firm, in which share ownership is linked to provision of investment capital and the assumption of risk. In common with the Escondido Framework, he describes the company as an structure independent of ownership and sees one of its purposes being long term survival, delivering value to society at large. He comes close on occasion to describing some of the other risk bearing parties, the market related transactional considerations and the interests of different stakeholders. In particular, he bemoans the failure of corporations to engage with wider social and environmental concerns.

But rather than continuing down the path developed in the Escondido Framework he focuses on the shareholder and sees the failure of the modern corporation lying in the lack of commitment of shareholders to the company. His prescription is reform to tie in shareholders to the company, to increase their commitment to the firm – hence the book’s title. In contrast to our model, Mayer remains committed to a view that shareholders “own” the company, rather than owning pieces of paper that entitle them a share in the profits of the company and which have a value reflecting a market perspective on the discounted value of the expected future cash flows. What he is unable to explain is how tying in shareholders in this way will improve the quality of decision taking by managers, enhance their accountability, or contain their ability to extract economic rent in the form of salaries, bonuses and equity incentives.

[1] Firm Commitment, Colin Mayer, Oxford University Press 2013

Is Capitalism Killing America?

I was stopped in my tracks this morning by an email from the Stanford Graduate School of Business with the subject line “Is Capitalism Killing America?”. It is not the sort of thing that the world’s top business school (at least that was how it was rated forty years ago when I was there) normally sends to its alumni.

The key feature in the email newsletter was an article with the subheading “Young & Rubicam Chairman Emeritus Peter Georgescu says it’s time to end the era of shareholder primacy[1] which reviews Georgescu’s new book Capitalists Arise! End Economic Inequality, Grow the Middle Class, Heal the Nation (Berrett-Koehler, 2017). Georgescu, a fellow Stanford GSB “alumn”, is looking to chief executives to think about how, and for whom, they run their companies.

Capitalism is an endangered economic system, Georgescu says. He cites by economist William Lazonick, who studied S&P 500 companies from 2003 to 2012 and discovered that they routinely spend 54% of their earnings buying back their own stock and 37% of their earnings on leaving just 9% of earnings for investment in their business and their people.

“Innovation is the only real driver of success in the 21st century, and who does the innovation? Our employees. How are we motivating them? We treat them like dirt. If I need you, I need you. If I don’t, you’re out of here. And I keep your wages flat for 40 years,” says Georgescu, who points out that growth in real wages has been stagnant since the mid-1970s.

Georgescu continues by noting that the lack of investment in business and their people feeds back into demand, undermining sales growth. With median household income in the US less than 1% higher today than in 1989: “There’s no middle class, and the upper middle class has very little money left to spend, so they can’t drive the economy. The only people driving the GDP are the top 20% of us”. 60% of American households are technically insolvent and adding to their debt loads each year. In addition, income inequality in the U.S. is reaching new peaks: The top layer of earners now claim a larger portion of the nation’s income than ever before — more even than the peak in 1927, just two years before the onset of the Great Depression.

Georgescu blames the ascendency of the doctrine of shareholder primacy.

“Today’s mantra is ‘maximize short-term shareholder value.’ Period,” he says. “The rules of the game have become cancerous. They’re killing us. They’re killing the corporation. They’re helping to kill the country……..

“The cure can be found in the post–World War II economic expansion. From 1945 until the 1970s, the U.S economy was booming and America’s middle class was the largest market in the world. In those days, American capitalism said, ‘We’ll take care of five stakeholders,’. Then and now, the most important stakeholder is the customer. The second most important is the employee. If you don’t have happy employees, you’re not going to have happy customers. The third critical stakeholder is the company itself — it needs to be fed. Fourth come the communities in which you do business. Corporations were envisioned as good citizens — that’s why they got an enormous number of legal protections and tax breaks in the first place.

“If you serve all the other stakeholders well, the shareholders do fine,” he says. “If you take good care of your customers, pay your people well, invest in your own business, and you’re a good citizen, the shareholder does better. We need to get back to that today. Every company has got to do that.”

It’s refreshing to hear this from one of the grand old men of the commercial world in the United States. But in his critique of “shareholder value”, he fails to single out the principal beneficiaries, the chief executives and top management teams themselves (including our fellow business school alumni) who have exploited the system to cream off an ever increasing share of the rewards in salaries, bonuses and options, all the while failing to invest in productive assets, innovation, securing long term positions with customers and local communities, and in the people who work in the companies themselves.

[1] https://www.gsb.stanford.edu/insights/capitalism-killing-america?utm_source=Stanford+Business&utm_medium=email&utm_campaign=Stanford-Business-Issue-122-10-1-2017&utm_content=alumni

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

How to build a business that last 100 years?

The Boston Consulting Group’s latest BCG Perspectives brings a TED talk from one of its partners, Martin Reeves, titled “How to build a business that last 100 years”. His thesis is that we should look to lessons from biology to create lasting businesses. He links the failure of businesses to survive – pointing out that the average US public company has a life of only thirty years and probability that any public US company will still be around in five years’ time is only 32% – to a “collapse of the corporate immune system”.

He explains that human immune system, and indeed all successful biological systems from forests to fisheries, and indeed such long lasting social systems as the Roman Empire and the Catholic Church, display six characteristics:

redundancy (“millions of copies of each component — leukocytes, white blood cells – a massive buffer against the unexpected”),
diversity (“not just leukocytes but B cells, T cells, natural killer cells, antibodies”),
modularity (“the surface barrier of the human skin….the very rapidly reacting innate immune system…..the highly targeted adaptive immune system……if one system fails, another can take over”),
adaptivity (“able to actually develop targeted antibodies to threats that it’s never even met before”),
prudence (“detecting and reacting to every tiny threat, and furthermore, remembering every previous threat, in case they are ever encountered again”),
embeddedness (“in the larger system of the human body, and it works in complete harmony with that system, to create this unprecedented level of biological protection…… if one system fails, another can take over, creating a virtually foolproof system”).

He explains that along with and as a consequence of these characteristics, biological systems are complex and can seem inefficient, in contrast to the instincts of most managers and what is taught in business schools and preached by consultants.

Reeves continues by applying these lessons to examples of corporate failure. His first is the tragic loss of independence of Kongō Gumi, builder of Japanese temples for 1,428 years and managed by members of a single family until it forgot the principle of prudence, borrowed heavily to finance real estate purchases in the 1980s and was finally liquidated in 2006 and its assets sold to a large construction company.

Shitennoji Temple, built by Kongō Gumi (578-2006)

He then contrasts the collapse of Kodak with the successful adaptation of Fujifilm, which used its capabilities in chemistry, material science and optics to allow it to diversify into sectors outside photographic film, surviving “because it applied the principles of prudence, diversity and adaptation”. He also cites the success of Toyota in surviving a devastating fire in the only plant which supplied it with valves for car-braking systems. He describes Toyota’s ability to work collaboratively with its suppliers to repurpose production as an application of “the principles of modularity of its supply network, embeddedness in an integrated system and the functional redundancy”.

I am sure that there is something in Reeves’ argument, but some of it is contrived and overall it would be more compelling if some of the example illustrated his six principles more comprehensively, rather than only illustrating one or two.

Certainly Kongō Gumi’s demise reflects a lack of prudence – but the most extraordinary aspect of the story is that it had survived for as long it did, which may reflect the lack of underlying change in the Japanese temple market over almost a millennium and a half. To quote Business Week’s report on its demise:

“To sum up the lessons of Kongo Gumi’s long tenure and ultimate failure: Pick a stable industry and create flexible succession policies. To avoid a similar demise, evolve as business conditions require, but don’t get carried away with temporary enthusiasms and sacrifice financial stability for what looks like an opportunity. These lessons are somewhat contradictory and paradoxical, to be sure. But if sustained success came easy, then all family businesses would have a 1,428-year run.”

The Fujifilm example illustrates the benefit of diversity in a portfolio, but says nothing about the photographic film enterprise itself. Fujifilm’s survival represents the success of a corporate parent in managing a portfolio (ie the business of managing businesses), protecting the interests of a top management group, but says nothing about the business unit that brought together employees who worked in factories producing film, the customers that constituted the channel to the camera owner, or its suppliers. Essentially, as technology moved on, the “virtual space” between the various market interfaces disappeared and nothing that could be done to protect this enterprise. Its corporate shareholder – the Fujifilm group company – had elected to redeploy the cash flow into other businesses because the ultimate shareholders were either not in a position to, or chose not to, intervene.

Toyota is celebrated for how it manages itself supply chain and the nature of these relationships, but the fact of its ability to bring brake valve production on-line quickly illustrates only three, and possibly only two (given that it explicitly did not have redundancy in its supply chain given that it maintained a single source for these components), of Reeves’ biological system characteristics.

Considering Reeves’ argument and his examples and relating them to the Escondido Framework model of the firm, I certainly concur with three of his principles: adaptivity, prudence and embeddedness. I get redundancy, although not quite as he defines it, but at least that bit of spare capacity, underused resource, or financial headroom. But the need for and appropriateness of modularity and diversity must depend on the circumstances, and sometimes are in conflict.

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

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

The dumbest idea in the world?

In an article in today’s FT Michael Skapinker describes how the debate around shareholder value is turning. He notes that Richard Lambert, his former boss now at the CBI, has suggested that the era “Jack Welch capitalism” – the elevation of shareholder value – was drawing to a close, but that the celebrated Jack had marked this himself last year when described shareholder value as “the dumbest idea in the world”, adding that “Shareholder value is a result, not a strategy … Your main constituencies are your employees, your customers and your products.”

Skapinker notes that Unilever’s chief executive, Paul Polman, has recently said the said same to the FT: “I do not work for the shareholder, to be honest; I work for the consumer, the customer. I discovered a long time ago that if I focus on … the long term to improve the lives of consumers and customers all over the world, the business results will come.”

Skapinker’s own observation on these comments, and what has been going wrong, are worth repeating in full:

“I am sure these leaders did not mean shareholders did not matter; rather that they were best served by businesses that performed well over the years. That meant selling goods and services to customers who were happy to come back, and employing staff committed enough to encourage them to do so. Doing that, and doing it profitably, would, over the years, be reflected in the share price.

“The problem has been the rise of shareholders who are not prepared to wait years, but who want a return now, so that they can sell their shares and repeat the trick elsewhere.”

He observes that the focus on shareholder value has resulted in the design of the executive remuneration packages that were designed to address the “agency problem” and to encourage them to do what was best for shareholders. However, any scheme designed to reward a manager will reflect the relatively short time horizon of the individual – unlikely to be in post for more than ten years and probably a great deal less, so in due course retired and on their way to satisfying Keynes’s “long-run” condition. In contrast, companies or, for that matter, their investors, particularly institutions like pension funds and life insurance companies have very long term, even unbounded, time horizons. It is also worth reflecting on the time that it can take to create a great corporation – building a Unilever, a GE, a McKinsey or BCG, one of the great universities, or even one of the sustainable technology companies (Microsoft is now 45 years old and Apple 44 years old), is a matter of generations.

The second issue that Skapinker refers to is interesting. It is hard to see a moral argument for the promiscuous shareholder who trades shares on short term price movements having pre-eminence over the other constituencies (to use Jack Welch’s terminology). With well-developed equity markets, the investor has a far more fungible stake in the company than most employees, suppliers or customers. However, there are parallel issues to executive pay in the rewards in the fund management industry. Many fund management remuneration packages encourage short term trading rather than long term active engagement with investee companies. This is despite mounting evidence (probably best illustrated by the success of an even more iconic figure than Jack Welch – one Warren Buffet, sage of Omaha) for the superiority of long term investment strategies over playing short term market movements.

Skapinker completes his challenge to the primacy of shareholders by observing that “it is the customers who provide the revenue, the employees who produce the goods and services and society that tolerates the company’s presence. It is hard to reward one when the others suffer.”