August 1, 2013 Leave a comment
Recently, business author and Forbes.com contributor Stephen Denning took up a topic that we found compelling — arguing from new research that suggests that privately held firms engage in greater investment than publicly-traded firms. The short version of the argument goes that public firms invest less of their profits in new capacity or ventures to grow the company itself than do private firms. There are a number of explicit and implied explanations of this apparent phenomenon, including claims that public firms are essentially engaged in “maximizing shareholder value” in a way that tends to be short-term in nature.
One might paraphrase and say that public companies play to the market to maximize value via their stock price rather than long-term company value. This case has often been made in more simplistic terms, but there is some intuitive appeal to the argument. For years lip service has been paid to the contributions and values of small and medium-sized businesses (SMBs) to our economy, but the research might finally be validating what many people hold in their gut — the feeling that small business contribute far more to the economy than they are given credit for, and conversely that publicly-traded companies might be getting credit for doing good for the economy when they’re really just doing good for themselves.
We might not agree with some of Denning’s praise of certain companies he deems to be creative contributors, but the observations and conclusions are certainly worth considering. What do you think???
-SMB Matters Blog Team
How The ‘World’s Dumbest Idea’ Killed The US Economic Recovery
Now the Financial Times reports that the short-term shareholder value theory has a new feather in its cap: it is responsible for killing the economic recovery that should have occurred after the financial meltdown of 2008.
Over the last month, the Financial Times has been doing a great job in cataloguing the problems caused by the shareholder value theory. Now Robin Harding has terrific article pinpointing its role in undermining the US economic recovery.
In his article entitled “Corporate investment: A mysterious divergence” he explores a conundrum that has puzzled the world’s top economists: why is net investment at a measly 4 per cent of output when pre-tax corporate profits are now at record highs – more than 12 per cent of GDP?
In standard economic theory, this makes no sense. When profits go up, companies should be seizing investment opportunities to lay the groundwork for even more profits in future. In turn, that investment should create jobs, generate more capital goods and lead to higher wages. That’s how capitalism is meant to work. So why isn’t it happening? Mr. Harding explores systematically why all the leading scapegoats for what’s gone wrong—regulations, Obamacare, tax policy, fear of another financial crisis and so on—and shows why they don’t add up.
Then he comes up with the kind of thing that you rarely see in economics—a study that enables us to pinpoint the problem by offering “with” and “without” data.
A brilliant study by economists from the Stern School of Business and Harvard Business School, Alexander Ljungqvist, Joan Farre-Mensa, and John Asker, entitled “Corporate Investment and Stock Market Listing: A Puzzle?”compares the investment patterns of public companies and privately held firms. It turns out that the lag in investment is a phenomenon of the public companies more than the privately held firms.
“They find that, keeping company size and industry constant, private US companies invest nearly twice as much as those listed on the stock market: 6.8 per cent of total assets versus just 3.7 per cent.”
As Matthew Yglesias at Slate writes:
“On this account we are reaping the bitter fruits of the “shareholder value” revolution. Executives at publicly traded companies are paid to generate higher share prices, which is done by hitting quarterly earnings targets. This leads to underinvestment relative to the behavior of managers of privately held firms. Not because managers of private firms are indifferent to the interests of shareholders, but because there’s less need for creating the shareholder value link via a simplistic relationship between compensation, share price, and quarterly earnings.”
As Mr. Harding concludes, it is “time to stop thinking about corporate governance and executive pay as matters of equity and to regard them instead as a macroeconomic problem of the first rank.”
There is another way: the Creative Economy
There is of course another way to run organizations, as illustrated by Amazon [AMZN] and other companies that are pursuing the Creative Economy. Their objective is not short-term profits but value for customers. The financial returns from this different approach are extraordinary.
The argument offered by executives that “the stock market made us do it” has the same legitimacy as “the dog ate my homework”, when public companies like Amazon [AMZN], Whole Foods [WFM] and Costco [COST] have successfully pursued customer value, despite the pressures of Wall Street. So isn’t it about time we stop compensating corporate leaders for meeting their quarterly numbers and instead shift the focus of business to its true goal of adding value to customers?
And read also: