Shareholders: Don't Fall for This Myth

There have been plenty of examples of corporate managements and boards using "the maximization of shareholder value" as a rationale for outrageous screw-ups in recent years. That's where Lynn Stout's 2012 book The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public comes in, attempting to bring a new perspective to the conventional wisdom.

Although the book includes some good points to ponder, one might wonder if the subtitle should have been: "Why Management and Boards Should Have Complete Control and Shareholders Should Just Go Away." For many of us, that's a troubling concept that would do more harm than good in our marketplace.

The mythical mandate to maximize shareholder value
Granted, Stout examines some interesting and thought-provoking elements. She contends that the conventional wisdom regarding a mandate that corporations "maximize shareholder value" actually isn't a legal obligation at all. It's a concept most closely associated with economist Milton Friedman's treatise on the social responsibility of business that has grown to become like gospel.

Stout also hits a home run in her allegations that the prevailing market psychology often makes otherwise kind people act quite antisocial when it comes to investing, even if the events they're weighing have a negative impact on other people and eventually, even themselves.

Take investors who mulled buying BP right after the Deepwater Horizon disaster, assuming they were getting a "bargain." The notorious BP incident is one of the first and primary examples Stout gives of companies that chase short-term profit to the detriment of greater society. 

Stout's points that share price is a flawed metric as an anchor and that short-term thinking is a major problem are solid, too.

Overall, though, Stout's excellent points don't outweigh the ones that don't add up. For anyone who believes in investing according to stakeholder value and strong corporate governance, logic goes downhill in much of Stout's assessment of "the shareholder value myth."

Attacking strong corporate governance
Stout's dismissal of strong, shareholder-friendly corporate governance policies and defense of management-centric businesses is where an interesting twist doesn't hold up to scrutiny. In fact, her arguments that solid governance policies like declassified boards, majority voting, and so forth aren't good for corporate performance seem unconvincing if not invalid.

For example, Stout cites "an important survey paper," "The Promise and Peril of Corporate Governance Indices," which contended "the empirical literature investigating the effect of individual governance mechanisms on corporate performance has not been able to identify systematically positive effects and is, at best, inconclusive." According to the footnotes, that paper appeared in Columbia Law Review in 2008, right after a major asset bubble busted.

However, there's conflicting, more recent data. In 2010, The Corporate Library (now known as GMI Ratings) published research showing a correlation between good corporate governance and good performance benchmarked to the Russell 1000 index over the 2003-2010 time frame. Companies in a hypothetical portfolio utilizing the strictest governance screens showed the highest level of outperformance, at 275 annualized basis points.

One of the strangest arguments in the book was that management's enriching themselves at shareholders' expense was related to the obsession with stock price and therefore shareholders' fault. Managements and boards have learned to exploit many channels in order to gain big paychecks; without shareholders, would we suddenly find selfless managements that take the greater good and the long term into account? It's doubtful.

Indeed, requiring restricted stock incentives that vest over the long term and mandating financial clawback provisions for poor corporate and management performance over the long term would solve such problems.

One of the book's major logic disconnects is the concept that shareholders have been powerful over recent years. Although Stout insists throughout that "shareholder primacy" has been the rule, anyone who has truly watched corporate governance issues knows that the reality is that shareholders have had very little power or say, even as they fight for more now.

Just because managements and boards have simply used the "maximizing shareholder value" meme as their excuse for poor performance and ill behavior doesn't mean the blame really does fall into shareholders' laps.

Meanwhile, Stout blames the "shareholder primacy" idea for things like companies going private, staying private, or going public with dual-class stock structures, which make public shareholders' votes meaningless against management's.

She's right that many recent high-profile IPOs have had dual-class stock structures, but examples like Facebook and Zynga illustrate a tech trend where managements of well-known consumer-facing companies have no desire to cede control.

Actually, companies with this stock structure make up a minority of companies overall. Last September, GMI Ratings revealed the number as just 40 S&P 500 companies and 268 Russell 3000 companies. One recent statistic showed that just 20 of the 170 IPOs between January 2010 and March 2012 had multiple-class stock structures.

You don't own jack
Another distasteful premise in the book is that shareholders aren't really "owners." True, too many investors these days are focused on the short term, but the real problem is that the "ownership" idea has been neglected, with managements and boards having to endure little or no accountability.

Stout's correct to point out that "shareholders" include everyone from Americans passively invested through mutual funds, to individual investors, shareholder activists, and hedge-fund types.

When addressing the general retail investor, though, Stout describes a class that's "rationally apathetic," going on to say, "It simply doesn't make economic sense for them to put much time and effort into finding out what's going on at any of the particular companies in which they hold shares."

A discussion of "rational apathy" of investors is a problem in our marketplace, and shouldn't be expressed as simply a given. Understanding our stocks and why we invest in them is what we at The Motley Fool strive for, after all. 

Institutional investors, too, should be keeping an eye on managements and boards. Just because these shareholders failed at proper stewardship for years doesn't mean that blaming shareholders and ceding control to self-interested managements and boards is the answer.

If shareholders actually did take their ownership more seriously, we wouldn't face many of the problems that have cropped up in recent years.

Shifting blame
The notion of "shareholders" is taking a beating lately. Take Nationwide's recent ad campaign that it "puts people over profits" and cares more about its customers because it doesn't have to answer to shareholders. Stout's book plays into that trend.

Although Stout does acknowledge the existence of "prosocial investors" who invest with a conscience and positive investment vehicles like socially responsible funds that are increasingly popular, the main thrust of the argument shifts the blame for corporate incompetence, malfeasance, and value destruction away from poor managements and shoddy boards to shareholders.

Taking away what little power shareholders have and giving more to managements and boards isn't the answer to our current problems. A marketplace of more strongly management-centric companies would likely throw grease on the smoldering fires that engaged, responsible shareholders have been fighting.

The Shareholder Value Myth is a thought-provoking read, although many of us may not agree with its conclusions and it begs for quite a bit of critical thinking. That quality makes us all better investors, after all.

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