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Rekenthaler Report

The Doctrine of Shareholder Value Has Indeed Helped Shareholders

Workers, however, appear to be another matter.

Shareholders First
American stocks have outdone even the bravest expectations. Over the past 30 years, the S&P 500 has gained an annualized 9.8%, resulting in a compounded return exceeding 1,600%. In 1989, the entire globe’s gross domestic product summed to $20 trillion, expressed in current dollars. Today, publicly traded U.S. equities are worth a collective $30 trillion.

As even the dull-witted have suspected that some of the stock market’s rise owes to changing practices in corporate management. By the late '80s, the concept of “maximizing shareholder value” was widespread. This dictum, initially advanced by Milton Friedman in 1970, had become the received wisdom at MBA programs. Corporate executives answered to one party: their shareholders. Nobody else counted, unless they proved useful to meeting that goal.

(If that last sentence seems overstated, consider this direct quote from Friedman: “A corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsi­bility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while con­forming to the basic rules of the society.” That doesn’t leave much room for any interests, save those of shareholders.)

Because equity owners measure success primarily by how a company’s stock performs, the doctrine of shareholder value gave corporate managements a clear and obvious duty. Their most important task was to increase their stock’s price. How that was to be achieved remained up to them. Not in question was the penalty for failure. Presumably, the possibility of being fired would focus management’s attention. After all, said the good doctor, nothing concentrates a man’s mind quite so much as the knowledge that he will soon be hanged.

Such was the theory, and the stock market has risen accordingly. However, as the saying goes, correlation is not causation. Stocks may have appreciated for reasons other than new corporate-management techniques. It is even possible, albeit unlikely, that executives have harmed stock prices by managing for shareholder value. Without the numbers, it’s all guesswork.

Evaluating the Evidence
Three professors now claim to have those numbers. In “How the Wealth Was Won: Factor Shares as Market Fundamentals,” MIT’s Daniel Greenwald, Berkeley’s Martin Lettau, and NYU’s Sydney Ludvigson show “novel evidence behind the sharp increase in equity values over the post-war era.” That is, they credit the stock market’s performance to several factors, then measure the size of each factor. The largest recent effect, it turns out, comes from corporate management’s decision to maximize shareholder value. At least, that is my interpretation of the authors’ findings. Whether it is warranted, you may shortly judge.

(Note: This column is inspired by “Why Are Stocks So High?”, published last week in Retirement Income Journal. That article discusses the same paper, albeit from a different perspective.)

The economic-pricing model used by the authors differs from the techniques that are customarily used for assessing investment returns. Thus, I cannot comment on their model’s strengths and limitations and must take their results on faith. Not my favorite approach, but sometimes one must trust without verifying. (If you feel qualified to assess their approach, feel free to email me your thoughts.)

The Economic Tide
However, the results are easy to understand. Broadly speaking, the authors identify four sources of stock market returns: 1) that which comes from economic growth, 2) that which owes to favorable financial conditions, such as lower taxes and interest rates, 3) changes in the equity risk premiums (that is, changes in stock market valuations due to investor sentiment), and 4) how much of potential corporate profits accrue to shareholders, as opposed to other parties.

The first source, presumably, is best. Taxes and interest rates may be raised as well as cut; stocks may become less popular as well as more; and future shareholders may receive less of the overall proceeds--those landing instead in the hands of various other parties, such as rank-and-file employees, management, or bribe-taking outsiders. But economic growth is economic growth. It is the essential ingredient for improving not only shareholders’ fortunes, but those of overall society.

Happily, the authors report, economic growth underlay 92% of the stock market’s 1952-88 gains. There was nothing fluky about the period’s results, unless one believed that its economic growth rate was unsustainable. During that era, tax policies did become more favorable, and the equity-risk premium rose, but neither factor was critical. Stocks rose first and foremost because the economic tide floated their boats.

Redistributing the Wealth
Then things changed, greatly. Over the next three decades, from 1989 through the end of last year, economic growth ceased to be the largest factor. It wasn’t that it disappeared. On the contrary, economic growth remained near its previous level--high enough to have lifted stocks to their 1952-88 rate of return. But equities performed far better in the second period than in the first (particularly when measured in real terms), and that increase did not come from economic growth.

Instead, it came from workers. In the authors’ words, 54% of the stock market appreciation from 1989-2018 came from “rents” that were “reallocated to shareholders and away from labor compensation.” That is, rather than reinvesting their cash flows into their businesses, either as projects that would create new jobs, or as additional compensation for existing employees, companies increasingly retained those monies. Perhaps they remained as cash, were spent as dividends, or were used to buy back shares. In all cases, the benefits accrued to shareholders, rather than to workers.

The growing inequality of wealth, of course, is a familiar political tale. Also familiar is the triumph of the principle of shareholder value in the nation’s business schools and along Wall Street’s halls. The paper, seemingly, connects those two narratives. Investors have reaped the fruits of the past 30 years’ economic growth at the expense of everyday workers.

More research is required before the topic can be regarded as settled. Nonetheless, the paper’s outcome is at least strongly suggestive. For the foreseeable future, it is better to own investment capital than human capital. Particularly if that investment capital is placed in equities.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.