Reluctance to invest is holding back both growth and employment
By James Saft
(Reuters) — Corporate cash hoarding, low investment and the buy-back culture: the problem may not be so much shareholders as executives.
The reluctance to invest by companies on both sides of the Atlantic is one of the enduring puzzles of the post-crisis years and is widely blamed for holding back both growth and employment.
Andy Haldane, chief economist at the Bank of England, is the latest to wade into the debate, last Friday calling insufficient investment "one of the main reasons world growth had been sub par" and bemoaning that profits instead go to finance dividends and share buybacks.
"They are almost eating themselves, taking their internal funds and distributing that to shareholders rather than investing themselves," he told the BBC.
Haldane said the proportion of UK company profits used for share buybacks or dividends had increased by six to seven times since the 1970s, now accounting for 70 percent of profits, laying the blame squarely on the philosophy that gives primacy to the interests of shareholders.
That idea "shareholder value maximization" (SVM) comes in for a lot of criticism, and rightly so, as it's been observed to lead to short-termism. Haldane appealed instead to a vision that would reach a different balance in serving the interests of shareholders, employees, clients and other stakeholders.
But SVM is misnamed, as it conflates the teacher saving for retirement, who has precious little control over company strategy, with the executives who do and who are paid largely in shares. That executive compensation system, heavy on share options, creates a set of perverse incentives: to skimp on investment today and to manage earnings by buying back shares.
This creates an illusion of higher profitability, one often rewarded by the stock market, but which can leave companies hollowed out, with little new product and a dwindling franchise due to underinvestment.
Economist Andrew Smithers has tied the growth of bonus and share option culture to changes in corporate behavior. The limited time nature of share options makes the bar higher for executives hoping to benefit themselves from investment or research spending they might authorize.
As well, volatility in reported public company earnings has increased massively, allowing insiders, who come and go with more frequency, more opportunities for timing the issuing of share options and their redemption. Any option trader can tell you that the value of an option is driven by its volatility rather than any long-term measure of return.
UNICORNS
Defending a gambit into an area well beyond the already wide remit of the Bank of England, Haldane asserted company strategy is a concern in part because the financial crisis was the result of banks seeing high returns and using borrowed money to create them.
Again, that's right, but only part of the story. The driving force behind reckless risk-taking at the pre-crisis banks was very likely employees who wanted to use other people's money to back speculations they themselves would benefit from disproportionately. Certainly the banking industry has no good recent record of shareholder value maximization.
If you want examples of how to overcome the dynamic of low investment and self-serving earnings management, look no further than privately held companies, particularly in technology. Because they are more closely held, shareholders are better able to channel executive energy toward building for the future.
There are now well over 100 "unicorns," privately held companies with billion dollar-plus valuations. Including such names as Uber and Airbnb, these companies are investing furiously for the future. To judge by the valuations they attract, their investors believe they will be taking substantial market-share away from the publicly traded companies now eating their own seed corn.
None of this might surprise John Asker and Alexander Ljunggvist of New York University and Joan Farre-Mensaof Harvard Business School, who authored a 2014 paper that found that listed companies invest less than their private peers and are less sensitive to opportunities. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1603484
Many investors, at least those with the option to invest in non-public companies, are voting with their feet, seeing the share buy-back and earnings management game for what it is: a drag on long-term returns.
Corporate short-termism poses a serious problem, both for the economy, which is dragged down by low investment, and for investors themselves, who will ultimately be left holding the bag if companies don't grow and innovate.
The best way to solve that isn't by widening the remit of companies, but by reforming executive compensation and giving long-term savers real control.
At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at [email protected] and find more columns at http://blogs.reuters.com/james-saft
