Shareholder Value Is Undervalued - Cliff Asness

Topic:

Corporate Governance, Market Efficiency

The idea that corporate management should focus on maximizing shareholder value is under attack, often in hyperbolic terms, with this idea blamed for great and varied harm (e.g., underinvestment, inefficiency, inequality and the failure of people to appreciate the film Ishtar). Recently, James Montier of the esteemed, including by me, money manager Grantham, Mayo, Van Otterloo & Co., voicing the views of many, wrote a piece calling it “The World’s Dumbest Idea.”[1] In addition, attacks have appeared in The New York Times and in TheWall Street Journal. A simple web search shows this to be a concept with many prominent learned detractors and few public defenders.[2]

Luckily for markets and the economy, this is not the world’s dumbest idea — not close. It’s imperfect, as all things are, but it’s not even a little bit “dumb.”

Alas, many who think they are attacking “maximize shareholder value” have misidentified their target. Instead they oppose some practices and ideas that often get mistakenly jumbled together. There are debates to be had about all of these disputes, but few touch on the core issue of maximizing shareholder value. Some attacks are by authors genuinely concerned about, and looking to improve, markets; while others are thinly veiled anticapitalist screeds. Either way, they are pointing their fire in the wrong direction.

Basically, if capital markets price things well (with few ex ante errors, or put differently, the market is close to “efficient”) then maximizing shareholder value is a very good idea. Believing that markets make common and giant predictable errors is the only legitimate beef one can have with maximizing shareholder value, and it’s absolutely fair to debate this tenet.

But instead of confining the debate to this central point, or even realizing that this is the central point, critics attack shareholder value for many ancillary reasons. For instance, they laugh off the concept as vacuous, the absence of a strategy. They attack share”‘based and particularly options”‘based compensation. They attack markets and managers for being too “short-term.”[3]They attack the titular idea as inducing the “expectations game,” something they hold in great contempt. Finally, they attack — and at least this salvo is on the core concept — the idea that the firm should be run for its owners, instead of for a diffuse and sometimes amorphous set of stakeholders. Some critics have valid and important points about these things. However, as I will explain, with little exception, they are not actually criticizing the shareholder value idea at all.

What Is “Maximizing Shareholder Value”?

First, let’s step back and examine what the idea of “maximizing shareholder value” is and why it’s intimately tied up in how “efficiently” the market prices shares.[4] Put simply, it’s the idea that management’s efforts should go into maximizing today’s stock price. Gee, that does sound very short”‘term doesn’t it? I mean, it has the word “today’s” in it and that’s pretty darn short-term! Maybe the critics are onto something?

Well, it really isn’t and they really aren’t. Why? Because today’s stock price is itself the market’s forecast of what the firm is worth considering the rest of eternity (only the first few millennia really matter). The market values Apple higher than Commodore International not on a current whim, but because the expected future cash flows to Apple’s owners (shareholders) are ridiculously higher than those to Commodore International’s (OK, I may have gilded the lily by choosing a foil that went bankrupt a long time ago, but I’m a bitter former Amiga owner).

When management takes action today, in principle and mostly (yes, just mostly, I’ll get to that) in fact, the price today moves based on the market’s collective assessment of that action’s effect on the long-term value of the company. It only looks short-term to those who don’t understand this, don’t want to understand this, or keep hearing about this “Martin Gale” fellow and dismiss him as some British or Canadian crank. Of course, this is all only if the market is working reasonably “efficiently.”

So How “Efficient” Is the Market?

Alas, markets aren’t perfect. Few things are perfect. Markets get things wrong every day (certainly clear after the fact, which is often mistaken for the point, but sometimes clear even before the fact) and sometimes do so rather spectacularly. For instance, I am more than willing to call the technology episode of 1999-2000 a “bubble,” and shared the trenches with GMO and others in doing so real-time. Now, going the other way, I also think the term “bubble” is grossly overusedthese days. That is, there is a bubble in saying “bubble.” In other words, I think bubbles do occur, just rarely.

In particular, as one type of imperfection, the market may be too “short-term.” Earlier I discussed how today’s stock price is not actually a “short-term” measure but our best guess of long-term value. But that doesn’t make it a perfect guess, and, at the risk of overusing this term, one way it may be imperfect is for price to move too much based on “short-term” not “long-term” events. I have written elsewhere that truth probably lies somewhere in between those who assert markets are wildly inefficient and those who assert they are nearly perfectly efficient. Thankfully, “imperfect” markets can be pretty darn useful. Anyway, if the problem one has with the concept of maximizing shareholder value is that markets are too short-term, then it seems exhorting, cajoling and educating us all to be more long-term in setting prices would be a better solution than attacking the goal of maximizing shareholder value. Indeed, some take this tack, pointing out where they think management is focusing too much on the short-term, and recommending reforms, particularly accounting reforms, that they feel will better deliver shareholder value, as opposed to bizarrely scuttling the concept because, perhaps, we can do better. Frankly, if critics are not urging that we work on better delivering true shareholder value, then I’m not really sure what their solutions are, so I’m a little scared!

Stepping back, one must admit that the market’s long-term record, warts and all, is superb. If markets priced things as poorly as the critics assert, directly or by implication, we’d expect to see societies that adopted them floundering, while societies that adopted the opposite — and please pause and consider for a moment what the opposite really is — flourish. More mundanely, if the critics were right in their stridency, we’d expect to see an abundance of consistently successful active stock pickers regularly beating the market by taking the money of rubes who bought into short-term stories spun by venal management (though the truism that the average can’t beat the average would still hold). Rather, over the long term, we see few such outrageously successful active managers with the total number a lot closer to that expected from random chance (though probably exceeding it by a bit).

Considering all the evidence, we must conclude that markets are imperfect. But actually we knew that going in, as nothing is perfect. More specifically, the market makes ex ante errors and very rarely it makes large predictable ones. But overall, it has proven a highly effective way of setting prices and close enough to “efficient” that few have consistently beaten markets. Furthermore, other means of setting prices, or worse, allocating resources without prices, have been utter tragic failures compared to the market’s success.

Focusing on the Stock Price Is Not a Strategy: Yes, but Duh…

One common refrain among critics is the true statement “maximize shareholder value is not a strategy but the result of a strategy.” Indeed they are correct, one does not enhance shareholder value by meditating on the stock price, stalking it or covering the walls with pictures of it all connected by push-pins and string. One maximizes it by creating value, the most you can. The practical details of this vary tremendously from company to company, but usually entail having some combination of great products, perhaps a mission that is truly beneficial to the world, satisfied customers or clients, and a team of employees that is motivated to deliver. Those who think they’ve made a trenchant telling critique by pointing out that “maximize shareholder value is not a strategy” are not wrong, but they must tell us what and who exactly they are criticizing. Who thinks it’s a strategy unto itself and not the result of a good strategy? Maximizing shareholder value is an objective. Of course you still need a strategy to get there!

Options-Based Compensation

The critics’ most common target is probably management compensation that is tied to share price, and particularly options-based compensation. Tying management compensation to share price might be, on net, a bad idea; particularly when the plan is one”‘sided options-based (I’m not arguing this point here, or conceding it, just admitting it’s possible).[5] Options-based compensation may indeed often, though for no necessary reason, be used by those waving the shareholder-value banner, but the critics fall here for the post hoc fallacy.

There are legitimate causes for concern with stock-based compensation. First, if, as discussed above, the market has any tendency to be too “short-term,” admittedly so will the price of shares or options given to management. But, again, the accusations of “too short-term” are hurled with way too much confidence.[6]

Second, the “one sided” part of options-based compensation may matter as it gives management an incentive to maximize the value of its options which, a bit ironically given this is exactly what we’re arguing about, is not the same as the value of the common shares.[7] How can they be at odds? Well, options on shares are a somewhat different beast than shares themselves and this difference carries over to when they’re used as compensation. You can increase option value by, all-else-equal, raising volatility and that’s not necessarily in the shareholders’ best interest. Now, in the presence of debt, shares are also an option on the value of the company but options of a lesser gamma (sorry for the brief geekdom) and don’t have nearly the same bias. In fact, while perhaps they have a point in isolation (perhaps!), much of the criticism of maximizing shareholder value has been more about one”‘sided options”‘based compensation[8] than the more basic notion of management maximizing share price. Those raising this argument should be clear they are criticizing a specific practice — options-based compensation — and not the idea of maximizing shareholder value.

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