The letter Laurence Fink sent to clients was surprising. Well, not clients exactly. He wrote to the people with whom he invests his clients’ money – namely, the 500 CEOs of the biggest companies in the United States (the companies listed on the S&P 500 Index).
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Fink is the biggest investments manager in the world. Over the last three decades, he turned BlackRock Inc. into a monster with more than $4 trillion under management in mutual funds, provident funds and pension funds. Put otherwise, the scope of money under its control is five times all the Israeli public’s assets.
The day before he sent his letter to the 500 CEOs – something he does annually – he leaked it to Andrew Ross Sorkin, his favorite reporter at The New York Times. He wanted the world to know what BlackRock was advising the biggest companies on Wall Street.
Which was: You are too focused on the short run, on gratifying investors, which often leads you to invest most of your company’s profits in buying back your stock. You are hurting savers and the broader economy.
Fink didn’t invent the idea that massive stock buybacks are damaging to the companies and the economy. Coincidentally, or not, the day before Fink sent that letter, I met with the man most identified with that thesis: William Lazonick, a Harvard grad and today a professor of economics at the University of Massachusetts Lowell, where he runs the Center for Industrial Competitiveness.
Lazonick’s ideas had been considered maverick until a few years ago. But since the great financial crisis on Wall Street in 2008-2009, and with inequality gaining legitimacy as a topic, people like Lazonick have gained legitimacy.
Last September, Lazonick published an aggressive paper in the Harvard Business Review, called “Profits Without Prosperity,” analyzing stock buybacks by the big U.S. companies over the last 10 years, as a move designed chiefly to benefit the CEOs but hurting investors – and most Americans – as well as American investments and innovation.
Lazonick’s piece won the HBR McKinsey Award for best article in last year’s Harvard Business Review, which is essentially a conservative, pro-business publication. No less surprising, some of the people on the committee that chose the article, and praised his meticulous methodology, were businessmen themselves (including the former CEO of Amgen) who make or made their money from giant companies that bought back shares.
In fact, gradually, the HBR has been shifting from pro-Big Business to ideas like Lazonick’s, which look at the general good rather than that of Harvard grads and their ilk. The HBR, like many other publications and economists, realized that to stay relevant, it needs to rethink its ways: the days of applauding CEOs of giant companies isn’t over – they still control the money and jobs – but the legitimacy of this applause among readers is waning.
The sickness on Wall Street
I asked Lazonick what he thought the chances were that the HBR would have run his article before the financial crisis. Slim, he said, and told me the HBR editors negotiated with him for a year and a half about the article’s style, language and message. He, too, had been surprised that his piece had been picked as the best article, and that, overnight, his concepts had become popular and legitimate.
The crisis revealed how the financial markets were being led by speculation and manipulation that wound up controlling the economy, he explained. Now there’s a global movement to restore the function of the financial system toward serving the manufacturing economy.
Centrist think tank The Brookings Institution, which usually doesn’t like to challenge the establishment too much – and certainly not the Wall Street behemoths – has also decided to run a Lazonick article, expanding on the theory he presented last year in the HBR. Meanwhile, Lazonick isn’t that excited about Fink’s letter: all Fink’s doing is positioning the problem with stock buybacks as a problem of looking only at the short-term, Lazonick explains, but the problem is a lot more fundamental.
Lazonick’s attack on Wall Street wasn’t confined to delegitimizing the buybacks fever (on which the big companies on The Street have spent a stunning $3.4 trillion over the last decade – that’s more than half their profits). He’s looking back all the way to the 1980s, to articles by breakthrough economic professors like Michael Jensen and Nobel laureate Eugene Fama about the efficient capital markets, and basic neoclassic economic theory that views the aspiration to maximize profits by business as the driver of a more efficient economy.
That, in Lazonick’s opinion, is where Wall Street’s sickness lies: in the axiom that took hold on Wall Street in the last 30 years, and in the world at large – that a company’s sole raison d’tre is to make profit for its shareholders, which leads to the most efficient allocation of resources.
Not God’s work
Shareholder Value Maximization, or SVM, laid the foundation for boom times and, mainly, for the adulation and remuneration of the managers of the big Wall Street companies. The idea that the CEO focusing solely on “creating value for shareholders” is doing God’s work, and benefiting society at large, together with the thesis that giving options to managers creates an association between their interests and those of shareholders, legitimized the leap in CEO pay – from 30 times that of the average worker to 300 times that.
It also led to half the companies’ profits going not to new investments but to buying back stock, which, says Lazonick, isn’t designed to exploit tax breaks but to benefit the CEOs themselves.
Lazonick isn’t the first to attack SVM. Amusingly, its chief critic is a man who embodied the system for 20 years: Jack Welch, CEO of General Electric from 1981 to 2001. The financial crisis in 2008 woke him up, leading him to remark that maximizing shareholder value is “the dumbest idea in the world.” Companies should focus on workers, clients and products, Welch concluded.
The dumbness that Welch sees may not be the same dumbness Lazonick sees. He names two main flaws with the concept of SVM, which are pretty provocative, not to say extreme:
1. SVM assumes that only the shareholders have a residual right to a company’s profits. Other interested parties in the company, such as its managers, workers, suppliers, the government and creditors, are compensated for risk and their labor through contracts. Only the shareholders have no contractual coverage, so the profits belong to them.
That is wrong, contends Lazonick: The taxpayer is taking the risks and is the central investor in all companies, through the government’s support for the business environment of the companies – the public services it provides, subsidies, sometimes direct investment in R&D. For instance, health-care companies benefit from the roughly $30 billion that Washington invests in research each year.
Regarding workers, Lazonick argues that their wage often does not compensate them for the risk they’re taking. When a company fires a worker to maximize profit, it is breaking the contract with the worker, who expected to continue working there over time.
These ideas lead Lazonick to argue that SVM isn’t a theory of value creation; it’s a way to siphon off existing value. Once the myth that only the shareholders assume the risk is shattered, he argues, obviously the vast distribution of profits through stock buybacks and dividends over the last 30 years weren’t really from “free cash flow.” Some of that cash flow wasn’t free; it should have been reinvested in the economy, the workers, development and innovation, he explains.
2. Axiomatically, the capital market is the instrument by which savers route their savings to companies that use the money for investments. But is it so? Here, too, Lazonick takes a different view. Most investor money doesn’t go to investment in the companies themselves – meaning, into buying newly issued shares – it goes to trading in shares that already exist on the market. In fact, Lazonick’s figures show that over decades, the U.S. capital market hasn’t been a mechanism to raise money but to redistribute it. Issues of significant amounts of new shares happen only during bubbles, while over time, the big Wall Street companies chiefly give their profits to shareholders. In net terms, on average, they give their shareholders $40 billion a year through stock buybacks or mergers and acquisitions.
Investment is the key
Wall Street made itself an image of financing corporate growth – and it did so in the 1980s, says Lazonick. But he claims its function since has mainly been to enable company founders, managers and investors to exit.
Hence Lazonick’s central argument: that SVM needs replacing with a new theory that companies should make investments their central goal, not profits. If the companies stop spending tens of billions of dollars on buying back stock, there would be vast resources for innovation, and employee training and retention. (How? Ban equity buybacks.) Meanwhile, some of the resources not given to shareholders would go to tax, enabling the government to invest in infrastructure and human capital, which would lay the groundwork for the next generation of innovation.
Enterprises that focus on innovation need to have people with insight into how companies create competitive products, and to have representatives of the workers and taxpayers involved in the process of innovation, says Lazonick.
If CEOs aren’t to focus on maximizing profit, what should they be focusing on? And how should their performance be measured? Simple, says Lazonick: They should focus on their success in managing companies that create quality products that achieve big market shares, which in turn reduces their cost of production; that is how their performance should be measured. To achieve that, they need to be guided by the theory of innovative business – which is exactly what is missing from the SVM theory.
Meanwhile, looking back at 30 years of “financialization,” widening inequality and crony capitalism in the United States, can any difference be seen between Republicans and Democrats? Lazonick says he does not see one, but believes recently he saw a glimmer of hope that change might come.