Of Owners and Ownership

Public ownership of shares is, in many ways, the essence of modern capitalism — which, along with the rule of law, has been responsible for the spectacular growth in global living standards over the past 200 years. Today, public ownership of shares is under significant pressure on a number of fronts.

A diminishing pool of public equity market investors is engaged in “active” investing (i.e., actually analyzing the merits of companies and selecting their securities accordingly). A growing plurality of investors chooses indices and engages in virtually no individual company or security analysis. This type of investing delegates security selection to small, anonymous committees at the index construction firms. Among the active investors are classic stock pickers at some mutual funds and hedge funds, a depleted cadre of analysts at investment banks and advisory firms, and a relatively small group of “activist” investors.

Activist investors do not just analyze and select securities and companies in which to invest. They also interact with company managements, publicly and/or privately, in a dialogue that the activist hopes will validate its analysis (or show why it is wrong) and lead to improvements in the company’s performance. Activists aim to influence outcomes and “make something happen” to cause a company’s share price to increase and hold its gains.

The dirty little secret about public capitalism is that many executives and directors of public companies abhor its essence: public ownership of “their” companies. Whether shareholders own shares for one minute or for 30 years, they are owners, deserving all of the privileges of ownership. Of course, their ability to exercise those privileges depends on, among other things, the rights conferred by their shares, the number of shares they are able to acquire, and their ability to voice their views and convince management and/or other shareholders (including index investors) of the merits of their analysis. However, on all of these fronts, the fundamental rights of owners are increasingly being pressured due in large part to the efforts of well-compensated corporate advisors and lobbyists, who masquerade as advocates for a new, more enlightened capitalism.

We have learned from decades of experience that most public company management teams do not like being told what to do, and they really do not like their performance to be critiqued by outsiders who have the temerity to call themselves “owners.” However, imagine if these same executives were not allowed to critique the performance of their own employees. Suppose one of these executives suggested that an employee adopt a performance-improvement plan and that employee responded by alleging that he or she was a victim of a “short-term attack,” one that focused too much on the numbers and overlooked his or her many positive intangible qualities. How would this executive react to such a response?

Corporate managements and boards are supposed to work for the owners — the shareholders. However, many act as if they report to … nobody. This observation is not true of all executives and directors, of course. We have encountered quite a few thoughtful and shareholder-oriented CEOs, and we have worked successfully with scores of companies to create substantial amounts of shareholder value. However, we have also seen companies use a variety of techniques to ward off outside inputs, no matter how valuable those inputs may be.

These techniques include: posturing as “national champions;” playing upon nationalistic impulses against outsiders; changing the subject from their own past performance to the holding period of activists (despite the many instances of activist engagements that generate, in a short period, significant long-term value for all of the shareholders); marshaling support from the government or the press; lobbying for regulations that make it harder for activists to build positions; and calling on the corporate defense industry to invent and proselytize legal barriers to activists (poison pills and the like).

While activists are the owners of the shares in which they invest, the largest activists represent millions of direct and indirect beneficiaries who receive most of the value from the activism as well as from other trading activities — including sovereign wealth funds; savings plans; college students benefiting from university endowments; retirees (teachers, bus drivers and many others) — who receive monthly retirement benefits from pension plans; and museums, orchestras and a range of other cultural institutions paying their staff and keeping their lights on.

These people and institutions are among the real owners of interests in shares held by activist investors. The narrative of a battle between rich-guy investor and beleaguered but beneficent management is just phony. Activists often represent “the people” much more than do the executives and directors on the other side of the table, many of whom own little or no stake in their company other than free options (heads they win, tails the shareholders lose).

Index investors are currently the largest investors in almost all large companies, but they cannot catalyze improvements in individual company performance, given the huge number of companies their governance teams must cover. Yet the clients of index investors still benefit when an activist creates increases in value that endure over time; activists are also incentivized to focus on long-term value because they want to earn the support of the index firms in future campaigns. Indeed, index investors need activists even more because the former cannot sell the underperformers in the index. The refrain “if you don’t like the management, just sell the stock” never made much sense to us anyway — why not use your rights as an owner to interact with management teams and try to effect changes?

Companies have added another anti-shareholder arrow to their quiver— claiming a need to prioritize all “stakeholders” equally. As we have explained in past writings, this goal is impossible, given that many of a company’s stakeholders are in competition with each other or at least necessarily at arms-length. Boards of directors simply cannot owe equal duties to suppliers, the community, workers, the environment and creditors. Did we leave anyone out? Oh yes, the owners of the enterprise, a.k.a. shareholders.

In reality, the prioritization of shareholder returns is perfectly consistent with the goal of balancing the needs and competing interests of all of the company’s other stakeholders. The best leaders constantly adjust to maintain equilibrium among stakeholders’ competing interests — and indeed, they must serve the needs of stakeholders in order to keep the company healthy and profitable for the shareholders. This balancing act is never perfect, and it exists as a layer of discretion on top of the bedrock of the plethora of rules and laws that already exist to protect stakeholders.

But what the balanced approach does not do — and what the “stakeholder supremacy” theory of capitalism is designed to do instead — is allow weaker corporate management teams to justify poor shareholder returns by citing a need to serve some higher corporate purpose. The fact that it is largely gibberish is disguised by the air of moral superiority with which it is presented, leaving all too many investors uncomfortable challenging its logic, its purposes or its impact on corporate performance and rates of return.

Oddly, shareholders themselves are generating a rising share of the pressure to adopt stakeholder supremacy. We think we might have some insight into this puzzle: In recent years, investors have gotten so used to high and consistent returns from stocks that they now assume that such returns — the returns on which so many important social goods depend — must be easy to generate, and that no harm will come to shareholders from encouraging corporate executives and boards to take their eyes off that particular ball.

In public capitalism, the shareholders are the owners. Boards and managements work for the owners and should be accountable to the owners. Jobs and the prosperity that citizens mostly take for granted depend upon this accountability and on the inputs and insights of the few parties who have done the work, have skin in the game and try to effect constructive and needed changes.