Just how sound is shareholder-value primacy?

Rethinking shareholder and company value

By R. Paul Herman and Srdana Pokrajac

The debate around shareholder-value primacy heated up at the end of February when a representative from conservative think tank National Center for Public Policy Research (NPCCR) asked the Apple (Nasdaq: AAPL) CEO Tim Cook to commit to act only for the benefit of shareholder return on investment (ROI), expressing concern that Apple’s investments in renewable energy might jeopardize company and shareholder value.

NCPPR questioned the soundness of Apple’s membership in the Retail Industry Leaders Association (RILA), which supports sustainability initiatives and encourages its members to apply such views in their business operations. Apple’s shareholders seem to align with Apple, and NCPPR’s proposal only obtained 2.95 percent of the votes at the annual shareholder meeting.

In her new book, “The Shareholder Value Myth,” Cornell University Law Professor Lynn Stout seeks to debunk the shareholder primacy myth, or “ideology” as she defines it. She points out that there is no legal requirement to maximize shareholder value in the United States. Stout has researched the question of company purpose and corporate governance for the past two decades and has come to a conclusion that the belief that the purpose of the company is to maximize shareholder value does not derive from corporate law, but rather from business practice and academia.
Maximizing shareholder value is interpreted as legal requirement because of the concept of fiduciary duty. A director or manager has two types of fiduciary duty, duty of loyalty and duty of care, which are open to interpretation and can be fought in Court if shareholders or investors manage to actively engage and organize. Duty of loyalty simply implies that the manager will not be guided by self-interest, and duty of care – often expressed as business judgment rule – implies that managers or directors will make sound decisions, in good faith and in the best interest of the company. It is this last concept – the best interest of the company – that is perhaps the most open to judgment.

Lynn Stout points out that whereas in the 1960s the average holding period for a stock was eight years; nowadays, it is four months, not to mention high frequency trading examples of holding periods of 22 seconds . These trends show that shareholders seem to be in for the short term, which creates pressure for companies to maximize short-term profits even at the expense of future gains. Share price is in the spotlight, but we could ask this: What does share price really represent? Does it reveal valuable information on company value, and, if so, how quickly can that value change?

Paradoxically, Amazon (Nasdaq: AMZN) has been operating with losses since 2012 but its share price has been close to $400 in the past three months, with a Price to Earnings ratio of 621 and Earnings Per Share of $0.58. This really is contradictory to the whole shareholder-value ideology, but it seems to work just fine. Maybe these are hints for us to start rethinking the concept of shareholder and company value and change our everyday business mantra. Not that profits do not matter, but if we aspire to solid and stable markets that will provide solid returns with minimal risks, we should change our expectations and take ownership of our own irrationality.

Investing strategies should ideally account for the alignment in nature between the assets and the funds. It is unreal to expect high short-term returns from investments that need time to ripen. Steven Milloy’s Free Enterprise Investment Fund that in 2009 became the Congressional Effect Fund (Nasdaq: CEFFX) provides an extreme example of investments that were on purpose countering “ethical investments” and very poorly trying to meme the S&P 500. Over consecutive years, Milloy filed multiple proxies against FedEx (NYSE: FDX) whose sustainability practices included reducing fuel consumption and choosing renewable energy sources and hybrid electric vehicles. Milloy believed that such efforts were working against shareholders value, however, his defunct fund’s performance showed annualized losses of 6.58% in the period 2005-2008, compared to annualized losses of 5.47% of S&P 500. Conversely, FedEx is still making profits while caring for the environment.

On the other spectrum from Milloy’s failed fund, guided by a Long-Term Patient Capital philosophy, are pension funds such as the California State Teachers’ Retirement System (CalSTRS) and the California Public Employees’ Retirement System (CalPERS), whose mission is to provide retirement benefits to California teachers and public sector employees and have specific rules about where the funds are invested. For example, CalSTRS has 21 risk factors, including:

  • monetary transparency – a country or company transparency about their financial data
  • worker rights – workers’ rights are respected, workers have the right to organize and bargain collectively, there is no human trafficking and forced and child labor are banned
  • environment – companies or countries show concern for climate change, air quality, water quality, and land protection
  • war conflict – companies or countries are not involved in acts of terrorism; and
  • human health – companies or industries do not have products that are detrimental to human health.

CalSTRS’s portfolio generated a 12.6 percent average annual return over the past three years, which is 10 basis points below the policy benchmark, but it ranks in the top quartile among peer funds. CalPERS three-year return of 11.3 percent exceeded the benchmark by 23 basis points at the end of fiscal year in June 2013.

CalSTRS and CalPERS might not have the highest returns, but they are an example of how long-term investments that take into account ethics and environment will not harm returns, and will in some cases outperform the market.
Clearly, it’s difficult for investors to determine when companies are making wise long-term investments in responsible practices; misalignment exists between many companies
and their shareholders. However, if companies forgo innovation and long-term thinking in the name of short term profits, ultimately the company does damage to itself, and consequently to its shareholders. Ideally, the investment strategies of investors and companies have to align – that will solve the issue of unrealistic return expectations that often result in unpleasant surprises after things have seemingly been going too well.

R. Paul Herman is CEO of HIP Investor Inc., advising investors and rating portfolios on future risk, return potential and impact on society. Srdana Pokrajac is an advisor to HIP Investor. This is not an offer of securities. Details and full disclosures are at www.HIPinvestor.com

Posted April 25, 2014 in 25115