Guest post: Stockholders are Fungible, Employees are Not
by J Tzimiskes (who is currently juggling a job in the private sector while studying for a Wayne State MBA, getting a blog post or two in when he can. Previously, he worked for New York State and holds a Masters in Political Science from University at Albany and a biology degree from University of Toronto. He blogs at Tsimiskes)
Stockholders are Fungible, Employees are Not
This has been on my mind after reading some review’s of Piketty’s “Capital in the 21st Century” (which I really need to make time to read). Paul Krugman’s recent post on it made a major point gel for me when he observes that:
How relevant is this story to what has happened so far? In the United States, as Piketty himself stresses, soaring inequality has to date been largely been driven by labor income – by “supermanagers” (I prefer superexecutives.)
Something that I’ve been considering as I take management classes is that it seems that a well managed firm should end up developing a strong espirit de corps and a great deal of management loyalty in the company. Companies should end up with long term employees and management that will oppose stockholder efforts to extract revenue from the company instead of using it to serve employees. Psychological characteristics and organizational behavior should be leading companies to have an in group of employees opposed to the out group of stockholders.
Yet, instead, we’ve seen labor share of income decline and record breaking profits. Despite the performance advantages of developing strong employee morale and loyalty companies seem prone to emphasizing staffing cuts and biased towards hiring more aggressive, less loyal employees to the expense of a strong corporate culture.
A possible explanation is that stockholders recognize that strong employee cultures can be against their interests. This forces them to compensate top management extravagantly in order to encourage them to identify with stockholders instead of the corporation they run and to engage in business practices which weaken the corporation in the long run in favor of higher profits now.
This tension ultimately results from the fact that there is no reason why the corporate entity should have any preference for what sort of capital funds it or who is providing it while there is a strong mutual identification amongst the employees of an organization. In turn, providers of capital have no reason to have a preference over which corporate entity receives their funds, with only some minor restrictions they can quickly and easily trade their stock for that of other corporations. Overcoming this difference in commitment requires capital to pay large bribes if it wants to extract wealth from companies. This also helps explain how common restructurings are despite a poor record of giving expected returns as well as a tendency for boards to hire in outsiders despite insiders with better knowledge of the company.
Examples of this would be a number of managers that have been hired to break strong, successful corporate cultures which led to market dominance and stable performance but relatively weak returns to shareholders. HP and Carly Fiorina being the textbook example from my classes.
Employee owned companies really are much sounder economically and psychologically. They would squelch the relentless extraction of labor profits by the parasite class and would encourage real innovation instead of punishing it the way most capitalist companies do. Most real innovation happens outside of large firms which then acquire it and congratulate themselves on being forward thinking.
I recognized at least ten years ago that whenever profitable companies announced a cost-cutting plan that resulted in lay-offs the stock price soared unreasonably and very quickly. At the time, my response wasn’t so sophisticated. I just knew that the stock market over-priced these stocks and that the long term interests of the company (particularly its customers and workers) were being ill served.
Today i’d add that these moves should be less frequent because hedge fund traders and vulture capitalists would be all over these companies for a couple of years before the cuts.
Typically, profit is the result of efficiencies. It’s the reward of efficiencies. Producing more output, and higher quality output, with fewer inputs raises living standards.
That, in itself, benefits the masses.
Then, what to do with profits? How should profits be distributed? Should there be a profit sharing plan?
For example, a friend started a firm about 15 years ago and has well over 100 employees now. He distributes most of his profits to his employees, giving them big bonuses around Christmas based on seniority, and has several employee appreciation days a year with food from caterers, cash, gift cards, and raffles of goods.
Moreover, he pays the highest possible wages for his workers, who all earn $30,000 to $60,000 a year, and buys equipment to make the work easier for them. He pays himself $150,000 a year. He could pay himself much more, if he wanted to, but limits his pay.
That’s always been his business philosophy, to pay his workers as much as possible and make their jobs easier. Attracting and retaining better workers was likely a major factor why he was able to take market share from his competitors.
The only way to move from one economic revolution into the next is through efficiencies, because of limited resources.
A thousand years ago, most people worked in Agriculture. However, today, less than 3% of the U.S. workforce produces more than enough food to feed the entire country.
A similiar trend is taking place in manufacturing. Article and Chart:
U.S. Manufacturing: Output vs. Jobs Since 1975
Jan 24, 2011
Since 1975, manufacturing output has more than doubled, while employment in the sector has decreased by 31%. While these American job losses are indeed sobering, they are not an indication of declining U.S. competitiveness. In fact, these statistics reveal that the average American manufacturer is over three times more productive today than they were in 1975
Chart of U.S. manufacturing real output:
These trends allowed the U.S. to move into the Information and Biotech Revolutions. Facilitating efficiencies in the Agricultural and Industrial Revolutions allowed the U.S. to move more quickly into the Information and Biotech Revolutions, where the U.S. now not only leads the world, it leads the rest of the world combined (in both revenue and profit).
There has been only four major economic revolutions. Perhaps, the fifth will be nanotechnology. Many more will follow, as we produce more with less. The question is how fast do we want to move into new economic revolutions?
Typically, profit varies by the timeline being observed, and the monopoly power and necessity ranking of the service or goods being provided.
In the short term, a bonfire of straw beats a bonfire of oak. A going concern can increase its momentary profits by bonfire strategies.
Finally, by definition “profit” is a waste (to the consumer) — it is that portion of what they pay that doesn’t go directly to making a product or hiring a service. High profit businesses are, from the consumers standpoint, always overpriced. From the standpoint of other businesses, high profit, monopoly businesses are competitors too, as the biggest necessary monopolies skim off disposable income before it ever becomes available to the slightly less necessary, less monopolistic players. They make competition difficult not only in their own sector, but in all other sectors.
For a society valuing competition as a way of improving goods and services, no monopoly should be allowed to stand unless it is something people can take or leave with little consequence.
This isn’t rocket science, for heaven’s sake.
Noni says: “by definition “profit” is a waste (to the consumer) — it is that portion of what they pay that doesn’t go directly to making a product or hiring a service.”
Profit makes U.S. firms more efficient, allows investment, or rewards savers (e.g. in 401(k)s and IRAs).
The U.S. would’ve been unable to invest heavily in the Information and Biotech Revolutions without profit. And, creating efficiencies in those economic revolutions generated more profit to invest in emerging industries.
Consumers benefit tremendously from efficiencies in older industries and creation of new industries, although market power, in new industries, keeps prices high, initially. However, the U.S. benefits in international trade from that market power.
I call it “The Attack of the MBAs”
Business CEOs are not interested in the future, they are interested in the next quarter’s stock price. It’s why the investment banks tanked the world’s economy while the CEOs made ludicrous piles of income despite their fraud and mismanagement.
The Board of a company has a fiduciary duty to the stockholders. The Executive team reports to the Board. And while stockholders certainly have the option to sell their shares if they don’t like the direction the company is taking with regard to splitting up the revenues among stakeholders, let’s not forget that stockholders are the owners of the company.
Officers’ and directors’ first fiduciary obligation is to the corporation itself, not to stockholders directly. (Which stockholders would those be, the long-term investors banking on the long-term success of the enterprise, or the ones hoping to make a killing on trading?)
Peaky said: “Profit makes U.S. firms more efficient, allows investment, or rewards savers (e.g. in 401(k)s and IRAs) … The U.S. would’ve been unable to invest heavily in the Information and Biotech Revolutions without profit. And, creating efficiencies in those economic revolutions generated more profit to invest in emerging industries…”
Efficient? Exactly how? I don’t see evidence that one follows the other, nor evidence that American corporations are particularly efficient, plus you need to define “efficient.” Usually means the least effort for a given result, so what effort and what results are you specifying?
Allows investment? I will allow “allow,” but allowing something doesn’t mean that thing will necessarily follow. US corps and financials are currently sitting on over $3.5 T that is not being invested.
Rewards 401k holders and savers? Hahahahahah!!!
And finally, “… The U.S. would’ve been unable to invest heavily in the
Information and Biotech Revolutions without profit. And, creating efficiencies in those economic revolutions generated more profit to invest in emerging industries…”
No, by and large the big research strides that made modern info and bio business wealthy have been undertaken by government sponsored entities. You should know this by now. Plus, corporations are still by far the biggest recipient of government dollars. Others can fill in the references here, I have to go babysit in a moment, but here’s a link for the moment. http://news.investors.com/ibd-editorials-brain-trust/031414-693376-corporate-welfare-to-fortune-500-is-exposed.htm
“… part of the problem is corporate welfare that is so well hidden from public view in the budget that no one has really measured how big this mountain of giveaway cash to the Fortune 500 really is. Finding out is like trying to break into the CIA.
Until now. Open the Books, an Illinois-based watchdog group, has been scrupulously monitoring all federal grants, loans, direct payments and insurance subsidies flowing to individuals and companies.
This week is Sunshine Week in Washington, a designation made 10 years ago to promote transparency in government operations and how tax dollars are spent.
It’s an attempt to force federal agencies to release information on where the $4 trillion budget is really spent — and Open the Books will release a new report on corporate welfare payments to the Fortune 100 companies from 2000 to 2012.
Over that period, the 100 received $1.2 trillion in payments from the federal government…”
Noni, yes, federal spending is most inefficient, and there are opportunity costs.
Efficient is allocating limited resources to produce more with less time, effort, and money, which allows profit and more investment.
Of course, when there’s uncertainty, firms will be risk averse.
even conceding the point that Fiduciary Duty is first to the organization, the stockholders would be no lower than second in the hierarchy, if not equivalent, and there are points in time, i.e., the Revlon precedent, where stockholders are primary to all other interests.
This is what the CEO of Marsh & McLennan said last week about profit – it’s one of many examples of an executive who understands his job:
“When we’re thinking about the firm and we’re in the Executive Committee, we make our decisions in the interest of clients,
colleagues and shareholders. We make decisions which we believe are in the best interest of all 3 over the mid- and long-term.
We have no interest in shorting one for the other. In our view, it’s all linked together. Big companies like to measure things. They
like to count. And we’re no different. We look at everything. We’ve got plenty of metrics. But we don’t lose sight of the fact that
profit and profit growth, that’s the most important metric. Nothing good can happen in Marsh & McLennan Companies unless
profit is going up. When profit is going up, we can invest more in colleagues. We can invest more in the business. We can built [sic]
more client technologies. We can acquire more firms. We can return more capital to shareholders. Profit is good. And we spend
more time than any other factor in thinking of ways to grow our profit.”
To build from your comment, a major issue I was trying to raise with this post is whether or not it really is a good thing from a market standpoint to have shareholders so high up the hierarchy in who has claim to the profits produced by the company. Are shareholder interests really as likely to align with the company’s interests as the interests of management and employees?
It also needs to be noted that our institutions already possess a bias towards shareholders that distorts how compensation is distributed. A really simple example of this is that if a company decides to distribute its profits to employees this becomes an expense and would be looked at poorly by the market. But this same distribution would be classified as dividends or a share buyback and looked at favorably by the market.
Now, this makes perfect since from the shareholder perspective and is essential for a newer company that has a non-trivial likelihood of needing to raise capital. The current institutional framework works very well for this.
But how about a large multi-national with substantial foreign holdings and diversified assets? Why should this company continue to work for shareholders? Shareholders definitely deserve a return on investment, this is necessary so that capital markets work properly for new companies. But why should this outflow of wealth be perpetual? Is there any net benefit to anyone but shareholders of an economic system that institutionalizes perpetual rents because of the initial need for capital? Employees and managers develop company specific skills and knowledge which cause them to identify strongly with the company, shareholders are always a bit more distant (I am exempting partnership arrangements or closely held non-publicly traded firms which tend to have a different relationship with their owners).
Should we really be content with an institutional arrangement where compensating employees reduces profits and is seen in a negative light by most measurements of a business’s success?
“I am exempting partnership arrangements or closely held non-publicly traded firms which tend to have a different relationship with their owners” Why? And at what point do closely held become “non-closely held”.
It’s the shareholders who own the company. It’s their money. In choosing to purchase the shares they have a claim on the future cash flows of the business. If you haven’t yet learned in your MBA classes, you will (or should), the theoretical value of any financial asset is the market’s view of the present value of future cash flows, where present value is calculated by discounting at rate of the risk-adjusted opportunity cost of capital.
The reason distribution to shareholders in the form of dividends our buybacks are viewed favorably is that cash is being returned earlier than otherwise expected by the market and thus is discounted at a lower rate for cost of capital. The reason increasing compensation to employees is viewed negatively is the company is directing cash flow away from the owners of the company and to employees.
If employees want higher standing in the hierarchy, they should accumulate the shares. If they have developed specific skill sets that they feel are not being appropriately valued by the company, they can seek employment elsewhere. There are sticking costs on both sides of that equation.
Setting aside the notion of control premiums, why should 10 non-operating owners of a company each owning 10%, e.g., “closely held”, be entitled to a higher proportional share of cash flows than 10 million owners each owning 1/10 millionth of the company?
“Typically, profit is the result of efficiencies. It’s the reward of efficiencies. Producing more output, and higher quality output, with fewer inputs raises living standards.
That, in itself, benefits the masses.”
Not unless prices fall, which reduces profits, it doesn’t. Benefit to the masses comes from uncaptured efficiency (i.e. consumer surplus) not from profit.
I’ve been saying for some time that ultimately the purpose of very high executive pay is to socially isolate the management from the workers. In the old world of company towns, the manager saw his employers daily out of work. The first change was physically removing the head office from the productive units. Then came self-selection in enclosed very rich enclaves. This hasn’t necessarily been deliberate but it has been self-reinforcing.
Reason, you’re completely ignoring costs.
Lower costs can raise both profits and consumer surplus.
And, efficiency allows income to rise.
The pie isn’t fixed. It’s not a zero-sum game.
” The pie isn’t fixed. ”
The pie isn’t fixed. The way the pie is distributed is fixed.
Which , frankly , makes me want to take a dump on the pie.
“Reason, you’re completely ignoring costs. ”
No I’m not. If increased productivity is to benefit the general public then EITHER
incomes must increase or the prices of products must fall. Cost is irrelevant.
And by the way regards your earlier argument about profits being necessarily for investment – well yes some profits are necessary for investment, but not necessarily more.
1. Investment funds do not just come from retained profits, other people’s savings (like the savings due to reduced prices) can be the source.
2. Investment is incentivised by returns over the cost of capital. But this doesn’t necessarily require increased returns, the cost of capital might fall.
And (in reply to some