On Shareholder Value

In response to this email:

"I need your brain. I very badly want a response to this. Please be nice but honest. I don't know enough context to respond with something defensible.

https://thesustainableinvestor.net/2016/02/23/fact-v-fallacy-the-legal-duty-of-public-corporations/

"

TL;DR: The article's definition of shareholder value is incorrect - shareholder value is truly a very long-term measure, much more so than any concept of "stakeholder value," which is frequently absurdly easy to game in a really negative way. Short-termism lies instead in the tendency of markets to extrapolate from short-term results to long-term outcomes, and the overall error is to equate near-term stock price with shareholder value. However, per-share long term shareholder value is by far the most efficient and least corrupt measure a system can target, and combating that extrapolation bias should be the focus, not moving away from shareholder value.

If shareholder value were defined even remotely like the article defines it, then the article would be reasonable.

The notion of short-termism in business is nebulous and thus gets badly abused.

What is shareholder value and why do we maximize it?

Shareholder value, at its simplest, is the discounted set of all future profits attributable to a single share of equity. This means that the concept of maximizing shareholder value has almost nothing to do with short-term EPS; a responsible manager tries to manage the per-share results of a company over a span of decades. This obviously incorporates a wide range of outcomes, which is why risk is an important component of thinking. It also incorporates the legal consequences of malfeasance, the operational consequences of being shitty to your employees/suppliers/customers/creditors, etc.

In fact, the whole rationale for using shareholder value - which I think this article misses the point of - is that shareholder value is only maximized when you do everything else right. They're at the bottom of the totem pole, the people who get what's left after employees have been compensated and incented, suppliers and customers have been served, and debtholders have been repaid.

In short, shareholder value maximization is anything but short-term - it is one of the few metrics you can actually look at that ISN'T short term and doesn't screw someone over (I have yet to see any measure of "stakeholder value" that looked dynamically at how incentives change when you put in stakeholder initiatives, nor have I ever seen a policy proposal acknowledge economic gravity when it tries to stop something bad from happening but instead just delays it and makes it worse - think "the euro" and "chinese credit-driven stimulus" type problems). Usually, the one who gets screwed is the equity - if they don't have a legal right to be prioritized, it's absurdly easy to steal from them. Occasionally, in really dire situations (think subprime, we'll come to this), "stakeholder" initiatives can screw the customer and the lower-level employees, as well.

For what it's worth, shareholder value maximization makes it MUCH easier to raise capital for innovative businesses - having done a lot of investing in Europe and Asia, where shareholder value is not a focus, the pace of innovation, the manner of competition and the level of corruption is staggeringly poor - managers and governments essentially loot the businesses under the guise of "social welfare" or whatever, and it makes honest businesses very difficult to fund (and makes the whole system far less trusting, which drives away the honest people, and becomes a pretty insidious vicious cycle).

Even in the US, for what it's worth, having looked at a bajillion businesses, there's far more waste and inefficiency in the direction of not being shareholder-oriented enough than there is in being too shareholder-oriented. Probably by more than one order of magnitude, actually... the exceptions tend to be industries whose regulatory regime is badly designed, and the fix is almost never as simple as a refocusing of company priorities.

Then why are there so many problems?

A) there is no such thing as a perfect system, just one that is better than alternatives

B) That's glib, so let's talk about short-termism.

Short-termism isn't a problem with the theory, it's a problem with human behavioral bias. It's the tendency of people to extrapolate from short-term earnings to long-term earnings.

Investors do this - stocks go up a ton on quarterly earnings not because of three months of earnings but because of what those quarterly earnings signal about the long-term trajectory of the company. It's amazing how different the reactions look like to companies missing a quarter when it's clearly a temporary issue vs. when it's the first manifestation of an issue that permanently impairs the long-run trajectory of the company - if you tell the market you're out of business 6 years from now but the intervening 6 years will be great, your stock is almost certain to be punished (unless that's what everyone was expecting anyway). 

That, incidentally, is why it pays to have an IR team that is both honest and good at communicating - investors, by virtue of being at the bottom of the totem pole (and thus being highly vulnerable), can be very skittish, and the ability to communicate honestly about what types of events are temporary vs permanent is a valuable skill. This doesn't happen often because a lot of management teams know their career isn't that long, and so they care far more about the stock price NOW than they do over time because by pretending the long-term trajectory is better than it is, they are paid more for being smart. Thus, they have their IR teams pretend that negative events are temporary and positive events are permanent, no matter what they actually are. This would be termed an "agency cost", where the management is NOT maximizing shareholder value but instead maximizing their own compensation... it is the antithesis of shareholder value, and investors get pretty pissed when they figure out that's what you're doing.

For what it's worth, Enron and Worldcom didn't "maximize shareholder value", they committed fraud to pretend they were. Subprime was the product of a regulatory environment that incentivized social goals of homeownership (ie, customer welfare) over social goals of a solvent banking system (when the latter was far more consistent with long term shareholder value, as anybody who has ever looked at credit will tell you), exacerbated by a set of customers and private sector businesses who couldn't extrapolate forward to see that the incentives the government offered to distort sources of value would end in disaster. BP oil was a perfect storm of engineering errors that had nothing to do with shareholder maximization and everything to do with engineering system design that I promise you the CEO had nothing to do with and barely understood. 

Lynn Stout's quote is mostly true (the tragedy of the commons example is a bit of a straw man, but i'll let it slide)... it's just really, really obvious - it's unfortunate for the state of the lay discourse that this analysis is what passes for thoughtful. The real mistake the Chicago school made was to assume markets are efficient and thus to claim you can equate short term stock price with shareholder value - the mistake was not in the shareholder value maximization part of the system.

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On the Chris Christie M&Ms photo

It makes me sad that so many people (rightly) willing to go to the mat for even small slights to racial, gender and LGBTQ equality are so willing to post photos mocking Chris Christie's struggles with obesity just because they disagree with his politics. 

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How crises start

For people who want to know how crises start, oil is a pretty good case study- relevant to the housing bubble, the current Chinese collapse, student loans/for-profit Ed, and many others. The short answer is "it takes a confluence of factors" including overoptimistic industry participants, short-term oriented sources of financing and regulatory overengineering. 

1) a trend that seems more sustainable than it is to industry participants (Saudis keeping oil prices high, plus production going out because of Iranian sanctions and assorted Middle East wars. For subprime, house prices remaining regionally uncorrelated. For China, rural to urban migration, low labor costs and good capital investment opportunities. Etc)

2) overly-loose financing, supported by banks in the interest of short-term loan growth and bondholders  stretching for yields to fund pension payouts/endowment withdrawals/insurance claims. Allowed by state/federal gvt in the interest of something else (job growth and energy independence here, in case of subprime it was home ownership, with for-profit ed it was college access, etc)

3) key regulatory overreaches by well-meaning but not very thoughtful government officials: in this case, when you take a mineral lease in the US, you have a short amount of time (usually ~3 yrs) to have drilled in the area or the lease reverts to the government - so even companies who would have liked to be conservative stretched to drill as much as they humanly could to keep their land. Canadian cos have struggled far less because the regulatory is laxer (more time and each well secures you more area) so debt wasn't as required to keep your land. 

For-profit Ed had gvt willing to guarantee 90% of student loans to promote enrollment. Subprime had gvt willing to buy loans sight unseen to promote home ownership and a bunch of requirements from the 90s that lending standards be lowered to support better economic outcomes for disadvantaged groups. China... Has a very long list :p

https://www.washingtonpost.com/news/wonk/wp/2016/03/25/the-big-bust-in-the-oil-fields/?hpid=hp_hp-top-table-main_oilbust-820pm%3Ahomepage%2Fstory

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Poorer than any U.S. state (HT KPC)

http://blogs.spectator.co.uk/coffeehouse/2014/08/why-britain-is-poorer-than-any-us-state-other-than-mississippi/

From the Official Rackspace Blog- A Sad Day For Patent Reform. A Bad Day For Innovation.

Disgraceful.

http://www.rackspace.com/blog/a-sad-day-for-patent-reform-a-bad-day-for-innovation/

Completely agreed.

	Megan McArdle (@asymmetricinfo)
4/15/14, 11:02 AM I'm speechless. Completely inexcusable. The administration deserves all of the criticism it will get, and then some. nytimes.com/2014/04/16/us/…

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Compassionate Use

http://www.cnn.com/2014/03/10/health/cohen-josh/index.html?hpt=hp_c2

My understanding with compassionate use is that the biggest issue is that complications experienced by compassionate use cases can be used as adverse events that prevent approal. I don't think the CNN explanation gets at this at all. Am I wrong?

Summers to Fed?

The fact that Summers to Fed has even been discussed is a sign of complete economic illiteracy by the administration. It's genuinely shocking that there isn't a single person in the administration either smart enough or brave enough to say so. 

First, the positive. I think he'll do a better job than his critics suggest on bank regulation. He doesn't like the complex regulatory schemes that others within the administration have favored because he thinks complex rules are too easy to be gamed. On this, I agree. 

However, to anybody who thinks this role is primary (like, clearly, Obama), have you been paying no attention at all to anything happening in stock or credit markets? The stance of monetary policy - QE, tapering, IOR, *interest rates*.... That literally shapes the path of the US economy, and Summers is simply not qualified to carry that out in two important ways. Content wise, I agree with Scott Sumner - he has zero knowledge of monetary policy at the zero bound. His "paper trail" suggests he believes monetary policy is ineffective at the zero bound. This is an absolutely archaic notion, and this belief outweighs any potential role as a financial regulator. It's like asking your pediatrician to be your dentist because he's generally smart and great with kids when he has never worked on teeth before. 

Speaking of great with kids, the other qualification for Fed chair is temperament with the media. Every time you speak, six billion people hang on your every word. Thousands of people make a living interpreting what you say and how it will affect monetary policy over the short, medium and long run. It is a position for somebody who doesn't speak thoughtlessly, who understands the importance of every word they say. Watch one Bernanke press conference and you'll see exactly what I mean - the man is extremely careful to preserve 100% the credibility of every word  coming from both the institution and the position. And should be! Larry Summers is notoriously thoughtless and blunt in his opinions. Has everyone forgotten how he got himself fired from Harvard? How he alienated people there, how he alienated people in the government working there, his style in every meeting?

I believe Larry Summers would have made an excellent Treasury Secretary- better in his little finger than Jack Lew could ever hope to be with his whole body. Summers WAS a good treasury secretary under Clinton and would handle the increased importance of the position with aplomb. But Fed Chair? Is Obama completely incompetent?

I hate the perception, looking at my opinions, that I've moved rightward. I'm as difficult to place as always. I just think this administration is being run by an (economic/managerial) idiot. 

Fixing the Financial System

This is a draft of something I've been thinking about for the last week. Unfortunately, I don't have time to look at it for a minute longer, so I'm posting it as is. please forgive the slightly less-than-perfect organization

There seem to me to be two fundamental ways of protecting the financial system. The first is to restrict what financial institutions can do (let's call this "activity fencing") and the second is to restrict the amount they can do it (which is basically deleveraging).

Activity fencing has been a common cry, but I suspect it is far inferior as a method. A number of reasons come to mind. 

Firstly, most of the activities that banks would be restricted from doing are services that banks provide to clients to assist them in reducing their own risk. For example, much of the widely-disparaged prop trading is the bank helping a client de-risk and holding the other side of the deal on its own balance sheet. In many, though not all, cases, this is simply until the bank can find an appropriate counterparty. 

Hedging in this manner can be a big win-win for clients. Think quickly about upside-downside risk of an airline and a refinery hedging the price of jet fuel. Both firms, highly capital intensive and often themselves quite levered, face far more existential risk from an unfavorable move in jet fuel than they benefit from a favorable one. Hedging is by no means zero sum in impact, even if it is in cash flow. 

Thus, banks providing these services is a form of risk pooling, no different from and in many ways superior to that found in a health insurance company. If we aggregate all the risks together, many will cancel out, so that the net remainder of risk is far less. A lot of this remainder ends up on financial institution balance sheets as prop trades. 

Another analogy is inventory management. It is fundamental in operations management that the total amount of inventory you need to hold is lower for a pool of inventory serving lots of outlets than it would need to be on an aggregate basis if each outlet kept its own inventory. This is because each outlet risks over- or underpurchasing relative to inventory levels but must keep a safety stock of extra inventory to handle high demand periods. Aggregating up reduces the standard deviation in demand (outlets that are oversubscribed can cancel out those that are undersubscribed) and allows that safety stock to be significantly smaller. We can think of risk at banks in a similar fashion. 

The true problem of these activities, which legitimately reduce risk on their own, is that it is not easy to measure how much you have actually reduced risk, and if you overestimate how much risk you've reduced, you take on too much additional risk and end up with an institution that is too risky. I hope it is clear in this framework that the issue is not one of "useless" activity but instead one of measurement of just how much that activity is helping. 

Addressing this fundamentally must happen by restricting legitimately helpful activity where it is very hard to measure the amount of help it provides on the margin. The question is whether this should be done more by restricting types of activity (activity fencing) or restricting amounts of activity (leverage). 

Restricting types of activity leaves a lot of risk to corporations. Corporations are generally not too bad at knowing the risks they're going to face, and they tend to be pretty efficient in identifying the risks they want to fix.  Restricting bank activities thus brings down significantly the corporate activity level by limiting them to the risk they can handle unhedged. This sounds nice, but insurance would get significantly more expensive and harder to get, anything commodities-based (airplane flights, food, etc) would be more expensive and harder to get, etc. 

In fact, thinking about returns to scale, it is very likely that the first credit in a hard-to-measure activity is still a much better one to have societally than the marginal (last) credit in an easy-to-measure one. In fact, that marginal credit in an easy-to-measure area is still probably hard to measure when levered up. Would you rather hedge Berkshire Hathaway's fixed/floating interest with a swap (hard to measure but clearly safe) or a subprime mortgage (much easier to measure but not deterministically so, and risky!)

Given this, it seems far more logical to focus on deleveraging, because by deleveraging you prevent banks from taking on too much additional risk regardless of whether they think they can handle it on a measurement basis. It also eliminates the marginal credits that would be the sources of the most problems in a given financial product if that product were to get hit. 

Now, it's important to note here that banks need a return on equity capital to make them able to retain investors. This return may go down as risk goes down, but it certainly does not go down proportionate to risk decreases because of the opportunity cost of capital for investors. 

Given this, in the long term, significantly deleveraging banks would almost certainly reduce credit availability and increase interest rates for those who can get credit. It would necessitate a substantial increase in the money supply to maintain systemic liquidity. Note that we have already observed deleveraging, reduced credit availability and a flood of new money. Interest rates to individuals or organizations who aren't great credits will almost certainly have to rise from here - banks are almost universally earning an ROE below any decent measure of their cost of equity capital, and while it takes time for them to rework their balance sheet, a delevered bank needs a lot of equity and this will eventually revert upwards, which means lousy depositor rates continue but creditor rates creep upward. 

The dynamic leads us to the unfortunate conclusion that it is close to impossible to have credit easily available to groups with credit risk (small businesses and low income individuals) while also having a highly stable financial system. Countries that have avoided this problem are few, far between and largely riding a commodities boom out of China that won't last forever. I'm trying to think of adjustments to the tax system or effective government programs that could mitigate this credit availability issue but all of the solutions I can think of are highly inefficient. 

This also makes me think about the efficacy of monetary policy under different leverage levels. Safer credits are safe because they have predictable businesses. Adjusting interest rates may not affect their borrowing and investing decisions as much as it would for lesser credits and we may thus need more aggressive monetary policy responses for the same effect under a safer banking system. 

GDP-Indexed Bonds

Tyler Cowen outlined a number of hypotheses on why countries don't issue GDP-indexed bonds. It can be found here:  Marginal Revolution Why no gdp-indexed bonds? 

He had 5 hypotheses - Falsification, Adverse Selection, Existing CDS markets, Illiquidity of splitting a small country's bond market, and governments not running big budget surpluses in good times.

I have a sixth that I suspect may dominate all of the above: who are the investors? Banks, who I suspect are by far the largest purchasers of government bonds, tend to already have plenty of floating rate liquidity available to them on both the asset and liability sides (note that GDP-indexed and floating interest rate bonds should come close to comovement, unless you're basing it on real GDP, in which case all you're doing is stripping the inflation protection from floating rate bonds, which would be a substantively inferior product to what banks can get already and would thus require a discount). Individual investors who buy bonds tend to do so because they want the reliability of a fixed cash flow even (especially!) when GDP drops. And making products to sell to financial services firms (mutual funds and hedge funds) is not exactly a recipe for great pricing.

I am sure countries COULD sell GDP-indexed bonds, but how much worse would the terms be relative to a fixed rate?