Wednesday, April 18, 2012

Shareholder delusions of grandeur.

Challenging assumptions about the power and role of shareholders.

Of all the metaphors in the English language, the one that is the most intriguing is the “tail that wags the dog.” It creates all kinds of flights of fantasy involving different breeds and different tails. Because I have two pet boerboels, the most fanciful to me is imagining their docked tails wagging 40 odd kilograms each of solid muscle and bone.

The metaphor fits well with the concept that shareholders are an omnipotent collective that have ultimate control over the destiny of companies and that this power is entrenched in the overwhelmingly vital contribution they make to the company and society as a whole.

I must emphasise that this is not an attempt to demean or understate the important role that the shareholder and therefore capital plays. There is no point in trying to establish a hierarchy of importance to company wealth creation. It is as senseless as arguing that breathing is more important to life than blood flow.

But for whatever reason, perhaps even as a throwback to cold war rhetoric, and certainly rooted firmly in concept of the inalienable right of ownership, the paramountcy of shareholders and the overriding importance of increasing shareholder value dominate business thinking and coverage of business affairs. This has done little more than demean the real overall value of companies to society and the important contribution of other role players. It has also skewed the debate around Black economic empowerment, cultivating a delusion that empowerment lies in ownership and that Malema style “economic freedom” can only be achieved through possession or control of productive resources, including companies.

The paramount importance of shareholders is not even statistically true. As a recent example I have converted the Barloworld 2011 value-added statement to a Contribution Account© which I have explained in an earlier article.

clip_image002The graphic shows that Barloworld employees (including management) were responsible for nearly 80% of the value created last year. Shareholders created 12% and government 9%. Because of its structure, the company’s wealth distribution differs significantly from the national average of 50% to employees, 35% to capital and 15% to the state. Barloworld today is a very different company from the industrial conglomerate it used to be years ago, and is more of a brand trading company than a manufacturing one which accounts for the relatively large employee share.

It really does not matter whether we want to challenge the concept that wealth distribution represents each share of wealth creation. Statistically, value added is a measurement of contribution, and therefore each share of distribution must measure the relative share of contribution. We all have our subjective views on relative values, but price is the only objective common ruler of value that we have.

Taking the Barloworld example further, wealth created of about R8½-bn in 2011 (adjusted to Contribution Accounting) was its contribution to South Africa’s Gross Domestic product, and nearly 19 000 employees contributed (and received) some R6.7bn. But to really assess the company’s impact on the economy, you have to note the total revenue of just under R50bn, and the fact that because of the company’s activities it created a revenue stream of more than R40bn for others.

I’ve always been bemused by the focus of company reporting and the emphasis on the net profit figure. In the Barloworld case, after tax profit was just over R1bn or 2% of revenue. Heavens! What happened between R50bn and R1bn! To argue further that the R50bn is all made possible exclusively through squeezing out R1bn seems ludicrous at best. In a future article, I will argue that with the growing stakeholder approach to companies, the predominance of the income statement over the value-added statement, or preferably the Contribution Account can be questioned.

One argument for shareholder dominance is that they earn the right of control because they take all the risks. This may be true in cases of one or two individuals who have a major shareholding and are actively involved in the company. But for the large body of shareholders represented by institutional investors, one has to factor in relative risk. They would hardly feel the loss of a small part of a portfolio spread over many investments. In today’s world, jobs are not guaranteed and the loss of a job to an employee is far more devastating and the risk far greater.

The biggest misconception about company ownership is that shareholders are a small generic collective with identical aspirations, expectations and behaviour traits. In addition they are often portrayed especially in populist rhetoric as an elitist bunch of capitalist fat cats that “profiteer” from the masses.

Nothing is further from the truth. Shareholders can range from the one man owner of a small company to millions in large corporations represented by pension funds, insurance companies and investment management companies. In Barloworld, for example, directors and employees hold only 0.13% of the issued share capital. The rest is held by the general public, largely (66%) through pensions and life insurance. In turn, nearly half of this is held by the government employee pension fund.

The classic understanding of shareholding is that it provides capital in return for a share in the profit of a company or venture. For a very large number of small and medium entrepreneurs, who are the backbone and significant contributors to GDP and employment, “ownership” spells a lot of red tape, stress, and an income below that of an average government employee, according to economist Mike Schussler.

As companies grow and need more capital, they issue shares which raise capital on a stock exchange. In most of these cases, the founders are still heavily involved in the operations of the company and their relationship with it is very different from a share investor. At this point, the company is still primarily focussed on its operational activities in the marketplace and does not readily kowtow to the whims of shareholder interests apart from offering competitive returns.

Something fundamental seems to happen though, when these economic entities get swallowed up into large holding companies, in turn owned by institutional investors whose interests then become overriding, often narrowly focused on short-term returns and leading to the appointment of “professional executives” to ensure their outcomes. This leads to a centralisation of economic power, paradoxically funded by public money, and wielded by “proxy”. Many forget very soon that they ultimately get their power from being custodians of the public’s savings.

In the process, we create very powerful portfolio managers and institutional Geppeto’s who appoint their own Pinocchio’s in companies to chase maximum shareholder value in the shortest time possible. Rewards at this level are set up to encourage this behaviour but when these Pinocchio’s act exclusively to enrich themselves, the Geppeto’s shout: “Foul! We asked them to steal for us, now they are stealing from us!”

It is small wonder that the world has rebelled, with some shareholders (Theo Botha) challenging both Geppeto and Pinocchio and some Geppeto’s (Allan Gray) challenging Pinocchio. It has all culminated in an erosion of consumer and investor trust in business and their executives.

Yet, at the heart of a good business lies a very socialist principle: that of people serving people. When it stops doing that, shareholders should run…much sooner and faster than when profits are down!

For their power is a delusion. Real power resides with customers.

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