Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

Hurdle rates are critical to the way in which companies allocate capital, but they are deeply affected by expectations – or what Keynes called ‘animal spirits’. 24The hurdle rate of a project is usually determined relative to the cost of capital – basically, interest rates on borrowing and dividends to shareholders. The project should generate returns, calculated as an Internal Rate of Return (IRR) or Return on Invested Capital (ROIC), 25higher than the firm’s cost of capital. But an odd discrepancy has appeared. On the one hand, the cost of debt-financing has been at record lows and could reasonably have been expected to encourage that kind of finance. On the other hand, according to the investment bank J. P. Morgan, 26the weighted average cost of capital remains quite low at 8.5 per cent but the median hurdle rate (minimum return on investment needed to justify a new project) reported by S&P 500 companies is 18 per cent. This suggests that companies are not pursuing investment opportunities unless the differential between their expected returns and their cost of capital is around 10 percentage points. Why would they leave such opportunities on the table? One explanation, given the exigencies of MSV, is that they have easier alternatives – such as share repurchases.

MSV, then, sets off a vicious circle. Short-term decisions such as share buy-backs reduce long-term investment in real capital goods and innovation such as R&D. In the long run, this will hold back productivity. With lower productivity, the scope for higher wages will be limited, thus lowering domestic demand and the propensity to invest in the economy as a whole. The spread of financialization deep into corporate decision-making therefore goes well beyond the immediate benefits it brings to shareholders and managers. As Hyman Minsky observed, there appears to be an inevitable dynamic of the capitalist system: unless properly regulated or with the right buffers, it will expand too fast. Steady growth caused by increased borrowing – which speeds up value extraction – is matched by the rising value of assets. Everything seems to be fine – until people start to query the value of assets. Then trouble brews.

FINANCIALIZATION AND INEQUALITY

One of the key precepts of MSV, as we’ve seen, is that the incentives of management and shareholders need to be aligned, and that the best way to do this is to compensate management by awarding them shares. Senior managers soon embraced MSV when they realized how it could help them to increase their pay (Figure 23). The original spirit of MSV has been perverted: the massive share options which have been a major part of many CEOs’ pay packages do not really align with managers’ and shareholders’ interests. Managers – depending on the terms on which they are granted options – enjoy an almost free upside, with no downside. They are partly insulated against the ups and downs of share prices that are the lot of long-term investors via anti-takeover devices such as the ‘golden parachute’, a cash reward if they lose their job, or ‘poison pills’, which trigger an event such as the sale of a valuable corporate division to reduce the company’s value when faced with an unwelcome takeover attempt.

Figure 23.Median CEO pay in the US ($m, constant 2011 $) 27

Shareholders were not the only stakeholders whose interests were imperfectly aligned with those of managers. Despite a period of downsizing (corporate speak for firings), which – especially after the late-1980s conquest of conglomerates – was meant to strip away surplus management and raise the productivity of employees who survived the cull, the ratio of CEO pay to workers’ pay also soared (Figure 24).

The emphasis on short-term results has also led to another self-fulfilling outcome: the reduced tenure of management. As seen in Figure 25, the average tenure of CEOs has over the past few decades dropped from ten years to six. When one considers that CEO pay is heavily weighted towards share price performance, the need for companies to perform in the short term can be viewed not as pressure from an external gatekeeper gone rogue but as a mutually advantageous set-up that has served the interests of an elite few at the expense of the many.

The importance of EPS (earnings per share) growth as a measure of corporate success has become as much a proxy for MSV as the share price. But EPS has not always enjoyed this totemic status. While Samuel Palmisano (IBM President from 2000 to 2011, and CEO from 2002 to 2011) argued that IBM’s main aim was to double earnings per share over the next five years, half a decade earlier in 1968 Tom Watson Jr (IBM President from 1952 to 1971) argued that IBM’s three core priorities were (1) respect for individual employees, (2) a commitment to customer service and (3) achieving excellence. Although they are anecdotal, the two pronouncements by two different CEOs of IBM at two different times illustrate how priorities have evolved.

Figure 24.CEO-to-worker compensation ratio in the US 28

Figure 25.CEO tenure in the US 29

Palmisano’s statement reflects what most corporate CEOs would parrot to their investors these days. This measure of a company’s performance comes down to its two major components: earnings and the number of shares. The first, earnings, is an output from the profit and loss account of a company. It is notoriously vulnerable to manipulation. Earnings are usually calculated according to the Generally Agreed Accounting Principles (GAAP), the widely accepted framework of standards, rules and conventions accountants follow in drawing up financial statements. But within GAAP there is scope to adjust earnings to allow for exceptional items (which must be reported but can recur for several years), such as company restructuring charges, and extraordinary items (isolated events which do not need to be reported), such as hurricane damage. Managers therefore have some leeway to massage earnings. More than that, earnings are fundamentally determined by the company’s operating profits, which in turn are the product of sales growth and earnings margins.

The number of shares outstanding is less vulnerable to accounting manipulation, but corporate actions can definitely influence it: for example by granting shares and share options for CEO and management compensation, and via share buy-backs. A delicate balance must be struck. Awarding shares to managers as part of their pay reduces EPS growth. Buying back shares can raise EPS, provided that the cost does not offset the gains from lowering the number of shares in issue.

Sales growth and improved profit margins, the two components of earnings growth, are positively influenced by investment, whether in plant and equipment (capital expenditure) or R&D. Investment is the story corporate managers like to tell. But there is another, quicker and more predictable way to improve margins, about which managers are less forthcoming: cutting costs. It’s a process that companies have embraced – to the detriment of investment.

Figure 26 shows how business investment in the US is now around its lowest level for more than sixty years, an amazing and disturbing phenomenon.

At the same time, as discussed in the previous chapter, the decoupling of average productivity and earnings means that the share of total value added going to wage earners has also steadily declined. William Lazonick, the chronicler of share buy-backs, has characterized these two trends, when taken together, as a shift from a model of ‘Retain and Invest’ to ‘Downsize and Distribute’. The first strategy – ‘Retain and Invest’ – uses finance only to set up a company and start production. Once profits are being made loans are likely to be at least partly repaid because retained earnings are a cheap way of financing the next production cycle and investments to expand market share. The second strategy – ‘Downsize and Distribute’ – is entirely different. It views companies merely as ‘cash cows’ whose least productive branches have to be sold. The resulting surplus is then distributed to managers and owners, rather than to others such as the workers who have also contributed to the business. The result may hamper the growth of the company and even cut the workforce – ‘Downsize’. If the shareholders are happy, however, the strategy is justified.