Are Shareholders Their Own Worst Enemies?

Cornell’s Lynn Stout challenges the shareholder-value “ideology.”

Cornell Law School’s Lynn Stout is challenging the cherished idea that nothing is more important than share price.

Ideas have consequences, we all know, but some have more consequence than others. If ever the business world generated a consequential idea, surely it's the notion of "shareholder value;" that publicly owned companies exist solely for the benefit of their stockholders, and that the CEO's highest—perhaps only—responsibility is boosting the share price.

That may sound uncontroversial, but Cornell Law School professor Lynn Stout says the "shareholder-primacy ethos" encourages a focus on short-term earnings while neglecting the long-term view and the larger, societal consequences of corporate behavior. Her new book, The Shareholder Value Myth, makes the whole concept sound like little more than a convenient rationale for enriching corporate managers and institutional investors at the expense of ordinary folks.

[See Why Investors Shouldn't Worry About the Next 10 Years.]

Stout calls shareholder primacy "an ideology," not based in law or solid economics. Even GE legend Jack Welch, viewed in the 1980s and 90s as the high priest of shareholder value, by 2009 had come to see it as "the dumbest idea in the world." Stout's alternative is known broadly as "managerialism," or the idea that large corporations should consider not just their shareholders but also their "stakeholders"—employees, customers, counterparties, and society at large.

We chatted with Stout about her book. An edited transcript:

Who is most responsible for popularizing shareholder primacy, and do you think their motives were self-serving?

It's the product of what you might almost describe as academic central planning or an attempt at intelligent design. It was the brain-child of the Chicago School economists, invented in the lab, as it were. But it was very useful to certain influential interest groups, among them executives like Jack Welch, who recognized early that if you could structure their compensation around share price and then run the firm to maximize share price, they individually could get very wealthy. And, in fact, that's exactly what Jack Welch did. [GE] was very well run for a time. But a lot of people have criticized that emphasis on constantly raising share price for [GE's] failure to keep up with research and development, and hollowing out some of its workforce, and for causing it to spend a lot of time lobbying Congress for tax loopholes, which may be good for GE shareholders but is bad for the human beings that own GE shares if they happen to be taxpayers.

[See Investors: Look Past Politics.]

Do you draw a distinction between institutional and individual shareholders?

The significance of the rise of institutions is not that they have different interests from individuals, but that now those interests are being channeled in a fashion that actually may be counterproductive. There are two things that happen when you introduce institutional intermediaries. The first is, because they tend to own larger blocks of stock collectively, they actually have more influence over boards, more clout. That wouldn't be a problem, necessarily, if it weren't for the second characteristic of these institutions, which is that many of them are short-term investors that tend to hold their shares for a couple of years or even a couple of months. And it's that second characteristic that is the source of much of the trouble. It's not that mutual-fund managers are myopic people. It's just that they recognize the reality that if they can't generate short-term returns in a market where it's all a relative game, they're going to lose assets to funds that do generate short-term returns.

But individuals are partly responsible?

The [average] holding period for stocks was eight years in 1960; it's down to four months. One of the primary causes is that the cost of trading stocks has declined so dramatically. Once upon a time, brokers and dealers imposed a fixed commission on trades that was quite high. We also used to have a stock-trading tax. It was reasonably modest, but it also helped slow down trading. Throw in the convenience of internet technology, and now there's almost no marginal cost to trading stocks, which means people are constantly chasing their own tails. And by people, I mean individual investors but also pension and mutual-fund managers trying to beat the market by buying and selling. That has shortened our collective time horizon as investors.