Over recent months, a group of the world’s largest firms, banks and asset managers on Wall Street has been holding “secret summits,” the Financial Times reported last week. The goal, says the FT, is “to hammer out proposals for improving public company governance to encourage longer-term investment and reduce friction with shareholders.” The firms include BlackRock, Berkshire Hathaway, Fidelity, JPMorgan, the Canada Pension Plan Investment Board and the activist hedge fund, ValueAct. The most recent “secret summit” took place in December 2015.
The meetings are said to be taking place because of growing concern that publicly owned firms are driven by short-term gains in the stock market. Confrontations between activist hedge funds and managements are increasing, with institutional shareholders now often supporting the activists.
Dissident shareholders can be a pain in the neck for corporate managements. As the FT notes, “The largest companies typically face a half-dozen or more votes from dissident shareholders at each annual meeting, on topics ranging from executive compensation to environmental policies and political lobbying.”
When the dissident shareholders are activist hedge funds with billions of dollars at their disposal, the situation is rather more attention-getting. When activist hedge funds and institutional investors join together to form a combine and use their massive resources to demand that the firm change its ways, the managers of even the biggest firm have little choice but to go along with whatever the combine is demanding.
Yet proxy battles are time-consuming and costly for institutional investors. One can see why big firms like BlackRock have an interest in avoiding such public confrontations and finding ways to solve these issues in a quieter, more collaborative fashion.
It is not surprising therefore that BlackRock’s CEO, has written to the chief executives of all Fortune 500 companies warning them of the risks of “short-termism” and urging them to develop “long-term visions.” Thus BlackRock’s recent newsletter notes that in the largest proxy contests in 2015, BlackRock voted with activists 39% of the time. This was, the newsletter says, because the activists “offered better strategies than management.” The newsletter ties in with the current round of ‘secret summits’ aimed at reaching some kind of a truce between management, institutional investors and activists.
Will Wall Street’s “secret summits” and BlackRock’s calls for “long term strategies” make things better or worse?
On the surface, you might think: what could go wrong? A call to shift from short-term thinking to longer term value creation? Surely that could only do good! Let’s take a look. We’ll find that it depends on: value for whom?
The Risks Of Wall Street’s ‘Secret Summits’
There are a number of worrying elements about what is going on.
First, secrecy. When asked about the meetings last Wednesday (February 3) on CBNC’s Squawk Box, Larry Fink, CEO at BlackRock, would neither confirm nor deny that the meetings had even taken place. He would only confirm that BlackRock is “always having conversations with the firms it invests in.” The FT couldn’t find any participants willing to comment on the secret summits. If these summits are in the public interest, why such secrecy?
Second, location. The fact that the December meeting took place at JPMorgan on Wall Street is another alert. Given the compensation structure of Wall Street which is notoriously skewed towards huge bonuses for gains in the here-and-now, one has to wonder: how likely it is that these ‘secret summits’ will upset the current apple-cart that is so personally profitable to the executives involved? After all, when was the last time that Wall Street ever did anything that wasn’t in its own narrow short-term self-interest?
Third, the pervasive philosophy of shareholder value thinking of Wall Street. Wall Street is the very home of the world's dumbest idea--shareholder value thinking (MSV), in which the overriding goal of a firm is the extraction of value from the firm for its shareholders, if necessary at the expense of the organization, its employees and ultimately society. JPMorgan for example has explicitly adopted ‘shareholder value thinking."
Fourth, “long-term” on Wall Street is remarkably short. For instance, some analysts have welcomed the supposed “protections against malfeasance” at JPMorgan that are linked with long-term shareholder value and safety and soundness of investment. But the "long-term time-frame" is only three years. By contrast, any significant market-creating investment in the future is likely to require a gestation period of at least five to seven years, not three.
Fifth, the risks of long-term MSV are even more insidious than the short-term, ad hoc variety. Thus when the extraction of value from firms by shareholders takes place on a systematic basis over an extended period of time, then the firm can be left in a debilitated state and unable to compete in the marketplace. When this happens across whole industries over time, it has been shown to undermine national competitiveness.
Finally, we don’t have to imagine how this works in practice. We already have an illuminating case study of the approach at IBM, which shows the dangers. Some of the participants in the IBM case are precisely the same firms that are now involved in the ‘secret summits,’ including BlackRock, Berkshire Hathaway and Fidelity, That case study sheds light on what “long-termism” means for these firms. At IBM, this peculiar kind of “long-termism” was pursued systematically over a number of years with significant consequences.
‘Long-Termism’ At IBM
Thus an elaborate multi-year arrangement for “long-term value creation” took place from 2006 onwards at IBM, until it was abandoned in 2014. It included BlackRock, Capital Group, Berkshire Hathaway, Fidelity, Neuberger Berman, T. Rowe Price, and Wellington.
Ten years later, we can see how it worked and what the results were. It made a great deal of money for the institutional shareholders and the IBM C-suite, but it left IBM itself in a weakened condition.
And we know how it was done. That’s because in June 2014, IBM’s former CEO Sam Palmisano explained how this particular kind of ‘long-termism’ works. He had collaborated with shareholders, including some of the very “big guys” now involved in the Wall Street “secret summits.”
“We gave investors annual outlooks, and we gave them earnings,” says Palmisano. “You have to give them something—they’re owners… You want people to have some clarity so that they will invest in you... In 2006 we told [Wall] Street that we would go from $6 to $10 in earnings per share by 2010. We then tied long-term compensation to that model… We executed it, and it worked for us.”
For Palmisano, managing IBM was all about generating earnings per share for the big shareholders. “If you’re a small, young company and you’re driving revenue without a lot of earnings, you’ve got a completely different model… The Berkshire Hathaways, the Neuberger Bermans, the Capital Worlds are looking at a longer-term cycle for their investment returns.”
Palmisano treated the big shareholders as partners. “We decided to treat our large shareholders with total transparency, as best we could within regulations. We would meet with them. We’d have a couple of them come in every quarter and talk with the entire senior management team… Fidelity, Capital, BlackRock, T. Rowe, Wellington, Neuberger Berman—the big guys. They would each bring four or five portfolio managers…. They could spend as much time as they wanted with the businesses. The meetings went on for hours.”
Palmisano found that the big shareholders supported his primary focus on steadily increasing earnings per share. “Basically, the shareholders were just asking us to be friendly with capital allocation. They wanted more margin expansion and cash generation than top-line growth, because they knew that if we generated cash, we’d give it back to them in the form of a share buyback or a dividend, not a crazy large acquisition that no one else could see value in.”
And so Palmisano became very friendly with capital allocation for his big shareholders.
For the first few years, on the surface, things seemed to be going well. With the help of drastic cost-cutting and massive share buybacks, IBM under Palmisano doubled earnings per share in a five-year plan called “Roadmap 2010,” and followed it by “RoadMap 2015”, which promised a doubling of the earnings per share by 2015. The Roadmaps induced Warren Buffett to invest more than $10 billion in IBM in 2011, along with many other investors, who were impressed with the methodical way in which IBM was able to increase earnings per share. (Buffett’s investment was striking because of his long-standing and publicly announced aversion to investing in technology, which he confessed he didn’t understand.)
And it is not surprising that Palmisano’s memories of those sessions that "went on for hours" with “the big guys” are so lyrically happy. Those meetings did indeed end wonderfully for him. He left IBM in January 2012 with a net payout of $225 million, including all the options, restricted stock, pensions, deferred compensation, bells and whistles.
How could it be otherwise? Just think about the scene. You have the IBM C-Suite which is hugely compensated for jacking up the share price. And you have the managers of the big investors who are also hugely compensated if they get reliable information as to exactly how the share-price is going to be jacked up. Should it be any surprise that this self-interested cabal ends up jacking up the share price? The question remains: was this good for IBM and its other stakeholders or not?
Growing The Real Business?
But the prosperity that IBM's successive Roadmaps generated was a kind of Potemkin prosperity. It was a semblance of the real thing.
According to BusinessWeek, IBM’s soaring earnings per share and its share price from 2006 to 2012 were built on a foundation of declining revenues, failed acquisitions, capability-crippling offshoring, fading technical competence, sagging staff morale, debt-financed share buybacks, non-standard accounting practices, tax-reduction gadgets, a debt-equity ratio of around 174 percent, a broken business model and a flawed forward strategy.
Palmisano got out in 2012, just in time before these problems became apparent. Since then, IBM has had 15 straight quarters of revenue declines and the share price has declined by some 35% during a period in which the S&P 500 has increased around 40%.
Palmisano claims that IBM not only grew shareholder returns but also the real business. “We invested $6 billion a year in R&D. Throw in another few billion for acquisitions of technologies that we weren’t organically developing, and I’d say $10 billion, $11 billion a year. It was 10 percent of revenue. There aren’t a lot of companies investing 10 percent of revenue. At IBM, we knew we had to invest for the long term. Not everything works out. That’s why it’s called research and development.”
Sadly most of the new product initiatives and acquisitions under Palmisano didn’t work out. Is that surprising? Delivering great products and increasing value for customers wasn’t his prime focus. Palmisano viewed his role at IBM as a steward of a machine that makes money for the big investors. “You’re a proprietor at a point in time; you’re a steward. You’re not the founder. You’re there to protect the entity for long-term returns.”
Palmisano believed in share buybacks for “mature” companies. “You have jillions of dollars of cash on the balance sheet. Instead of buying an asset for $8 billion, why don’t you give some of that back?” … you’re not a start-up anymore….The investor expects returns—consistent returns.”
His successor, Ginni Rometty, embraced the same approach. “At the end of the day,” said Rometty in an interview with CNBC in October 2014, “this is about returning value to shareholders.”
So Palmisano, and Rometty set out to deliver consistent returns in the form of earnings per share. The cost to IBM itself of doing so has been considerable.
Two Kinds Of ‘Long-termism’
The ‘long-termism’ that was practiced at IBM is thus a very different kind of ‘long-termism from that practiced at Google, Apple, Amazon, Facebook or Unilever where the prime focus of management is on delivering increasing value to customers. In those firms, shareholder returns are the result, not the goal of the firm.
To observers like BusinessWeek, the kind of “long-termism” practiced at IBM, with its single-minded long-term focus on returning value to shareholders, is precisely what is killing IBM–and ultimately destroying real shareholder value.
As analyst Bert Hochfeld summarizes the situation as of early 2016, “IBM is in the midst of a profound and long lasting loss of market share in key business areas. IBM's success in what it calls ‘Strategic Imperatives’ serves to mask the company's real performance. Much of IBM's Cloud initiative is no more or less than simple cannibalization. IBM's software business has apparently hit a very hard and very disagreeable wall. It is hard to make a case for an Information Technology vendor that lacks unique and proprietary technology.”
“IBM ramped up its Indian presence extremely rapidly, from 9,000 in 2003 to 74,000 in 2010. But it still manages to have higher costs and it continues to lose share points to its major Indian-based competitors.”
BlackRock’s Newsletter To The Fortune 500
So in one sense, it can sound promising that Larry Fink, the chief executive at BlackRock, has just sent a letter to the chief executives of major corporations warning them of the risks of short-termism and urging them to think more about “long-term value.” Here’s some of the text:
“While we’ve heard strong support from corporate leaders for taking such a long-term view, many companies continue to engage in practices that may undermine their ability to invest for the future. Dividends paid out by S&P 500 companies in 2015 amounted to the highest proportion of their earnings since 2009. As of the end of the third quarter of 2015, buybacks were up 27% over 12 months.
“But one reason for investors’ short-term horizons is that companies have not sufficiently educated them about the ecosystems they are operating in, what their competitive threats are and how technology and other innovations are impacting their businesses.
“Without clearly articulated plans, companies risk losing the faith of long-term investors. Companies also expose themselves to the pressures of investors focused on maximizing near-term profit at the expense of long-term value. Indeed, some short-term investors (and analysts) offer more compelling visions for companies than the companies themselves, allowing these perspectives to fill the void and build support for potentially destabilizing actions.
“We are asking that every CEO lay out for shareholders each year a strategic framework for long-term value creation.
“Additionally, because boards have a critical role to play in strategic planning, we believe CEOs should explicitly affirm that their boards have reviewed those plans.”
It is promising that BlackRock is lamenting that increasing dividends and share buybacks are “undermining their ability to invest for the future” and urging them to think about “long term value creation.”
But the key question is: long-term value for who? After all, this is the very same BlackRock that collaborated with Sam Palmisano with those lavish dividends and share buybacks to extract value over multiple years from IBM at the expense of IBM's long-term future.
A Crucial Ambiguity In ‘Long-Term Value’
There is thus a crucial ambiguity as to what BlackRock’s campaign for long-termism is all about.
Is it a genuine effort to promote the long-term well-being of the companies being invested in, with a clear focus on delivering continuous innovation and value for customers, with shareholder value being a result, not the goal? Over the last twenty years, firms pursuing this path have been delivering to customers what they are coming to expect, namely, better, faster, cheaper, smaller, lighter, more convenient, more personalized and more sustainable products and services. Successful value creation and innovation will ultimately increase the value of the company.
Or is simply it a front for extracting value for shareholders in a more systematic and lower-cost fashion?
Sadly, the track record of BlackRock and others at IBM would tend to indicate the latter. 'Long-termism' purported to be adding long-term value, but in the end, it appears to have had the opposite effect on IBM itself.
What BlackRock Should Do
Let’s think positively and assume that BlackRock has learned from the experience at IBM and does indeed genuinely want to invest in firms that have a strong long-term future. What should it do?
Fundamentally BlackRock must make a choice between two radically different forms of 'long-termism.'
- One form of long-termism is to systematically extract value from firms over a sustained period of time and insist that managers adopt this as their primary goal, as at IBM. This will lead to ongoing disruption in the marketplace, a dispirited workforce, declining margins, a stagnating economy, increasingly severe financial crashes and systematic value destruction,
- The other form of “long-termism’ is that advocated by Peter Drucker where the goal of the firm is to delight the ultimate customer. In this form of 'long-termism,' everyone in the organization is focused on adding value and innovation for those for whom the work is done. Profits—and increasing shareholder value—are the result, not the goal of these organizations. The mindset honors and respects the talents and capacities of those doing the work not only for their own sake but also as a necessary element in generating value for those for whom the work is being done. We know how firms can do this. Scores of books have been written about it. We know that it works. A transition to this more productive mode of operation is not only possible, it is already happening. Organizations being run in the new way are competitively superior to traditionally managed firms. Institutional investors could play a crucial role in getting firms on to this more productive track.
The question is: which kind of ‘long-termism’ will BlackRock choose?
And read also:
The Copernican Revolution in Management
How America lost the capacity to compete
How CEOs Became Takers, Not Makers
World’s Dumbest Idea: Shareholder Value
Capitalism’s Future Is Already Here
The Best Management Article of 2014
Follow Steve Denning on Twitter @stevedenning
