Using strong language in a recent working paper, an economist has set his sights on debunking two of the most well-established ideas in corporate finance: the notion that “maximizing shareholder value” should be a company’s main goal and the principle that issuing stock has been one of the best ways for companies to raise capital.
“This essay is dedicated to the proposition that MSV misunderstands the historical role that the stock market has played in the evolution of the U.S. business corporation and its contribution to economic performance,” William Lazonick, an economics professor at the University of Massachusetts at Lowell, writes in “The Functions of the Stock Market and the Fallacies of Shareholder Value.”
In the paper, Lazonick contends that the “ideology” of maximizing shareholder value has legitimized “the looting of the U.S. industrial corporation.” By measuring performance in terms of MSV, corporate America has justified buybacks that do much more to enrich senior managements and hedge fund activists than to provide the resources needed to fund corporate assets, he argues.
“Conventional wisdom has it that the primary function of the stock market is to raise cash for companies for the purpose of investing in productive capabilities. The conventional wisdom is wrong,” the economist contends.
Citing federal government and academic research on the sources of corporate finance compared with other sources of funds, Lazonick writes that “stock markets in advanced countries have been insignificant suppliers of capital for corporations.”
In fact, the current 30-year surge in stock buybacks as a way to dish out cash to shareholders in the United States “has made corporations massive suppliers of funds to the stock market, rather than vice versa,” he writes. For instance, from 2007 to 2016 the net equity issues of nonfinancial corporations averaged -$412 billion per year, according to the Fed. In 2016, net equity issues were -$568 billion.
To be sure, new issuers can raise funds through public offerings. “But these amounts tend to be relatively small, swamped overall by the stock repurchases that have made net equity issues hugely negative. Moreover, when the most successful startups become major enterprises, often employing tens of thousands of people, these companies tend to become major repurchasers of their stock,” according to Lazonick.
Yet to most economists — and many senior finance executives — the major purpose of a publicly held corporation is to maximize shareholder value. Thus, they would think of the flow of cash from corporations into the stock market as “a ‘return’ of capital to shareholders who will then reallocate capital to its best alternative uses,” according to Lazonick.
But followers of MSV have not been able to connect the dots between shareholder cash and the productive uses it’s supposed to fund in corporations, the economist argues. MSV advocates lack “a theory of the value-creating, or innovative, enterprise, and hence cannot explain how ‘best alternative uses’ come into existence, and in particular the role of organizations rather than markets in creating value in the economy,” he writes.
Instead, since the 1980s, there’s been a growing split between investors, who lack the knowledge of how companies operate, and value-creating managers and executives. From the 1950s through the 1970s, companies tended to hold on to their earnings and reinvest them in “productive capabilities” like hiring and training, according to Lazonick.
In those three decades, New York Stock Exchange-listed companies, for instance, got the the cash they needed to invest in the productive capabilities of the company “from prior capital accumulations and current retentions out of profits, leveraged if necessary by bond market issues,” he writes. “By and large, the cash that provided this financial commitment did not come from the stock market.”
Since the 1980s, however, major corporations have tended to “downsize-and-distribute” via layoffs or pay cuts and distribute the cash gained to shareholders and to executives and employees via stock options, the economist writes.
Compounding what he sees as the “fundamental error” of MSV advocates — the belief that the stock market is a major net source of corporate finance — is “the assumption that it is only public shareholders who make risky investments in the corporation’s productive assets,” he writes.
Not so, the economist contends. “[Taxpayers,] whose money supports business enterprises and workers whose efforts generate productivity improvements” also take on considerable risk, Lazonick argues. Taxpayers take on the risk that their payments will go to nonproductive government subsidies, for instance, and workers assume the risk that they can be fired at will.
“MSV ignores the risk-reward relation for these two types of economic actors in the operation and performance of business corporations. Instead it erroneously assumes that shareholders are the only residual claimants,” the professor argues.