Why the Pursuit of Shareholder Value Kills Innovation

Is innovation against the interests of the shareholder-owned firm?

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Chris Dillow

Shareholder value, said Jack Welch, “is the dumbest idea in the world.” I was reminded of this by Tim Worstall’s reply to Liam Byrne’s demand to “reject once and for all the tired and increasingly flawed orthodoxy of shareholder value.” Tim says:

Increasing income, and/or wealth, is driven by technological advances that lead to greater productivity. And only societies which have had some at least modicum of that shareholder capitalism have ever had that trickle-down which drives the desired result.

This, however, overlooks an important fact – that shareholder-owned firms (in the sense of ones listed on stock markets) are often not a source of technological advances. Bart Hobijn and Boyan Jovanovic have pointed out that most of the innovations associated with the IT revolution came from companies that didn’t exist (pdf) in the 70s. The stock market-listed firm is often not so much a generator of innovations as the exploiter of innovations that come from other institutional forms – not just private companies but the state (pdf) or just men tinkering in garages.

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This fact seems to have become more pronounced in recent years. David Audretsch and colleagues show that innovative activity has come increasingly from new firms rather than listed ones. And Kathleen Kahle and Rene Stulz show that listed companies today are older, less profitable and more cash-rich than those of years ago. They say:

Firms’ total payouts to shareholders as a percent of net income are at record levels, suggesting that firms either lack opportunities to invest or have poor incentives to invest.

There are, of course, many possible reasons for this lack of investment. One might be that outside shareholders are so short-termist that they discourage firms from investing (though personally I doubt this). Alternatively, they might be too ill-informed to distinguish between good and bad projects and so often err on the side of caution.

A third possibility is that both investors and bosses have wised up to a fact pointed out by William Nordhaus – that innovation yields only scant profits because these get competed away*. It might be that Schumpeter was right: innovations tend to come from over-optimism and excessive animal spirits and that the listed firm, in replacing buccaneering entrepreneurs with rationalist bureaucrats, thus diminishes innovation.

From this perspective innovation is against the interests of the shareholder-owned firm, as it threatens their market position: the creative destruction of which Schumpeter wrote is by definition bad for incumbents. It’s no accident that the most successful stock market investor, Warren Buffett, looks not for innovative firms but ones that have “economic moats” – some kind of monopoly power that allows them to fight off potential competition.

Tim might therefore be taking too optimistic a view of shareholder capitalism: shareholder value might now be a restraint upon technological advances more than a facilitator of them**.

I don’t say this merely to criticise Tim, but to highlight a mistake made by many of capitalism’s cheerleaders – that they fail to see that the threat to a healthy economy comes not so much from lefties with silly ideas (or perhaps even from presidents with them) but from capitalism itself. For many reasons – of which the pursuit of shareholder value is only one – capitalism has lost some dynamism. In underplaying this, capitalism’s supporters are making the mistake of which Thomas Paine accused Edmond Burke: they are pitying the plumage but forgetting the dying bird.

* Apple is a counter-example here: Steve Jobs genius was not so much in fundamental innovations as in the ability to create products so beautiful that they had brand loyalty and hence monopoly power.

** The strongest counter-argument here might be that the prospect of floating on the stock market (often at an inflated price) incentivises innovation by unquoted firms.

Originally published at Stumbling and Mumbling.

2017 January 21

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  • Rick Derris

    Bart Hobijn and Boyan Jovanovic have pointed out that most of the innovations associated with the IT revolution came from companies that didn’t exist (pdf) in the 70s.

    Thank you for linking to the PDF and I’ll read it. I’m curious to see what the authors have to say.

    DOS was developed outside of the companies of the 1970s, but IBM almost went with CP/M, which had been developed by Digital. DOS borrowed heavily from CP/M. So many of the Lisa/Macintosh innovations came from that infamous visit to Xerox PARC. Ethernet came out of Xerox too. Those innovations came from existing companies that failed to “execute” on them.

  • Andy White

    Having worked for two IT companies that went public, one was part state-owned/part private in the mid 90s and one that went private in 99 both reduced (redefined) r&d cancelling and merging projects and letting staff go with out replacing them. They both also reduced training and expense budgets, they both also tried to do cross projects with business partners….

    Beyond that the attitude and ethos of both companies changed, middle and lower management became far more cost averse, and conservative/risk averse in term of their decision making.

    The bean counters/pencil pushers took over much of the corporate policy decisions… It became what will save/make most money as opposed to what is in the best interest of the company/staff and its clients.

    • RMGH

      One need look no further than pharma’s resistance to conducting any research for new antibiotics. Meanwhile, more and more resistant superbug strains are spreading. Pretty soon, simple surgery could be a thing of the past, becoming, once again, a high stakes game of Russian roulette with post-operative infection.

      With the need so great, why won’t pharma conduct the R&D needed to produce new antibiotics? Not enough profit of course….

  • Jeff Mowatt

    Until fairly recently, thanks to Lynn Stout and the Shareholder Value Myth there was a widespread belief that this was enshrined in law. 20 years ago the argument that this was not the case led to what today is described as the Fourth Sector or Social Business.

  • Matt Beaven

    Another important exception was Bell Labs. Large corporations innovate and do it well when they are resistant to market pressures for shareholder value and when they have innovation-minded people in key positions of power. It also helps if they are trying to placate congress out of fear of additional regulation.