Download Presentation slides

The US Stock Market
and the Governance of
Innovative Enterprise
William Lazonick
University of Massachusetts Lowell
Conference on Finance, Innovation, and Inequality
Sponsored by Innovation Knowledge Development Centre, The Open University
and DIME (Dynamics of Institutions and Markets in Europe)
Regents Park Conference Centre, London
November 9, 2007
Corporate governance and economic performance
In a modern economy, corporations exercise strategic control over
vast amounts of resources (nothing new: “the managerial
revolution in American business” occurred a century ago)
How should corporations be governed to achieve superior economic
performance?
• Definition of “superior economic performance”: stable and
equitable growth
• From a public policy perspective, corporate governance is about
the allocation of corporate resources and returns
• The task: How should corporations allocate resources and returns
to achieve stable and equitable growth?
Lazonick
Theories of resource allocation
A. The theory of the market economy (aka neoclassical economic
theory): the firm as a passive “optimizer” that responds to the
dictates of product and factor markets, with technological
alternatives taken as given – the firm as a nexus of marketmediated contracts
B. A theory of the corporate economy: must explain
a) how firms grow, often employing tens of thousands, and at times
hundreds of thousands;
b) how firms differentiate themselves from competitors in their
industry;
c) how some firms come to dominate an industry over very long
periods of time;
d) how new firms rather than incumbent firms enter an industry
We need a theory of the corporate economy…
Lazonick
The theory of innovative enterprise
Analysis of relation between corporate governance and economic
performance requires a theory of how and under what conditions
corporations innovate: i.e., theory of innovative enterprise
(see many publications by W. Lazonick and/or M. O’Sullivan)
Innovation: generation of higher quality, lower costs products than
had been previously available, given prevailing factor prices
Innovative enterprise depends on three sets of social relations:
1. Strategic control: abilities and incentives of corporate resource
allocators to invest in innovation
2. Organizational integration: incentives of people with different
hierarchical responsibilities and functional specialties to develop
and utilize the firm’s resources
3. Financial commitment: incentives of those who fund the firm to
sustain the process of developing and utilizing productive
resources until it can generate financial returns
Lazonick
Maximizing shareholder value
Approach to corporate governance that arose in the 1980s, and came
to dominate the corporate governance “debates” in the 1990s
Maximizing shareholder value: an adaptation of the theory of the
market economy to the reality of corporate control over the
allocation of resources -- all corporate participants enter into
contracts that determine the relation between productive
contributions and financial rewards – EXCEPT that in the real
world we know that business enterprises can generate large
surpluses (and large losses) -- for the sake of the allocation of
resources to achieve superior economic performance, shareholders
should lay claim to (be responsible for) these “residual” earnings
Lazonick
Agency theory: corporations run by managers – shareholders as
principals need to deal with “hidden information” (bounded
rationality, adverse selection) and “hidden action” (opportunism,
moral hazard) – can use the market for corporate control to
discipline managers
Agency theory says: “Disgorge the free cash flow”
“Free cash flow is cash flow in excess of that
required to fund all projects that have
positive net present values when discounted
at the relevant cost of capital. Conflicts of
interest between shareholders and managers
over payout policies are especially severe
when the organization generates substantial
free cash flow. The problem is how to
motivate managers to disgorge the cash
rather than investing it at below cost or
wasting it on organization inefficiencies.”
Michael C. Jensen, AER, 1986, p. 323.
Lazonick
Disgorge
the free
cash flow!!
“Market for corporate control”
• Takeover by shareholders puts in place managers who are willing
to distribute the “free cash flow” to shareholders in the forms of
higher dividends and/or stock repurchases
• Corporate raiders use the market for corporate control for debtfinanced takeovers, thus “bonding” corporate managers to
distribute “free cash flow” in the form of interest rather than
dividends
• Maximization of shareholder value can be achieved by giving
corporate managers stock-based compensation, such as stock
options, to align their own self-interests with those of shareholders,
even without the threat of a takeover
Lazonick
“Maximizing shareholder value”, 1980s and 1990s
Stock (S&P500) and bond (Moody’s Aaa) yields, 1960-2006
Annual average percent change
1960-69
Real stock yield
1970-79 1980-89
1900-99 2000-06
6.63
-1.66
11.67
15.01
-0.58
Price yield
5.80
1.35
12.91
15.54
0.57
Dividend yield
3.19
4.08
4.32
2.47
1.61
Change in CPI
2.36
7.09
5.55
3.00
2.76
Real bond yield
2.65
1.14
5.79
4.72
3.42
To realize price yields, one has to buy and sell stock
To realize dividend yields, one has to buy and hold stock
Lazonick
Stock yields are for Standard and Poor's composite index of 500 US corporate stocks
Bond yields are for Moody's Aaa-rated US corporate bonds.
Source: US Congress, Economic Report of the President 2007, Tables B-62, B73, B-95, B-96.
The New Economy boom and bust (and recovery?)
DJIA, S&P500, and NASDAQ Composite Indices
Sept. 1987-Nov. 2007
1000
800
600
400
200
DJIA
S&P500
Sep-07
Sep-05
Sep-03
Sep-01
Sep-99
Sep-97
Sep-95
Sep-93
Sep-91
Sep-89
0
Sep-87
Sept. 1987=100
1200
NASDAQ
Dow Jones Industrial Average: 30 stocks (28NYSE+2NASDAQ)
S&P500:500 stocks (85% NYSE, 15% NASDAQ)
NASDAQ Composite: currently 3113 stocks
Lazonick
Longest bull run in US stock market history
Percent rise in Dow Jones Industrial Average
• 1921-1929: about 500%
• April 1942-January 1966: about 950%
(in 1954 DJIA surpassed peak in 1929)
• July 1982-August 2000: about 1300%
• And in the late 1990s NASDAQ makes the
DJIA and S&P500 look like blips
Lazonick
Disgorging the free cash flow in the 2000s
Repurchases, dividends, net income, R&D expenditures, 1980-2006
(293 corporations in the S&P500 in October 2007 in operation in 1980)
2.40
2.20
2003-2006:
R&D up $28b. ($96m./co.)
RP up $248b. ($846m./co.)
Ave. R&D in 2006: $473m.
Ave. RP in 2006: $1,173m.
2.00
1.80
TD=Total dividends
RP=Stock repurchases
NI=net income (before taxes)
R&D=Research & development
1.60
1.20
1.00
0.80
0.60
0.40
0.20
0.00
RP/R&D
2006
2005
2004
2003
2002
2001
2000
(TD+RP)/NI
1999
1998
1997
1996
1995
1994
1993
1992
RP/NI
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
TD/NI
Lazonick
ratio
1.40
Critique of “maximizing shareholder value”
Flaws in the theory of maximizing shareholder value:
Lazonick
1. Agency theory fails to explain how, historically, corporations
came to control the allocation of significant amounts of the
economy’s resources: no theory of innovative enterprise
2. Measure of “free cash flow” is meaningless for investing in
innovation; besides the problem of defining “relevant cost of
capital”, anyone who contends that, when committing resources
to an innovative investment strategy, one can foresee the stream
of future earnings that are required for the calculation of net
present value knows nothing about the innovation process
3. Claim that only shareholders have “residual claimant” status
ignores the ways in which other stakeholders, especially
governments and workers, make productive investments in
corporations without a guaranteed financial return – so-called
“incomplete” contracts characterize the innovation process.
The problem with “stakeholder theory”
• Margaret Blair’s stakeholder theory: workers make investments in
“firm-specific” human capital with expectations of returns over
their careers -- hence have residual claimant status – but, in laying
off workers, a corporate executive could simply contend that
workers’ firm-specific human capital has become old and obsolete
(a risk that as “residual claimants”, workers chose to bear)
• For workers (or their advocates) to counter, they need a theory of
innovative enterprise that can critically evaluate the claims of
agency theory about the role of shareholders in the enterprise
• Are layoffs part of a restructuring process that will renew the
innovation process, or are they simply a way of redistributing the
corporate resources accumulated in the past from labor to capital?
• And what functions does the stock market, and “maximizing
shareholder value”, perform in the innovative enterprise ?
Lazonick
Innovation and the stock market
What drives stock prices?
1. Innovation: higher quality products at lower unit costs,
given prevailing factor prices
2. Speculation: bidding up of stock prices on the
assumption that there exist “greater fools” in the
market – until the “greatest fools” get left holding the
bag
3. Redistribution: reallocation of returns to shareholders
from other stakeholders, particularly through stock
repurchases
Lazonick
Innovation, speculation, redistribution
Stock price movements, Intel and Microsoft, Jul. 1986-Nov. 2007
SPECULATION
8000
REDISTRIBUTION
6000
5000
4000
3000
2000
INNOVATION
1000
Intel
Jul-06
Jul-04
Jul-02
Jul-00
Jul-98
Jul-96
Jul-94
Jul-92
Jul-90
Jul-88
0
Jul-86
March 1990=100
7000
Microsoft
Lazonick
Innovation, speculation, redistribution
Stock price movements, Intel, Microsoft (Jul. 1986-Nov. 2007), and
Cisco (Mar. 1990-Nov, 2007)
120000
SPECULATION
REDISTRIBUTION
80000
60000
40000
INNOVATION
20000
Intel
Microsoft
Jul-06
Jul-04
Jul-02
Jul-00
Jul-98
Jul-96
Jul-94
Jul-92
Jul-90
Jul-88
0
Jul-86
March 1990=100
100000
Cisco
Lazonick
Innovation
Innovation: higher quality products at lower unit costs,
given prevailing factor prices
The microelectronics revolution and the rise of the “New
Economy Business Model” (NEBM) drove innovation in the
1980s and 1990s, although the productivity benefits of the
revolution only became evident with the coming of the Internet in
the 1990s – a “retain-and-reinvest” allocation regime: companies
list on NASDAQ where investors expect growth that gets
reflected in stock price increases, not dividends
Key NASDAQ firms include (with dates of founding, IPO, and first
cash dividend) Intel (1968; 1971; 1992), Microsoft (1975; 1986;
2003), and Cisco (1984, 1990; none)
Lazonick
Speculation
Speculation: bidding up of stock prices on the assumption
that there exist “greater fools” in the market
Robert Shiller, Irrational Exuberance, 2000, p.18
• Assumes that all actors, pros and amateurs, have access to the
same information: fails to recognize the distinction between
“insiders” and “outsiders” (even through this distinction has long
been recognized in the law)
• Vastly understates the importance of stock-based compensation as
a source of top-executive income and as an inducement to engage in
perfectly rational exuberance
Given the long queue of “greater fools” willing to speculate on
stocks, the exuberance of “Wall Street” and corporate executives
was anything but irrational (although in some cases it turned out to
be illegal)
Lazonick
Speculation follows innovation
Lazonick
“Cisco is a $6 billion high technology stealth company, largely
unknown to the general public. Insiders joke that Cisco is often
confused with Sysco, a huge distributor of foodstuffs for restaurants.
Yet it is the fastest growing company in history and the third largest
company on Wall Street. Its CEO, John Chambers, gets little of the
attention paid to bigger stars of the high tech world like Bill Gates,
Larry Ellison, or even Lew Platt of HP. But if you had the prescience
to invest $1,000 in Cisco stock in 1990, you’d now be walking around
with roughly $100,000.”
First lines of Stanford case, “Cisco Systems: The Acquisition of Technology is the
Acquisition of People,” by Charles A. O’Reilly III, published October 27, 1998
(Lazonick’s emphasis)
17 months later, Cisco Systems, now very well known to the public,
had the highest market capitalization of any company in the world.
Redistribution
Redistribution: reallocation of returns to shareholders
from other stakeholders
Payout ratios:
1960s: 38.8%; 1970s: 41.3%;
1980s: 48.4%; 1990s: 56.5%;
2000-2005, 61.5%
Repurchases: Old Economy companies began to do them on a largescale in the mid-1980s as part of a “downsize-and-redistribute”
allocation regime – IBM’s large-scale buyback is credited with
leading the way in reversing the stock market crash of October 1987
– in the 1990s and, especially 2000s, New Economy companies have
joined in, as they try to get their stock prices up toward the
speculative peaks of 2000 (more info later in the talk)
Lazonick
CEO pay and stock options
Value of stock options: 19% of CEO compensation in large US
corporations in 1980, but 48% in 1994 (Hall and Leibman 1998, 661)
Recent study of CEO pay in S&P500 companies found that average
compensation in 2003 dollars rose from $3.5m in 1992 to a peak of
$14.8m in 2000, declining to $8.7m in 2003 (Jensen et al. 2005, 33)
Value of stock options: 28% of this pay in 1992, 49% in 2000, and
38% in 2003 -- of the change in pay 1992 -2000, 11% salaries, 15%
bonuses, and 57% options. Of the decline in pay 2000-2003, 14%
salaries, 11% bonuses, and 65% options
Largely as a result of gains from the exercise of stock options, the
ratio of the pay of CEOs of major US corporations to that of the
average worker increased from 42:1 in 1980 to 85:1 in 1990 to 531:1
in 2000, and stood at 411:1 in 2005
Lazonick
The stock market, the corporate allocation of
resources, and “sustainable prosperity”
• All three drivers of the stock market – innovation, redistribution,
and speculation -- are valid for certain times and places, including
certain industries and companies
• None of these drivers stands on its own; they are linked historically
and they coexist at a point in time
• How does the stock market influence the corporate allocation of
resources?
• What are the implications for innovation at the corporate level?
• What are the implications for the achievement of stable and
equitable growth, or what I call “sustainable prosperity” in the
economy as a whole?
HINT: Innovation enables growth, but speculation results in
instability, and redistribution results in inequity.
Lazonick
How, then, might the stock market affect innovation?
Building on the theory of innovative enterprise, we want to know
how the stock market influences strategic control, organizational
integration, and financial commitment
Need to know the functions of the stock market in the modern
corporation
Five functions of the stock market:
• Creation
• Control
• Combination
• Compensation
• Cash
Lazonick
Five functions of the stock market
in the industrial corporation
 Creation: the stock market induces financial commitment to
new firm formation by enabling private equity holders to
monetize their stakes
 Control: the stock market influences who exercises strategic
control by enabling the separation of share ownership from
managerial control
 Combination: the stock market provides a currency for
mergers and acquisitions, thus permitting the extension of
strategic control
 Compensation: the stock market provides a currency for
recruiting, retaining, and possibly motivating personnel, thus
facilitating their organizational integration
 Cash: the stock market serves as a source of financial
commitment, providing a company with funds without the
guarantee of a return
Lazonick
Application to the US ICT industries
Focus on 20 top Old Economy corporations and 20 top New
Economy corporations in the 2006 Fortune 500 list
Includes IBM, HP, Motorola, Texas Instruments among the Old
Economy companies
Includes Cisco Systems, Intel, Microsoft, Sun Microsystems among
the New economy companies
How have these companies actually used the stock market for
creation, control, combination, compensation, and cash, and what
can we say about the influence on innovation?
Lazonick
Creation
Clearly related to innovation, except in a speculative boom in which
the backers of potentially innovative (as well as outright fraudulent)
startups can cash in even in the absence of a commercializable
product
•Venture-based investments: committing finance
•IPOs of venture-backed companies: cashing in
•M&A deals for venture-backed companies: cashing in
Lazonick
Lazonick
Lazonick
Lazonick
Control
Separation of share ownership and managerial control the norm not
only in Old Economy but also in New Economy companies
For example:
Who is John Morgridge, and why with 1.0% of the stock is he the
largest shareholder of Cisco Systems among founders, directors, or
executives?
Why does Steve Jobs own “only” 1.2% of Apple, and Scott McNealy
“only” 2.2% of Sun Microsystems?
Why does Bill Gates own 9.5% of Microsoft, while Larry Ellison
owns 24.5% of Oracle?
Extent of dilution depends on what individual founders and
managers did with their stockholdings, and how companies used
stock for creation, combination, compensation, and cash.
Lazonick
Lazonick
Lazonick
Combination
Steven Ballmer, then president of Microsoft, interview in early 1998
(quoted in Cusumano and Yoffie 1998, 302):
“We’ve had to step up and either make or not make big investments on Internet
time. Like WebTV. Like HotMail. Some of them, I think, will prove smart. Maybe
some of them won’t prove smart. But they’re not huge decisions. We have a
currency [with our stock price] that makes them relatively small decisions. These
deals [WebTV and HotMail] were both done for stock. I still think it’s real money,
whatever it is -- $400 million of so per acquisition. But I can stop and say, ‘OK,
that’s half of one percent of Microsoft.’ That’s probably a reasonable insurance
policy to pay.”
Cisco Systems perfected the “growth-through-acquisitions” strategy
But careless stock-based acquisitions in the New Economy boom
contributed to the demise of an Old Economy company like Lucent
Technologies
Lazonick
Lazonick
Compensation
1950s: employee stock options, a tax dodge for top executives
1960s and first half of the 1970s: public backlash against this
privilege in the
Meanwhile, however, Silicon Valley startups were using broad-based
stock option plans as a way of inducing non-executive professional,
technical, and administrative personnel to leave secure career
employment with an established Old Economy company to take up
insecure employment with a New Economy startup
Used in this way for startups, stock options contribute to innovation
But broad-based stock option plans become problematic when these
companies have grown large
Lazonick
Stock option “overhang”
Lazonick
Lazonick
Benefiting from the boom
– and overgenerous boards
Lazonick
Benefiting from the boom:
Take the money and run
James Galbraith and Travis Hale, “Income Distribution and the Information
Technology Bubble,” University of Texas Inequality Project Working Paper 27,
January 2004: Virtually all of the growth in US income inequality came from four
counties in the United States: three in California that are part of Silicon Valley and
one in the state of Washington where Microsoft is headquartered
Lazonick
Lazonick
Lazonick
“Broad-based” employees did OK from options:
Their bosses did (and still do) much better
Lazonick
Cash
Cash: the stock market serves as a source of financial commitment,
providing a company with funds without the guarantee of a return
Only true in speculative periods, particularly the late 1990s when US
corporations sold stock at inflated prices to pay off debt or bolster
the corporate treasury
But in late 1990s boom, not the case for established companies – if
anything they bought their own stock to push stock prices up even
further – meanwhile their executives sold stock and got very rich
In Internet boom of late 1990s some speculative new ventures raised
huge sums through initial and secondary public offerings that could
then be used to fund investment in productive resources – e.g.,
Sycamore Networks, optical networking company founded Feb. 1998
in Route 128 -- previous year revenues of $11m, losses of $19m, and
155 employees,: Sycamore IPO in Oct.1999, raising $284m;
secondary offering in March 2000, netted another $1.2b -- top execs
sold a portion of their own stockholdings for $726m
Lazonick
Lazonick
Manipulation of the market
Lazonick
Why stock buybacks?
Lazonick
AMD and Intel
1995-2006: AMD R&D expenditure 20% of Intel’s, while revenues
13%
AMD paid no dividends and only $77m in buybacks in 2001
Intel paid $8.4b dividends and $55.9b buybacks – combined 91% of
NI
2001-2006: AMD captured market share from Intel – Intel’s
repurchases 111% of NI and total distributions, 133%
Lazonick
Microsoft kowtows to Wall Street
Microsoft announces
investments in online
business to compete
with Google and Yahoo!
CEO Ballmer (31st richest
man in the world) goes to
Wall Street to defend
Microsoft’s “big bold bets”
Microsoft announces 2-yr.
acceleration of its $30 billion
buyback program plus $20 billion
to be repurchases 2007-2011
28
27
Stock price, $
26
25
24
23
22
21
20
06
1/
/3
07
06
4/
/2
07
06
7/
/1
07
06
0/
/1
07
06
3/
/0
07
06
6/
/2
06
06
9/
/1
06
06
2/
/1
06
06
5/
/0
06
06
9/
/2
05
06
2/
/2
05
06
5/
/1
05
06
8/
/0
05
06
1/
/0
05
06
4/
/2
04
06
7/
/1
04
06
0/
/1
04
06
3/
/0
04
Microsoft stock price
Microsoft’s stock price movements, April-July 2006
Lazonick
The bottom line
Unstable and inequitable growth in the United
States
-- Growth through innovation
-- But instability through speculation
-- And inequity through redistribution
With the stock market playing a major role
Lazonick