Boardroom ignorance: How maximising shareholder value destroys wealth – Ted Black

Ted Black has a rare talent: he can demystify accounting ratios and unpick the theories that are held dear in business schools to set out where business operators are going wrong. And, equally important, he doesn't just criticise – he sheds light on how to change emphasis. Black has a focus on Return on Assets Managed (ROAM). In this article, part II of a series on how mismeasurement leads to mismanagement of firms, Black looks at how the mantra of maximising shareholder value can have the opposite effect. Useful ideas to consider as you reshape your business plans to survive and flourish in a world that's been given a major overhaul by the Covid-19 pandemic. – Jackie Cameron.The deadly virus of mismeasurement.By Ted Black* .Last time we looked at the "Germ Theory of Management" and linked it to production in a timber company. It showed how a system designed by management can make even the brightest and most talented of people who work in it act stupidly and perform ineptly. Let's now look at the way a business ideology – maximising shareholder value – causes mismeasurement and mismanagement of firms..___STEADY_PAYWALL___.It's a dogma that took off in a big way after a Milton Friedman article in 1970 argued that the sole purpose of a business is to generate profit for shareholders. He implied that CEOs and management work for them. It led to measurement and reward based on the share price in the foolish belief it would make managers think and act like "Owners"..But managers don't work for shareholders. They are employees of a business firm. The sole purpose of the firm is to create and keep customers who need and want to buy its products and services. It means that management's prime task is to strengthen its "immune system" through productivity improvement. The healthier it is, the more money it makes, the more cash it generates, and the more valuable it becomes..You can measure the value of a firm in several ways, but fundamentally it derives from the productivity of its assets – not the productivity of its workforce. Managers who blindly accept the "common sense" of cost control and planning for profit miss this point completely..The firm is also more than a "cash compounding machine" as Bruce Henderson (founder of Boston Consulting Group and "inventor" of strategy consulting) called it. It's a human enterprise. The brains of frontline, grass roots people who relate to and deal with customers, suppliers, and the community at large must make assets work. It's also where the seeds of strategy are sown – not in C suites advised by consultants, business school professors, bankers, accounting firms and lawyers..So has a focus on shareholder value resulted in improved productivity of the asset base – management's prime responsibility? It sure doesn't seem so..A few years after the banking collapse in 2008, Deloitte's Centre for the Edge published its Shift Index – a masterly study of shifting trends that emerged from an analysis of more than 20,000 US firms since 1965. A main finding is that Return on Assets (ROA) is the best financial measure of a company's performance and management's competence..The chart below, adapted from the study and an Economic Policy Institute Brief, shows a 50-year downward trend in ROA and a sharply rising one with CEO pay..The declining productivity trend gathered momentum from 1980. That's when, by chance, the late Jack Welch was about to take charge of GE. Because it became the bellwether firm of the shareholder value movement and Welch the 20th century's exemplar CEO, let's look at its performance over the years since..An irony of Welch's tenure, and of his protégé Jeff Immelt, is that their strategic focus on portfolio management violated a fundamental asset productivity measure – one discovered by GE's long-range planning work during the 1960s and 1970s. The function evolved into the Strategic Planning Institute with its data base known as PIMS (Profit Impact of Market Strategy). Its findings from research of thousands of business units around the world, became known as the "PIMS Principles" – ones that influence economic performance..Three main links between strategy and performance that emerged were:.In the long run, superior quality yields higher profits through premium prices; improving it relative to rivals is the more effective way to grow.Market share and profitability are strongly related.High investment intensity exerts a powerful drag on profitability..The first two are well known by management but not the third. It should be. Here's why….A firm is investment intensive when it uses a large asset base per Rand of sales compared to other firms. As intensity rises it has little effect on sales profit margins (ROS), but a huge impact on overall returns. Management's main focus is almost always on the ROS number..When Welch took the reins, GE was mainly an industrial conglomerate. Today, it is back to that after Welch had turned GE Capital into a huge financial enterprise. With a respectful nod to Henderson, the next chart shows GE Industrial's Cash ROAM% (Operating Cash Profit/Assets) since 1980..A perfect correlation..In today's currency values, GE's equity was $18bn in 1980 and formed 43% of the asset base. At year end 2019 it was $30bn, and 11% of the asset base. That's growth of only 67% over 40 years. During their tenure, Welch and Immelt bought more than 2000 companies and investment intensity reached 560%. .Jack Welch as exemplar, had a big effect on the way CEOs have managed since. Firstly, because of the market share effect on profitability, many copied his portfolio approach. It is largely influenced by Michael Porter's "Five Forces" matrix which proposes you design a market strategy that enables you to avoid competition but gain monopoly pricing power..Secondly, many firms followed his destructive approach in firing tens of thousands of people; moving production offshore; grading managers, yanking out the bottom 10%, and rewarding the top 10% with share options. Welch in one year during the 1990s earned 1,400 times the average US worker salary. Share buy backs, stopping pension fund contributions, cutting R&D, also helped boost the share price and earnings..As to leading people, his approach encouraged many firms to turn their organisations into places where a motivational, Tom Peters type evangelical style prevails to pump up enthusiasm for endless initiatives like "Workouts" and Six Sigma. Ones which, in the end, have little connection with the real levers of economic performance. .Here are more examples of firms, including GE and GE Industrial, that have gone down a similar path:.Woolies remains in the "Before" box but doubled its investment intensity causing the plunge in returns. For interest, AB Inbev is at the 500% mark and Naspers (excluding Tencent) off the chart with low returns..You counter investment intensity with a productivity ratio – Asset Turnover (ATO). It is the most important one of all and measures the sales productivity of the asset base. It takes us to another cause of low productivity – financial ignorance from boardroom to the workplace. .To prove it to yourself, do this test: in your next management meeting, ask your people to tell you how many cents profit the firm makes for every Rand of sales after tax (before COVID of course!). You'll see how few of them know. Hardly any will even know what it is at the operating profit level. Don't bother to ask what your ATO is or how many cents profit a Rand of assets generates. They are unlikely to understand the questions let alone have an answer. .That's because most companies, just as our government is doing in this crisis, use a command and control style of management that treats people like children, not adults. They don't share the numbers or use them to educate. It creates a huge barrier of ignorance that suits them until "S—t happens!". The trouble is most of that rolls downhill..In the end, when you look at the wave of mergers and acquisitions starting in the 1960s, the dotcom fiasco and then the banking collapse, the main result of the shareholder value movement, has been a massive transfer of wealth to management, bankers, corporate lawyers, big consulting and accounting firms..To borrow some words written by Peter Drucker when he looked at the investment intensity impact of mechanisation in the in the pulp and paper industry since World War 2, all you can say is that the shareholder value movement represents a massive triumph of financial engineering over economics and common sense..We can only assume that's what Jack Welch meant when he said it's the dumbest idea in the world. He sure proved it in spectacular fashion. In a way, his legacy reminds me of Macbeth's words on hearing of his wife's death:."Life's but a walking shadow, a poor playerThat struts and frets his hour upon the stageAnd then is heard no more. It is a taleTold by an idiot, full of sound and fury,Signifying nothing.".Let's hope this crisis brings about the right kind of change in the way we manage ourselves and the planet's resources. Our future, and that of generations to come, depends on it..Ted Black runs workshops, and coaches and mentors using the ROAM model to pinpoint opportunities for measurable, bottom-line, team-driven projects. He is also a freelance writer with several books published. Contact him at jeblack@icon.co.za.

Boardroom ignorance: How maximising shareholder value destroys wealth – Ted Black

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