Why there's no future in shareholder capitalism

Donald Kalff argues that intelligent capitalism will prevail, driving out the US business model

The time has arrived to take a fresh and agnostic look at the past, present and future performance of companies in the US and Europe that have embraced the American way of conducting business. Many believe in the virtues of this approach but their faith is misplaced. And, more importantly, attractive and highly competitive alternatives are not receiving the attention they deserve.

The defenders of the American Enterprise Model point to its stark and appealing features: the pursuit of shareholder value; a one-tier board; a strong CEO; the creation of independent divisions and business units that operate close to their markets; tight planning and control; performance evaluation based on financial (or at least quantifiable) targets; substantial monetary incentives; and managers who believe in competition and in winning with the widest possible margin. This model is emulated by virtually all large public companies in Europe and there seem to be no limits to its applicability. Outside its own realm, the model also sets standards for the organisational structure and culture of large sections of the public sector, such as utilities, public transport and healthcare.

The judgement that large American companies perform poorly is counter-intuitive but inescapable. At the top of the economic cycle in the late 1990s, profit per share - the favoured performance indicator of the top 500 companies in the US - remained stagnant, despite major share buy-back schemes financed with borrowed money. Moreover in retrospect, the profits reported in this period have to be corrected downwards to a very significant degree. Proper accounting of option schemes results in a 30% reduction in reported profits; the exclusion of profits from corporate pension funds accounts for a decrease of another 15%. On top of this, many companies among America’s top 500 made insufficient contributions to their pension funds and failed to make provisions for a variety of long term obligations such as healthcare benefits for pensioners and deferred income of top managers. This should have decreased profits at the time by at least another 15%, bringing the total reduction to 60%. And it should be noted that this figure does not even include the financial impact of all the litigation and criminal investigations that originated in the 1990s. All in all, a very poor performance at a time of high economic growth spurred on by a technological revolution.

The rapid growth in corporate profits since the recession of 2001 should also be re-examined.

This growth should partially be attributed to a totally unprecedented and, many would argue, irresponsible financial injection into the US economy. The combination of increased government spending, substantial tax reductions, the lowest interest rates in history and a feverish housing market all conspired to secure ongoing growth in consumer spending which, in turn, fuelled corporate profits.

Profits and profits-per-share also rose as a result of specific policies that flow from the basic characteristics of the American Enterprise Model.

Double digit growth of profit-per-share was increasingly seen as a stepping-stone to a higher stock price. Shareholder value (the net present value of future revenues and cost, including the cost of capital) was replaced by shareholder return on investment, the rise of the stock price per unit of time.

In combination with the short tenure of American CEOs and the strong link between their income and the performance of their company’s stock, this resulted in a significant reduction in the repertoire of corporate policies. Only policies that would pay off within three to four years were worth pursuing. And, to make matters worse, each of these policies had serious flaws.

Companies that buy their own stock to support their share price sooner or later undermine their financial resilience. Poorly performing business units can be sold or dismantled to improve profits, but this is a one time gain. Friend and foe now agree that corporate acquisitions, generally aimed at cost cutting, destroy value for the shareholders of the acquiring company. Less well-known is that, in most instances, these cost savings are lower than projected, productivity and market share growth are reduced, and research and development expenditure and research output suffer. The outsourcing of corporate activities remains popular but, with each step, the risks increase. Flexibility in meeting changes in demand and specifications decreases, and the vulnerability of the supply, production and distribution chain increases. Staff reductions immediately add to profits, but each new round of lay-offs yields less and less and comes at a higher price in terms of the deterioration of the organisation’s capacity to rebound, the destruction of imbedded knowledge and low morale of surviving staff.

To add insult to injury, interesting opportunities for increasing the economic value of a company, such as mergers, partnerships, international expansion and large investments were all too often ignored for the simple reason that profit-per-share would suffer during the tenure of the CEO.

Huge damage

The damage caused by this corporate straitjacket can hardly be over-estimated. The bottom line is that, over the past five years, many US style companies, concentrating on “profit per share”, have destroyed “shareholder value” in its original meaning of “economic value”. They have done this in the name of their shareholders. This must be one of the great ironies of our time.

All in all, there is ample reason to break away from the American Enterprise Model.

The search is on for alternative enterprise models. And the place to look is Continental Europe. The key difference with the US is that only 25% of the capital requirements of Continental European companies are met by stock markets. This in stark contrast to US companies that depend on stock markets for 75% of their capital requirements. As a result, most Continental companies escape the web of expectations spun by investment bankers, financial analysts, stockbrokers, strategy consultants and the financial media. Continental Europe harbours many small and large private companies, co- operatives and government-owned companies, each inclined to and capable of concentrating on value creation and producing excellent results.

There is also a need for the development of new models. Companies explicitly driven by the creation of economic value as a single objective provide clarity for all those whose interests are at stake. Companies that acknowledge that economic value is largely created by teams of middle managers and experts working inside and across corporate boundaries will do well. Those with managements that provide perspective, resources and protection for these teams will thrive.

The Rhineland or stakeholder model is no longer an alternative for the American Enterprise Model. Companies that pursue a multitude of objectives to satisfy customers, suppliers, shareholders and employees, each of them with their political supporters to increase their leverage, become, like their American counterparts, victims of short term interests.

The focus on economic value forces companies to take the interest of future customers into account. Cash flows five to 10 years from now contribute significantly to the economic value of the company. This stresses the need for continuity, continuity pre-supposes legitimacy and legitimacy implies the corporate imbedding in society. This is a far cry from the basically antagonistic stakeholder model, whereby vested interests first and foremost protect their inroads into the company.

Companies with a single objective that rely on the co-operation between increasingly specialised employees based on trust will outperform their competitors. Intelligent capitalism will drive out shareholder capitalism.

Donald Kalff MBA PhD, a former Shell manager and a former member of the KLM Executive Committee, is a writer, adviser and biotech entrepreneur. He is the author of An UnAmerican Business, due to be published by Kogan Page in November (and already available in the Netherlands, France and Germany).