Managers who focus closely on the stock price, whether by inclination or because they have incentives to do so, will often fail to serve the best interests even of their stockholders. This weeks lesson returns to the story about Al Dunlap and Sunbeam.
Can or must the obligations of directors to their company be translated into an obligation to achieve the highest possible price for the company’s stock?
That is the claim made by the shareholder value movement. The market, which represents the distilled wisdom of thousands of players in financial markets, knows best. The board of MCI, the telecoms group, has just rejected an offer from Qwest on the basis that the lower bid from Verizon would be better for the business. They have certainly deprived stockholders of the chance of a quick buck, but have they also frustrated the central purpose of financial markets: to direct assets to the managers who can deploy them most efficiently?
If you believe they have, you would do well to study the chaotic reign of “Chainsaw Al” Dunlap, arch-champion of shareholder value and one-time chief executive of Sunbeam, providers of toasters, mixers and blenders to generations of Americans. As I recounted in my last column (May 24), the agreement that took the business out of Chapter 11 bankruptcy left stockholders, whom Mr Dunlap described in his tract Mean Business as “the only constituency I am concerned about”, with nothing.
The longest chapter of that book is entitled “Impressing the Analysts”. It records Mr Dunlap telling a group of fund managers “we will be successful because I say we will be”. The remark was greeted, he notes modestly, with “enthusiastic shouting and applause”. Such exchanges are a powerful means of creating shareholder value. But not of building businesses.
The price of a company’s stock depends not on the value of a company but on the market’s perception of that value, which is often easier to change than value itself. Mr Dunlap’s relentless self-promotion and his purported emphasis on the primacy of shareholder interests achieved this. The mere announcement that he was taking the helm at Sunbeam almost doubled the stock price. At its peak, barely three months before Mr Dunlap was fired as the company fell to pieces, Sunbeam’s market value had increased fivefold since his appointment. Stock prices reflect underlying realities in the long run, but, even at Sunbeam, the five years from Mr Dunlap’s appointment to corporate collapse were longer than the “long run” of most executive incentive schemes.
Market values respond more immediately to reported earnings than to business fundamentals. But there are many ways to manage earnings short of the outright fraud at WorldCom – MCI’s predecessor – and the artificial schemes of Enron. Sunbeam filled warehouses with product and booked the revenues. Whether this was legal depends on the detail of the contracts, but its business purpose is to bring profits into the current quarter at the cost of an equal or greater reduction in later reporting periods. Other measures – scaling back development, postponing maintenance spending – raise no legal or accounting issues but have the same effect. They boost profit but reduce value.
Some people still believe, against all evidence, that the market is generally successful in giving a clear view of a company’s real performance through the rose-tinted lenses provided even by reputable finance directors. But judging the quality of a manager by his effect on the stock price is exactly equivalent to judging a weather forecaster on whether you like what they tell you.
Understandably, chief executives largely paid in stock options may check their company’s share price several times a day, but it is extraordinary that some of them believe that by doing so they gain information about their business. Anyone tempted to think this should remember the fate of Chainsaw Al. Or that of Bernie Ebbers, WorldCom chairman, whose familiar routine was to point to a chart of the stock price and ask fawning analysts for questions. Where business judgment and market judgment differ, managers’ responsibility is to implement their business judgment.
And since they are hired for their business judgment, it is for that, not for their ability to generate “enthusiastic shouting and applause”, that executives should be rewarded. Managers who focus closely on the stock price, whether by inclination or because they have incentives to do so, will often fail to serve the best interests even of their stockholders.