Profits without honour


The bullish 1990’s market lead companies like Enron and WorldCom to strive for unrealistic earnings growth – eventually by any means necessary. Their stories show that shareholder value should be an end, and not the aim of good businesses.

It is often said that socialism failed because it lacked incentives. But Soviet Russia had the greatest range of rewards and punishments imaginable – from the privileges of the nomenklatura to hard labour in the Gulag. Socialism failed because its incentives were perverse. If rewards and punishments are large enough people will try to meet the targets you set – but you will often wish they had not.

The story of the nail factory that met its quota by producing one gigantic nail because that quota was based on weight of output is no doubt apocryphal. But it identifies the general problem: whatever measure you choose, managers will focus on it at the expense of equally important criteria.

When Soviet production units, or the economy as a whole, fell seriously short of the plan, managers and their advisers responded by making the numbers up. It is a wry paradox that today’s failures of capitalism so closely resemble yesterday’s failures of socialism.

Incentivising managers to create value for shareholders has superficial attractions. But in the great stock market boom of the 1990s, companies had to report earnings growth in excess of 10 per cent a year simply to maintain their share price.

Even on the most optimistic analysis, the economy does not grow at 10 per cent a year. How could companies operating in a competitive market have continually increased profits more rapidly than the growth of their underlying business? The simple answer is that while individual companies could, the business sector as a whole could not.

The profits of established companies should grow more slowly than the world economy, because new businesses are constantly taking share from them. There is always scope for improving efficiency and introducing new technology; but in a competitive economy the benefits of greater efficiency and new technologies go to consumers. And the business environment is becoming more competitive, not less.

Analysts at investment banks struggled to square this circle: they explained how the genius of men such as Ken Lay of Enron and Bernie Ebbers of WorldCom had changed the rules of the competitive game. Stalin’s statisticians similarly recorded and applauded the heroic endeavours of individual Soviet workers such as Alexei Stakhanov, the apparently superhuman Siberian miner. They produced a rich tapestry of imaginary feats and bogus figures, like the shareholder value movement 50 years later.

In the capitalist fantasy, companies achieved impossible earnings growth by cutting the fat from their businesses. Only gradually will it emerge how much muscle they cut at the same time. The business of Marks and Spencer, the retailer, was unparalleled in reputation but mature. To achieve earnings growth consistent with a glamour rating the company squeezed suppliers, gave less value for money, spent less on stores. In 1998, it achieved the highest margin on sales in the history of the business. It had also compromised its position to the point where sales and profits plummeted.

Banks and insurance companies have taken staff out of branches and retrained those that remain as sales people. The pharmaceuticals industry has taken advantage of mergers to consolidate its research and development facilities. Energy companies have cut back on exploration.

We know that these actions increased corporate earnings. We do not know what effect they have on the long-run strength of the business, nor – and this is the key point – do the companies themselves know. Some rationalisations will genuinely lead to more productive businesses. Other companies will suffer the fate of Marks and Spencer.

All we can say with confidence is that customer perceptions of retail financial service businesses are poor, that the pipeline of new drugs is now smaller and that oil prospects look good mainly because of opportunities in the former Communist world.

Well established businesses, with strong competitive advantages, can use such tactics to take short-term profits at the expense of future growth. Newer companies without the opportunity have instead employed legitimate accounting wheezes.

Acquisition accounting attributes little value to the assets you buy, so that you can flatter future profits by releasing the hidden value. And if you pay yourselves and your employees in stock options, you are allowed to leave the costs out of the profit and loss account.

But these devices require rising stock markets. Acquisition accounting is a drug; you need increasing doses to maintain your habit. After two years of falling technology shares, people who work for technology companies have discovered that you need cash, not options, to pay the grocery bills. In this more hostile environment companies such as Enron and WorldCom were forced to the conclusion that the only way to produce the numbers the markets required was to invent them.

The danger now is of imploding corporations that disguise the continual erosion of their core business by consolidation and acquisition. Such companies would react to each disappointing earnings report with further cost cuts and job reductions. They would stave off the demands of predatory investors by slicing further into muscle and bone.

But many investors now realise that few companies can generate sustainable double-digit growth in earnings. The better alternative is a return to a more balanced conception of the nature of business.

Great businesses – such as Merck, Procter & Gamble, Shell and Marks and Spencer – were not built in the three-to-five-year time scale of a so-called long-term incentive scheme for managers. The massive shareholder value they generated was a by-product of their competitive strengths, not the object of the business itself, and for that reason was sustainable for long enough to provide our pensions.

Henry Ford – no mean creator of shareholder value – wrote that a business run only for profit would die because it had no long-term reason to exist. He might have been talking about Enron and WorldCom.

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