Count on this: Whenever the stock market crashes or the latest outrages of executive compensation hit the press, whenever an Enron explodes in a riveting display of financial fireworks or an AIG falls flat on its face, there will be calls for shareholders to pick up their pitchforks and revolt. They come from investor advocates, from politicians (such as Slate columnist Eliot Spitzer) of all stripes. Always that shareholder revolution seems to be just around the corner.
How can it not be? The poor individual investor — the proverbial “little guy” so many financial writers claim to be looking after — has had nothing to do but watch in disgust as reckless executives blow up his retirement nest egg. So long-suffering, so cruelly oppressed, it's a wonder that Homo investicus has not already marched on Wall Street to throw the bums out.
For those who would lead an army of these misused investors, a word of warning: You may have fewer legions to back you up than you might think. If anyone has pushed corporate managers to take on ever more risk and an ever shorter-term outlook, it has been investors themselves and the fund managers who represent them.
The record of investors at keeping an eye on reckless and exuberantly expansionist chief executives is poor. Before the banking crash, Bank of America chief executive Ken Lewis was lionized by investors (who actually pressed him to buy an investment bank, which he finally did with the ragingly insane Merrill Lynch acquisition). During the dot-com craze of the 1990s, investors readily cheered acquisitions that in retrospect are simply dumbfounding, like the $5.7 billion that Yahoo paid for the meaningless Broadcast.com — which made Mark Cuban a billionaire and forever saddled us with his antics.
Meanwhile, companies that have tried to follow the path of reason against the flow of the crowd have been jeered along the way. Analysts savaged the management of North Carolina BB&T bank and its moribund share price before the caution of its longtime chief, John Allison, was finally proved right and BB&T proved to be the only big bank to sidestep the mortgage crisis.
“When the music's playing, you have to dance,” Citigroup CEO Charles Prince famously said to explain his bank's ever-deeper plunge into disastrous lending. Prince is gone, but his phrase sticks as a motto for contemporary management, because no matter how grotesque the music might be, investors want to see their companies dancing.
The rhetoric of shareholder outrage maintains that the interests of shareholders — sensible, cautious, long-term investors — have been hijacked by unscrupulous managers hoping for quick payoffs. But the individual investor of the shareholder revolt fantasy is largely extinct, replaced by the holders of mutual funds and index funds. The net effect of the shift to investing through mutual funds and index funds has been to increase the distance between “owning” a share of stock and having any real long-term ownership interest in the company. And this has some perverse effects.
Forget everything you've been hearing about how gamblers inside banks ignored the long-term outlook and took risks that investors would never have countenanced if they knew. If the shareholders of American companies were still mainly individual investors hoping to retire on a steady stream of dividends, this might well be true. But they no longer are. Instead, corporate executives are playing to a constituency made up of fund managers who worry not that company management is taking on too much risk, but too little.
Consider this: Even the luckiest and most highly paid employees of public companies have their livelihood wrapped up in their jobs. If their company does badly, there will be layoffs. If it blows up, at the least they will be out of work. Not so for the shareholders. A mutual fund’s holdings have to be spread among shares in an absolute minimum of 20 or so companies and usually many more. An index fund's holdings are spread among the whole market.
The result of this is that employees of public companies are generally more risk-averse than the shareholders. The prototypical small investor counting on a steady flow of dividends is gone, replaced by the fund manager who has at risk in any one company only a small fraction of his portfolio. If a stock crashes, the value of his fund drops only a few percent.
If, on the other hand, a stock rises in a way that seems unjustified by a company's long-term prospects, the fund manager can sell it and take the profits (or at least the fund manager believes this, though in real life he rarely manages to time it right). He is not tied to the company's stock in any meaningful way. His name is not on the door, he is not relying on the dividends for his income, and the very last thing he wants is a seat on the board of directors.
On the whole, then, what fund managers want is precisely not what shareholder advocates wish they would want. Fund managers don't want safe decisions — they think they already have safety through diversification. They want corporate executives to take greater risks — or, as one of the seminal papers on CEO pay puts it, to act like entrepreneurs, not bureaucrats. This is one of the least understood themes in American business of the last couple of decades — few people who look at stock options, for instance, and the outsized rewards they offer executives, realize that the very idea behind paying executives with options was to persuade them to take greater risks.
None of this, ultimately, has turned out to be wise. The thinking that by holding shares in 20, 50, or 500 different companies via mutual funds investors would be insulated from risk turned out to be terminally flawed. Investors and economists believed that CEOs should be encouraged to, as the Harvard Business Review put it, “swing for the fences,” thinking that some of them would hit home runs. Instead, we discovered that it was perfectly possible for all of them to strike out as entire industries took identical and identically misguided risks.
In the face of this kind of recklessness the managers of mutual funds have at their disposal one powerful tool of protest: It is to sell their shares. If indeed they were to do this in response to outsized executive pay, reckless management and short term thinking, it would undoubtedly send a strong signal to management. That might be a real shareholder revolt.
Don't hold your breath waiting for that, especially now that the stock market is on a new bender. With no real “ownership” and little experience in thinking about long-term value, fund managers are not mainly concerned about the long term, industrywide miscalculations that destroy companies and industries. They remain stuck in the misapprehension that it is to their advantage for managers to take on more risk. And they respond quickly not to the long-term mismanagement, but to the prospect of short term gain or loss.
What makes them run screaming from a stock is seeing a company miss its quarterly earnings projections by a penny or two. Or, worse, fail to keep in lockstep pace with the growth of its competitors, however reckless the business decisions driving it. That, too, sends a strong signal to corporate management: just keep on dancing.