The US Stock Market and the Governance of Innovative Enterprise William Lazonick University of Massachusetts Lowell Conference on Finance, Innovation,

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  • The US Stock Market and the Governance of Innovative Enterprise William Lazonick University of Massachusetts Lowell Conference on Finance, Innovation, and Inequality Sponsored by Innovation Knowledge Development Centre, The Open University and DIME (Dynamics of Institutions and Markets in Europe) Regents Park Conference Centre, London November 9, 2007
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  • Corporate governance and economic performance In a modern economy, corporations exercise strategic control over vast amounts of resources (nothing new: the managerial revolution in American business occurred a century ago) How should corporations be governed to achieve superior economic performance? Definition of superior economic performance: stable and equitable growth From a public policy perspective, corporate governance is about the allocation of corporate resources and returns The task: How should corporations allocate resources and returns to achieve stable and equitable growth? Lazonick
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  • Theories of resource allocation A. The theory of the market economy (aka neoclassical economic theory): the firm as a passive optimizer that responds to the dictates of product and factor markets, with technological alternatives taken as given the firm as a nexus of market- mediated contracts B.A theory of the corporate economy: must explain a)how firms grow, often employing tens of thousands, and at times hundreds of thousands; b)how firms differentiate themselves from competitors in their industry; c)how some firms come to dominate an industry over very long periods of time; d)how new firms rather than incumbent firms enter an industry We need a theory of the corporate economy Lazonick
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  • The theory of innovative enterprise Analysis of relation between corporate governance and economic performance requires a theory of how and under what conditions corporations innovate: i.e., theory of innovative enterprise (see many publications by W. Lazonick and/or M. OSullivan) Innovation: generation of higher quality, lower costs products than had been previously available, given prevailing factor prices Innovative enterprise depends on three sets of social relations: 1.Strategic control: abilities and incentives of corporate resource allocators to invest in innovation 2.Organizational integration: incentives of people with different hierarchical responsibilities and functional specialties to develop and utilize the firms resources 3.Financial commitment: incentives of those who fund the firm to sustain the process of developing and utilizing productive resources until it can generate financial returns Lazonick
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  • Maximizing shareholder value Approach to corporate governance that arose in the 1980s, and came to dominate the corporate governance debates in the 1990s Agency theory: corporations run by managers shareholders as principals need to deal with hidden information (bounded rationality, adverse selection) and hidden action (opportunism, moral hazard) can use the market for corporate control to discipline managers Maximizing shareholder value: an adaptation of the theory of the market economy to the reality of corporate control over the allocation of resources -- all corporate participants enter into contracts that determine the relation between productive contributions and financial rewards EXCEPT that in the real world we know that business enterprises can generate large surpluses (and large losses) -- for the sake of the allocation of resources to achieve superior economic performance, shareholders should lay claim to (be responsible for) these residual earnings Lazonick
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  • Agency theory says: Disgorge the free cash flow Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below cost or wasting it on organization inefficiencies. Michael C. Jensen, AER, 1986, p. 323. Disgorge the free cash flow!! Lazonick
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  • Market for corporate control Takeover by shareholders puts in place managers who are willing to distribute the free cash flow to shareholders in the forms of higher dividends and/or stock repurchases Corporate raiders use the market for corporate control for debt- financed takeovers, thus bonding corporate managers to distribute free cash flow in the form of interest rather than dividends Maximization of shareholder value can be achieved by giving corporate managers stock-based compensation, such as stock options, to align their own self-interests with those of shareholders, even without the threat of a takeover Lazonick
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  • Stock yields are for Standard and Poor's composite index of 500 US corporate stocks Bond yields are for Moody's Aaa-rated US corporate bonds. Source: US Congress, Economic Report of the President 2007, Tables B-62, B73, B-95, B-96. Annual average percent change 1960-691970-791980-891900-992000-06 Real stock yield6.63-1.6611.6715.01-0.58 Price yield5.80 1.3512.9115.540.57 Dividend yield3.19 4.08 4.32 2.47 1.61 Change in CPI2.36 7.09 5.55 3.00 2.76 Real bond yield2.651.14 5.79 4.723.42 Maximizing shareholder value, 1980s and 1990s Stock (S&P500) and bond (Moodys Aaa) yields, 1960-2006 To realize price yields, one has to buy and sell stock To realize dividend yields, one has to buy and hold stock Lazonick
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  • The New Economy boom and bust (and recovery?) Dow Jones Industrial Average: 30 stocks (28NYSE+2NASDAQ) S&P500:500 stocks (85% NYSE, 15% NASDAQ) NASDAQ Composite: currently 3113 stocks Lazonick
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  • Longest bull run in US stock market history Percent rise in Dow Jones Industrial Average 1921-1929: about 500% April 1942-January 1966: about 950% (in 1954 DJIA surpassed peak in 1929) July 1982-August 2000: about 1300% And in the late 1990s NASDAQ makes the DJIA and S&P500 look like blips Lazonick
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  • Disgorging the free cash flow in the 2000s TD=Total dividends RP=Stock repurchases NI=net income (before taxes) R&D=Research & development 2003-2006: R&D up $28b. ($96m./co.) RP up $248b. ($846m./co.) Ave. R&D in 2006: $473m. Ave. RP in 2006: $1,173m. Repurchases, dividends, net income, R&D expenditures, 1980-2006 (293 corporations in the S&P500 in October 2007 in operation in 1980) Lazonick
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  • Critique of maximizing shareholder value Flaws in the theory of maximizing shareholder value: 1.Agency theory fails to explain how, historically, corporations came to control the allocation of significant amounts of the economys resources: no theory of innovative enterprise 2.Measure of free cash flow is meaningless for investing in innovation; besides the problem of defining relevant cost of capital, anyone who contends that, when committing resources to an innovative investment strategy, one can foresee the stream of future earnings that are required for the calculation of net present value knows nothing about the innovation process 3.Claim that only shareholders have residual claimant status ignores the ways in which other stakeholders, especially governments and workers, make productive investments in corporations without a guaranteed financial return so-called incomplete contracts characterize the innovation process. Lazonick
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  • The problem with stakeholder theory Margaret Blairs stakeholder theory: workers make investments in firm-specific human capital with expectations of returns over their careers -- hence have residual claimant status but, in laying off workers, a corporate executive could simply contend that workers firm-specific human capital has become old and obsolete (a risk that as residual claimants, workers chose to bear) For workers (or their advocates) to counter, they need a theory of innovative enterprise that can critically evaluate the claims of agency theory about the role of shareholders in the enterprise Are layoffs part of a restructuring process that will renew the innovation process, or are they simply a way of redistributing the corporate resources accumulated in the past from labor to capital? And what functions does the stock market, and maximizing shareholder value, perform in the innovative enterprise ? Lazonick
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  • Innovation and the stock market What drives stock prices? 1.Innovation: higher quality products at lower unit costs, given prevailing factor prices 2. Speculation: bidding up of stock prices on the assumption that there exist greater fools in the market until the greatest fools get left holding the bag 3. Redistribution: reallocation of returns to shareholders from other stakeholders, particularly through stock repurchases Lazonick
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  • Innovation, speculation, redistribution INNOVATION SPECULATION REDISTRIBUTION Stock price movements, Intel and Microsoft, Jul. 1986-Nov. 2007 Lazonick
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  • INNOVATION SPECULATION REDISTRIBUTION Innovation, speculation, redistribution Stock price movements, Intel, Microsoft (Jul. 1986-Nov. 2007), and Cisco (Mar. 1990-Nov, 2007) Lazonick
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  • Innovation Innovation: higher quality products at lower unit costs, given prevailing factor prices The microelectronics revolution and the rise of the New Economy Business Model (NEBM) dro