“We also see many governments failing to prepare for the future, on issues ranging from retirement and infrastructure to automation and worker retraining. As a result, society increasingly is turning to the private sector and asking that companies respond to broader societal challenges.” — Larry Fink
In whose interest should companies be run? For a long time, the prevailing view held that firms should put their shareholders first by maximizing profits and thus shareholder value.
But Luigi Zingales of the University of Chicago Booth School of Business believes firms and asset managers should expand their profit maximization objective and pursue policies that reflect what their investors want. And that isn’t always simply about the bottom line.
“I think ‘What should companies maximize?’ is the most important question we face in modern capitalist economies today,” Zingales explained at the 2019 CFA Institute Seminar for Global Investors, “because the way companies are run is at the very core of our capitalist system.”
Indeed, the Business Roundtable recently revised how it defines the purpose of the corporation and its member CEOs committed to leading their companies for the benefit of all stakeholders, not just their shareholders.
Whether this shift is motivated by public relations considerations or signals a true change in business practices remains to be seen. (For more on this topic, listen to “Shareholders vs. Stakeholders” from the Capitalisn’t podcast series hosted by Zingales and Kate Waldock of Georgetown University.)
The debate over shareholder value crystalized nearly 100 years ago when two competing perspectives about the objective function of the corporation emerged.
The Shareholder Primacy view held that firms should work to maximize profits and shareholder wealth. By contrast, according to the Stakeholders Perspectives view, firms should integrate the interests of customers, employees, suppliers, creditors, and communities, among other stakeholders, in addition to shareholders.
“The debate thus far,” Zingales said, “has clearly been won by the Shareholder Primacy side, from both economic and legal perspectives.” After all, shareholders should have decision rights since they are the “residual claimants” of the corporation, according to Zingales. They are paid only after all other claims are settled and thus bear the residual risk.
The Friedman Rule
Milton Friedman was a key proponent of Shareholder Primacy and authored the seminal essay “The Social Responsibility of Business Is to Increase Its Profits” that introduced what Zingales now calls the “Friedman Rule.”
Friedman stated that corporations should “conduct the business in accordance with their [stockholders’] desires, which generally will be to make as much money as possible while conforming to their basic rules of the society, both those embodied in law and those embodied in ethical custom.”
“The Friedman Rule does not ignore workers or customer needs or desires,” Zingales said. A company can adopt policies that serve a larger social purpose, appeal to millennials, attract talent, create a happy workforce, etc., and still be totally in accord with the Friedman Rule. If Walmart decides to stop selling assault-style rifles and ammunition because selling such products discourages people from shopping at Walmart, that’s still a profit-maximizing decision.
The Friedman Rule allows for other strategic objectives. Some companies — Patagonia, for example — assume the form of a “Benefit Corporation,” adopting pro-social policies that appeal to particular customers.
A key but often overlooked assumption of the Friedman Rule is that shareholders care only about returns. Zingales finds this especially intriguing when problems with broad social or ethical impact come into play. In “Companies Should Maximize Shareholder Welfare, Not Market Value,” Zingales and Oliver Hart contend that shareholders don’t just think about money: “They have ethical and social concerns,” they wrote. “In principle, these could be part of the ‘ethical custom’ Friedman refers to.”
As a result, Zingales recommends that companies seek to maximize shareholder utility or welfare, in addition to making money.
“Many people say, ‘I’m willing to sacrifice a little bit of my return in order to do the right thing,’” Zingales said. “‘Do I want to lose money? No.’ But most people have a little bit of social utility in their utility function.” How shareholders vote is one good way to determine their preferences, he noted.
Why Can’t Investors Just Vote with Their Feet?
Of course, shareholders can always unload their shares if they disagree with how a corporation conducts itself, right? Maybe not. As Zingales pointed out, if you are in an index fund — and passive mutual funds and exchange-traded funds (ETFs) now account for more than $4 trillion in assets — divesting isn’t so easy.
And even when it is, doing so might actually reward the behavior you’re seeking to punish. “Divestiture can lead to the opposite outcome of what people want,” he said. “It’s convenient, it doesn’t ruffle feathers too much, but it’s counterproductive.”
Divestiture raises the cost of capital for the company from which you’re divesting, he explained. But it also raises the expected return for the shareholders who don’t divest.
The debate has arisen now for a variety of reasons, according to Zingales, with growing interest in sustainability and environmental, social, and governance (ESG) issues among asset owners, a particularly critical one. Indeed, CalPERS CEO Chris Ailman defines ESG issues as “long-term operational business risks.”
“Today, ESG is a standard matter of conversation for serious investors,” Zingales said. “Certainly this is the case in Europe, but it is also coming to the US.”
Today, investors are not ignoring the problem, according to Zingales, but making a choice in a vague, subtle way. “We are choosing to give a zero weight to all the social preferences,“ he said. “If we only maximize shareholder value, as a result, we impose a zero weight in every utility function, which I think is hard to imagine is optimal.”
This was not historically the case, Zingales explained. Businesses were local or controlled by families that incorporated their social preferences into how they ran their businesses. “The combination of globalization, portfolio diversification, and capital market pressures has forced investors to put zero weight [for social preferences] in our utility functions,” he said.
Aggregating Investor Preferences
“In the last 50 years, investors’ social objectives have been largely ignored, but today there is a growing demand among investors to address them,” Zingales said.
“This raises new challenges, particularly for you as CFA charterholders, because we need to measure these objectives. If I have some social objectives, I don’t want to give out my money for fluff. I don’t want to give out my money for [a] general principle. I want to give it out for results. We need good measurements, good ways to aggregate preferences, and good auditing. That’s your job.”
- “Investor Ideology,” Patrick Bolton, et al., SSRN.
- “Bad and Not-So-Bad Arguments for Shareholder Primacy,” Lynn A. Stout, SSRN.
- “University of Chicago 2019 Convocation Address,” Luigi Zingales.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images/ burakpekakcan
Continuing Education for CFA Institute Members
Julia Hammond, CFA, is a director in the Educational Events and Programs group at CFA Institute, where she leads the planning for a number of annual and specialty conferences, including the Fixed-Income Management Conference, the Equity Research and Valuation Conference, the Latin America Investment Conference, the Alpha and Gender Diversity Conference, and the Seminar for Global Investors, formerly known as the Financial Analysts Seminar. Previously, she developed strategies for pension, endowment, and foundation fund clients at Equitable Capital Management (now AllianceBernstein), and she has also worked as an auditor for Coopers & Lybrand (now PricewaterhouseCoopers). Hammond served for a number of years as chair of the investment committee for the Rockbridge Regional Library Foundation. She holds a BS in accounting from the McIntire School of Commerce and an MBA from the Darden School at the University of Virginia.