A Blog by Jonathan Low

 

Sep 7, 2014

Profits Without Prosperity: From Value Creation to Value Extraction

People in the west pride themselves on having created a post-industrial economy. One based on creating value from intangibles like brand, intellectual and human capital.

But corporate behavior belies our pronouncements of faith in that progression. So many incentive structures are designed to value extraction over creation that the US and Europe look increasingly like those economies dependent on one crop or mineral.

In the western case, that crop is cash. The problem is that an economic strategy dependent upon value extraction that refuses opportunities to invest in the future is by its very nature unsustainable. So the entire edifice in constructed with an eye to impermanence; it is hard to justify building for the future if the prevailing structure is based primarily in a belief that the future is too uncertain to warrant more than a perfunctory nod towards anything beyond the scope of compensatory asset accretion.

Extractive economies almost always fall prey to their dependence on the now. The challenge for institutions in the US and Europe will be in finding a way that moderates their evident fear of the future with a renewed belief in the potential upside presented by the assumption of prudent risk in return for value. JL

William Lazonick reports in Harvard Business Review:

By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.
Five years after the official end of the Great Recession, corporate profits are high, and the stock market is booming. Yet most Americans are not sharing in the recovery. While the top 0.1% of income recipients—which include most of the highest-ranking corporate executives—reap almost all the income gains, good jobs keep disappearing, and new employment opportunities tend to be insecure and underpaid. Corporate profitability is not translating into widespread economic prosperity.
The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.
The buyback wave has gotten so big, in fact, that even shareholders—the presumed beneficiaries of all this corporate largesse—are getting worried. “It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies,” Laurence Fink, the chairman and CEO of BlackRock, the world’s largest asset manager, wrote in an open letter to corporate America in March. “Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”
Why are such massive resources being devoted to stock repurchases? Corporate executives give several reasons, which I will discuss later. But none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay, and in the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.
As a result, the very people we rely on to make investments in the productive capabilities that will increase our shared prosperity are instead devoting most of their companies’ profits to uses that will increase their own prosperity—with unsurprising results. Even when adjusted for inflation, the compensation of top U.S. executives has doubled or tripled since the first half of the 1990s, when it was already widely viewed as excessive. Meanwhile, overall U.S. economic performance has faltered.
If the U.S. is to achieve growth that distributes income equitably and provides stable employment, government and business leaders must take steps to bring both stock buybacks and executive pay under control. The nation’s economic health depends on it.
From Value Creation to Value Extraction For three decades I’ve been studying how the resource allocation decisions of major U.S. corporations influence the relationship between value creation and value extraction, and how that relationship affects the U.S. economy. From the end of World War II until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed at major U.S. corporations. They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what I call “sustainable prosperity.”
This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality.

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