Shareholder value creation is good for companies, investors and the wider world
Capitalism is in crisis. The consensus among politicians, citizens, and even executives is that business just is not working for ordinary people. It enriches the elites, paying scant attention to worker wages, customer welfare, or climate change.
Citizens, and the politicians that represent them, are fighting back. The precise reaction varies – occupy movements, Brexit, electing populist leaders, restricting trade and immigration, and revolting against CEO pay. But the sentiment is the same. ‘They’ are benefiting at the expense of ‘us’.
While radical calls to reform business drum up significant support, they risk throwing out the baby with the bathwater and ignore the crucial role that profits play in society.
Profits are often portrayed as evil value extraction and investors as nameless, faceless capitalists. But investors are not ‘them’; they are ‘us’. They include parents saving for their children’s education, pension schemes investing for their retirees, or insurance companies funding future claims. So any serious proposal to reform business must work for investors as well as society.
Viewing investors as ‘them’ and society as ‘us’ is an example of the pie-splitting mentality. It sees the value that a company creates as a fixed pie (see figure). Thus, any slice of the pie that goes to business reduces the slice enjoyed by society. Under this view, the best way to increase society’s take is to straitjacket business so that it does not make too much profit.
The pie-splitting mentality is practised by some investors also. They think that the best way to increase profit is to reduce society’s slice by price-gouging customers or exploiting workers, and view a company that takes stakeholder welfare seriously as ‘fluffy’ and distracted from the bottom line. Particularly in the crisis, some investors fear that purpose is a luxury and that companies should focus on survival.
But the pie is not fixed. The pie-growing mentality stresses that a company does not reduce investors’ slice of the pie by investing in stakeholders. Instead, it grows, ultimately benefiting investors. A company might improve working conditions out of genuine concern for its employees, yet these employees become more motivated and productive. A company might develop a new drug to solve a public health crisis without considering whether those affected are able to pay for it, yet end up successfully commercialising it. A company might reduce its carbon emissions far beyond the level that would lead to a fine, yet benefit because customers, employees, and investors are attracted to a firm with such values.
It might seem too good to be true that serving society might ultimately boost profits. So we need large-scale, rigorous evidence. That is what I gathered from a recent book, Grow the Pie: How Great Companies Deliver Both Purpose and Profit. One study shows that companies with high employee satisfaction – measured by inclusion in the list of the 100 Best Companies to Work For in America – outperformed their peers by 2.3-3.8% per year over a 28-year period. That is 89-184% compounded.
Further tests suggest that employee satisfaction leads to good performance, rather than the reverse. Other studies find that customer satisfaction, environmental stewardship, and sustainability policies are also associated with higher stock returns.
Implications for investors
What does this all mean for investors? I will stress three points. The first is the role of investors in business reform. As mentioned, investors are often viewed as the enemy, extracting profits at the expense of society, so business reformers advocate restricting investor rights. But such views are not backed up by the evidence. Rigorous studies show that, while shareholder activism does indeed increase profits, this does not arise from pie-splitting, but from pie-growing – improved productivity and innovation, which in turn benefits society. So any repurposing of capitalism should place investor engagement front and centre, as the new UK Stewardship Code aims to do.
The second, is on the role of ESG factors in investment decisions. ESG investing is often viewed as niche, only to be pursued by investors with an explicitly social mission, under the view that social performance is at the expense of profits. Instead, integrating these dimensions is good practice for all investors, including those with purely financial goals.
Good companies are not always good investments. If a company is good, and everybody knows it is good, then an investor pays for what he gets. It makes no sense to buy Facebook because it is a leader in social media – everybody knows this, so its shares are expensive. A good investment is a company that is better than everyone else thinks. Stakeholder capital is a prime example of such hidden treasure; it ultimately leads to profits, but the market does not realise this, owing to the pie-splitting mentality. The UN-backed Principles for Responsible Investment advocates that shareholders should consider ESG factors when choosing stocks. But if they improve financial performance, then the word ‘responsible’ is unnecessary. Taking such factors into account is simply a principle of investment.
The third implication is more nuanced. While ESG investing is not at the expense of profits, it is important not to go too far the other way. Some ESG advocates go to the other extreme and claim ESG investing is a panacea.
A leading UK broker has claimed that “study after study has shown that businesses with positive ESG characteristics have outperformed their lower-ranking peers”. These claims are often accepted uncritically given confirmation bias – the temptation to take evidence at face value if it confirms what we would like to be true. We would like to live in a world in which ethical companies perform better.
But that is not the case. The evidence shows that companies delivering value to all stakeholders across the board do not beat the market. They are probably making investments in an undisciplined way and forgetting about their responsibilities to investors. But those that deliver strong performance only to stakeholders material to their business – and scale back on others – do significantly outperform. This highlights the importance of investors evaluating companies in a discerning way that pays attention to materiality, rather than box-ticking and thinking that serving more stakeholders is always better.
Business needs to be reformed to regain public trust. But the reforms do not involve regulating companies to make them less profitable. CEOs and investors must take their responsibility to stakeholders seriously and seek to create profits only as a by-product of serving society, rather than through exploiting customers, employees, and the environment.
Creating social value is not simply ‘worthy’ – it is good business. The highest-quality evidence, not wishful thinking, reaches this conclusion: to reach the land of profit, follow the road of purpose.
Alex Edmans is professor of finance at London Business School and author of Grow The Pie: How Great Companies Deliver Both Purpose and Profit
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