The US Stock Market and the Governance of Innovative Enterprise

1. 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

2. 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

3. 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 • A theory of the corporate economy: must explain • how firms grow, often employing tens of thousands, and at times hundreds of thousands; • how firms differentiate themselves from competitors in their industry; • how some firms come to dominate an industry over very long periods of time; • how new firms rather than incumbent firms enter an industry • We need a theory of the corporate economy… Lazonick

4. 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. O’Sullivan) • 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: • Strategic control: abilities and incentives of corporate resource allocators to invest in innovation • Organizational integration: incentives of people with different hierarchical responsibilities and functional specialties to develop and utilize the firm’s resources • 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

5. 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

6. 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

7. “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

8. “Maximizing shareholder value”, 1980s and 1990s Stock (S&P500) and bond (Moody’s Aaa) yields, 1960-2006 Annual average percent change 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. To realize price yields, one has to buy and sellstock To realize dividend yields, one has to buy and hold stock Lazonick

9. 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

10. 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

11. Disgorging the free cash flow in the 2000s Repurchases, dividends, net income, R&D expenditures, 1980-2006 (293 corporations in the S&P500 in October 2007 in operation in 1980) 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. TD=Total dividends RP=Stock repurchases NI=net income (before taxes) R&D=Research & development Lazonick

12. Critique of “maximizing shareholder value” • Flaws in the theory of maximizing shareholder value: • Agency theory fails to explain how,historically, corporations came to control the allocation of significant amounts of the economy’s resources: no theory of innovative enterprise • 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 • 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

13. The problem with “stakeholder theory” • Margaret Blair’s 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

14. Innovation and the stock market • What drives stock prices? • 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

15. Innovation, speculation, redistribution Stock price movements, Intel and Microsoft, Jul. 1986-Nov. 2007 SPECULATION REDISTRIBUTION INNOVATION Lazonick

16. Innovation, speculation, redistribution Stock price movements, Intel, Microsoft (Jul. 1986-Nov. 2007), and Cisco (Mar. 1990-Nov, 2007) SPECULATION REDISTRIBUTION INNOVATION Lazonick

17. 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) drove innovation in the 1980s and 1990s, although the productivity benefits of the revolution only became evident with the coming of the Internet in the 1990s – a “retain-and-reinvest” allocation regime: companies list on NASDAQ where investors expect growth that gets reflected in stock price increases, not dividends Key NASDAQ firms include (with dates of founding, IPO, and first cash dividend) Intel (1968; 1971; 1992), Microsoft (1975; 1986; 2003), and Cisco (1984, 1990; none) Lazonick

18. Speculation • Speculation:bidding up of stock prices on the assumption that there exist “greater fools” in the market • Robert Shiller, Irrational Exuberance, 2000, p.18 • Assumes that all actors, pros and amateurs, have access to the same information: fails to recognize the distinction between “insiders” and “outsiders” (even through this distinction has long been recognized in the law) • Vastly understates the importance of stock-based compensation as a source of top-executive income and as an inducement to engage in perfectly rationalexuberance • Given the long queue of “greater fools” willing to speculate on stocks, the exuberance of “Wall Street” and corporate executives was anything but irrational (although in some cases it turned out to be illegal) Lazonick

19. Speculation follows innovation Lazonick “Cisco is a $6 billion high technology stealth company, largely unknown to the general public. Insiders joke that Cisco is often confused with Sysco, a huge distributor of foodstuffs for restaurants. Yet it is the fastest growing company in history and the third largest company on Wall Street. Its CEO, John Chambers, gets little of the attention paid to bigger stars of the high tech world like Bill Gates, Larry Ellison, or even Lew Platt of HP. But if you had the prescience to invest $1,000 in Cisco stock in 1990, you’d now be walking around with roughly $100,000.” First lines of Stanford case, “Cisco Systems: The Acquisition of Technology is the Acquisition of People,” by Charles A. O’Reilly III, published October 27, 1998 (Lazonick’s emphasis) 17 months later, Cisco Systems, now very well known to the public, had the highest market capitalization of any company in the world.

20. Redistribution Redistribution:reallocation of returns to shareholders from other stakeholders Payout ratios: 1960s: 38.8%; 1970s: 41.3%; 1980s: 48.4%; 1990s: 56.5%; 2000-2005, 61.5% Repurchases:Old Economy companies began to do them on a large-scale in the mid-1980s as part of a “downsize-and-redistribute” allocation regime – IBM’s large-scale buyback is credited with leading the way in reversing the stock market crash of October 1987 – in the 1990s and, especially 2000s, New Economy companies have joined in, as they try to get their stock prices up toward the speculative peaks of 2000 (more info later in the talk) Lazonick

21. CEO pay and stock options Value of stock options: 19% of CEO compensation in large US corporations in 1980, but 48% in 1994 (Hall and Leibman 1998, 661) Recent study of CEO pay in S&P500 companies found that average compensation in 2003 dollars rose from $3.5m in 1992 to a peak of $14.8m in 2000, declining to $8.7m in 2003 (Jensen et al. 2005, 33) Value of stock options: 28% of this pay in 1992, 49% in 2000, and 38% in 2003 -- of the change in pay 1992 -2000, 11% salaries, 15% bonuses, and 57% options. Of the decline in pay 2000-2003, 14% salaries, 11% bonuses, and 65% options Largely as a result of gains from the exercise of stock options, the ratio of the pay of CEOs of major US corporations to that of the average worker increased from 42:1 in 1980 to 85:1 in 1990 to 531:1 in 2000, and stood at 411:1 in 2005 Lazonick

22. The stock market, the corporate allocation of resources, and “sustainable prosperity” • All three drivers of the stock market – innovation, redistribution, and speculation -- are valid for certain times and places, including certain industries and companies • None of these drivers stands on its own; they are linked historically and they coexist at a point in time • How does the stock market influence the corporate allocation of resources? • What are the implications for innovation at the corporate level? • What are the implications for the achievement of stable and equitable growth, or what I call “sustainable prosperity” in the economy as a whole? • HINT: Innovation enables growth, but speculation results in instability, and redistribution results in inequity. Lazonick

23. How, then, might the stock market affect innovation? • Building on the theory of innovative enterprise, we want to know how the stock market influences strategic control, organizational integration, and financial commitment • Need to know the functions of the stock market in the modern corporation • Five functions of the stock market: • Creation • Control • Combination • Compensation • Cash Lazonick

24. Five functions of the stock market in the industrial corporation • Creation: the stock market induces financial commitment to new firm formation by enabling private equity holders to monetize their stakes • Control: the stock market influences who exercises strategic control by enabling the separation of share ownership from managerial control • Combination: the stock market provides a currency for mergers and acquisitions, thus permitting the extension of strategic control • Compensation: the stock market provides a currency for recruiting, retaining, and possibly motivating personnel, thus facilitating their organizational integration • Cash: the stock market serves as a source of financial commitment, providing a company with funds without the guarantee of a return Lazonick

25. Application to the US ICT industries Focus on 20 top Old Economy corporations and 20 top New Economy corporations in the 2006 Fortune 500 list Includes IBM, HP, Motorola, Texas Instruments among the Old Economy companies Includes Cisco Systems, Intel, Microsoft, Sun Microsystems among the New economy companies How have these companies actually used the stock market for creation, control, combination, compensation, and cash, and what can we say about the influence on innovation? Lazonick

26. Creation • Clearly related to innovation, except in a speculative boom in which the backers of potentially innovative (as well as outright fraudulent) startups can cash in even in the absence of a commercializable product • Venture-based investments: committing finance • IPOs of venture-backed companies: cashing in • M&A deals for venture-backed companies: cashing in Lazonick

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30. Control Separation of share ownership and managerial control the norm not only in Old Economy but also in New Economy companies For example: Who is John Morgridge, and why with 1.0% of the stock is he the largest shareholder of Cisco Systems among founders, directors, or executives? Why does Steve Jobs own “only” 1.2% of Apple, and Scott McNealy “only” 2.2% of Sun Microsystems? Why does Bill Gates own 9.5% of Microsoft, while Larry Ellison owns 24.5% of Oracle? Extent of dilution depends on what individual founders and managers did with their stockholdings, and how companies used stock for creation, combination, compensation, and cash. Lazonick

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33. Combination Steven Ballmer, then president of Microsoft, interview in early 1998(quoted in Cusumano and Yoffie 1998, 302): “We’ve had to step up and either make or not make big investments on Internet time. Like WebTV. Like HotMail. Some of them, I think, will prove smart. Maybe some of them won’t prove smart. But they’re not huge decisions. We have a currency [with our stock price] that makes them relatively small decisions. These deals [WebTV and HotMail] were both done for stock. I still think it’s real money, whatever it is -- $400 million of so per acquisition. But I can stop and say, ‘OK, that’s half of one percent of Microsoft.’ That’s probably a reasonable insurance policy to pay.” Cisco Systems perfected the “growth-through-acquisitions” strategy But careless stock-based acquisitions in the New Economy boom contributed to the demise of an Old Economy company like Lucent Technologies Lazonick

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35. Compensation 1950s: employee stock options, a tax dodge for top executives 1960s and first half of the 1970s: public backlash against this privilege in the Meanwhile, however, Silicon Valley startups were using broad-based stock option plans as a way of inducing non-executive professional, technical, and administrative personnel to leave secure career employment with an established Old Economy company to take up insecure employment with a New Economy startup Used in this way for startups, stock options contribute to innovation But broad-based stock option plans become problematic when these companies have grown large Lazonick

36. Stock option “overhang” Lazonick

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38. Benefiting from the boom – and overgenerous boards Lazonick

39. Benefiting from the boom: Take the money and run James Galbraith and Travis Hale, “Income Distribution and the Information Technology Bubble,” University of Texas Inequality Project Working Paper 27, January 2004:Virtually all of the growth in US income inequality came from four counties in the United States: three in California that are part of Silicon Valley and one in the state of Washington where Microsoft is headquartered Lazonick

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42. “Broad-based” employees did OK from options:Their bosses did (and still do) much better Lazonick

43. Cash Cash: the stock market serves as a source of financial commitment, providing a company with funds without the guarantee of a return Only true in speculative periods, particularly the late 1990s when US corporations sold stock at inflated prices to pay off debt or bolster the corporate treasury But in late 1990s boom, not the case for established companies – if anything they bought their own stock to push stock prices up even further – meanwhile their executives sold stock and got very rich In Internet boom of late 1990s some speculative new ventures raised huge sums through initial and secondary public offerings that could then be used to fund investment in productive resources – e.g., Sycamore Networks, optical networking company founded Feb. 1998 in Route 128 -- previous year revenues of $11m, losses of $19m, and 155 employees,: Sycamore IPO in Oct.1999, raising $284m; secondary offering in March 2000, netted another $1.2b -- top execs sold a portion of their own stockholdings for $726m Lazonick

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45. Manipulation of the market Lazonick

46. Why stock buybacks? Lazonick

47. AMD and Intel 1995-2006: AMD R&D expenditure 20% of Intel’s, while revenues 13% AMD paid no dividends and only $77m in buybacks in 2001 Intel paid $8.4b dividends and $55.9b buybacks – combined 91% of NI 2001-2006: AMD captured market share from Intel – Intel’s repurchases 111% of NI and total distributions, 133% Lazonick

48. Microsoft kowtows to Wall Street Microsoft announces investments in online business to compete with Google and Yahoo! CEO Ballmer (31st richest man in the world) goes to Wall Street to defend Microsoft’s “big bold bets” Microsoft announces 2-yr. acceleration of its $30 billion buyback program plus $20 billion to be repurchases 2007-2011 Microsoft’s stock price movements, April-July 2006 Lazonick

49. The bottom line Unstable and inequitable growth in the United States -- Growth through innovation -- But instability through speculation -- And inequity through redistribution With the stock market playing a major role Lazonick