James Montier of GMO has written a must-read white paper titled “The World’s Dumbest Idea”, namely, ‘shareholder value maximisation’, or SVM. To appreciate it, one must delve a bit into its background. In the ’80s, the US was alarmed by the economic strides made by Japan and Germany, whose fast growth was threatening the economic hegemony of the US, using stakeholder capitalism.
Under this form of capitalism, the interests of various stakeholders, like employees, suppliers, customers and shareholders, were looked after. It proved successful. Five of the top 10 banks were Japanese. The Nikkei index hit 38,900, and NTT Docomo was the most expensive stock in the world. Both Universal Studios and Rockefeller Centre were bought by the Japanese.
Alarmed at this economic Pearl Harbour, the US hit back by promoting shareholder capitalism, under which the interests of holders of capital (equity and debt) were supreme, and interests of other stakeholders were subservient. The goal of the corporation was SVM. It worked! US retained its economic hegemony. Japan was badly hit, and the Nikkei fell to 7,600 after its high in 1989.
Montier has, in his paper, been critical of SVM as the bane of a lot of global economic ills.
Montier makes several arguments to prove his point, but perhaps the most important is that the percentage typical CEO salary in the US in the form of fixed salary plus bonus is around one-third of the total package. Two-thirds comes from stocks and options. This pay structure makes the CEOs focus on short-term performance (witness the obsession of the investment community with quarterly earnings) —to the detriment of long-term growth.
As a result, companies invest less of their cash flow in creating assets (and jobs, with it) and more on returning cash to shareholders. The percentage of cash generated that is returned to shareholders has doubled, from around 18% in 1964 to around 35% in 2014.
The low investment continues, despite efforts by the central banks to provide funds for investment and for consumption. Although the US saw an encouraging job growth of 321,000 in November, an estimated one out of five families does not have a single wage earner, and are living off welfare cheques. Europe is worse. Switzerland is thinking of a scheme to give an annual income of $6,400 to every citizen, because of job scarcity.
As this column had mentioned earlier, the S&P index is rising even as global GDP forecast is falling. This is partly due to the share buy-back programmes undertaken by the CEOs as an SVM exercise.
One of the reasons why stock markets are moving up even when earnings are going down is due to ZIRP (zero interest rate policy). This is a precursor to NIRP, or negative interest rate policy. It leads to a carry trade, wherein investors borrow in one country at low interest rates and invest in stocks of another country. So long as the currency of the borrower’s country declines, and the stock markets invested in are rising, the carry trade yields good returns. If either of these factors reverse, the carry trade flows will also reverse.
Thus, despite all the quantitative easing that Bank of Japan is doing, its economy is not growing— it contracted in the July-September quarter deeper than expected, at an annualised rate of 1.9%. Europe is still in recession and ECB president Mario Draghi has postponed till January another QE. Greece is again in the pits, and its stock market has collapsed.
Now, Saudi Arabia and the US shale industry are engaged in a ‘who-blinks-first’ showdown. Saudi is not cutting back oil production, in order to maintain market share, and the resultant glut in supply, combined with a fall in demand thanks to slowdown in China (forecast by Nouriel Roubini at 5.4% for 2016), means that prices of crude oil have sunk to $60 per barrel.
Low crude oil prices have, of course, provided a relief to oil importing countries like India. In effect, around $1 trillion has been transferred from producing countries to consuming ones. But someone will have to blink.
Saudi may blink because its budget, and the social welfare programmes, need a $100 price for oil to balance. There would be unrest otherwise.
US shale producers may blink because simply to maintain production at current levels, the industry needs to keep digging new wells, and to get funding for this a minimum crude price is essential. There are varying estimates for the price, but the lower they go, the more tough it will become.
Last week the market corrected, as anticipated. The Sensex dropped 1,009 points to 27,350 and the Nifty dropped 311 points to 8,224.
To make the market healthier for the next upmove, which will happen, it really ought to correct more. The falling crude prices means that oil-producing countries will be importers of capital instead of exporters. This can reduce foreign institutional investors’ inflows to India. The slack can, however, be picked up by local retail and institutional investors, especially pension and insurance funds.
(J Mulraj is a stock market commentator and India head for Euromoney Conferences; views are personal)