Top of the News: Commentary
A SWEEPING PRESCRIPTION FOR CORPORATE MYOPIA
As a member of a panel advising academic researchers on U.S. competitiveness, Senior Editor Dobrzynski had an unusual vantage point for viewing the issue. Her report:
A couple of years back, two dozen of the country's best business professors set out to answer a question that has bedeviled Corporate America for years: Why are U.S. managers so shortsighted? Under the auspices of Harvard business school and the Council on Competitiveness, a private group of chief executives, the experts sought solutions to a problem that's so often blamed for declining U.S. competitiveness.
A funny thing happened along the way. Harvard's Michael E. Porter, the project director, discovered that policy- makers, managers, and investors all have been fixated on the wrong question. Management myopia per se isn't the cause of the decline. Nor is its offshoot, underinvestment. U.S. corporations invest too much in some areas--acquisitions, to name one. Porter says the other oft-cited culprits--high capital costs, impatient Wall Streeters, cantankerous shareholders, greedy managers, wrongheaded compensation plans, supine boards of directors--are all just symptoms, too.
The real blame, he now believes, goes to the way America's financial system allocates capital. It misdirects funds both among and within companies. Externally, the system shortchanges companies that can deploy capital most productively. Internally, it steers funds to wasteful projects instead of toward research, training, and other initiatives that would boost a company's long-term prospects. In short, Porter found, "the money doesn't go to the right companies for the right investments."
Porter's report, which synthesizes the research of 25 academics, should reset the agenda for reform. Deficiencies in America's financial system, he shows, are largely the unintended consequences of policy decisions affecting patterns of corporate ownership, stock valuation, and capital budgeting. They can be fixed without sacrificing the financial system's impressive efficiency and dynamism. What's more, the report should stop action on the old half-solutions that betray a misunderstanding of the problem. Taxing stock transactions or abolishing quarterly financial reports, for example, would do more harm than good.
TRANSIENTS. To understand why the nation's competitiveness is sliding, Porter looked at investment patterns. Sure enough, American companies invest less than foreign rivals in research, training, supplier relations, and other intangibles, thanks partly to Wall Street pressures and to the vagaries of macroeconomic policy. But there are some telling paradoxes. Some industries seem able to invest for the long term without being penalized by the market--pharmaceuticals, for instance. And the U.S. often shines in high-risk startup industries that require huge up-front investment, such as biotechnology. Here's another puzzler: Why do executives readily invest hefty sums in acquisitions, even though most never pay off?
Porter figured something had to be amiss in the way capital is allocated. Unlike rivals in Japan and Germany, which boast permanent, well-informed, and involved investors, U.S. companies largely get equity capital from a transient base of institutional owners. They hold small stakes in hundreds or thousands of companies, thanks to policies encouraging diversification of risk. Because of legal restraints, their investment information is filtered through Wall Street. They rarely influence management. To appeal to shareholders, managers set goals in terms of return on investment and stock price. Incentive compensation plans, especially stock options, further enshrine financial goals.
NUMBERS GAME. Inside corporations, a similar process takes place. As companies grow larger, management increasingly decentralizes operations. Lacking nuts-and-bolts information, top executives--especially in diversified companies--control the business via budgets, playing a numbers game with line managers. And when they select projects for investment, they base decisions on projected returns and other financial criteria.
These ways of allocating capital both within companies and outside them reinforce one another. The bottom line? Less overall investment, less spending on what can't be easily measured, less funding for long-term projects. The process favors what's easily valued, such as acquisitions. And it encourages misguided investment in mature businesses that face diminished prospects, because they too are better understood and more easily valued. Companies that want to head into new territory must explain the venture in detail to shareholders. But normally, there's no good way for management to communicate its case to investors. The exceptions: emerging industries and, say, turnaround situations, where investors know current earnings will be bad for some time but are willing to take a flyer on the future.
ACTIVE INVESTORS. How can all this be fixed? Refreshingly, Porter doesn't advocate mimicking the Japanese or German systems--which offer less flexibility to withdraw capital when a company is on the wrong track and little regard for small shareholders, to name two drawbacks. Instead, Porter proposes a panoply of initiatives by government, corporations, and shareholders that, taken together, would encourage management to make the investments that maximize the long-term value of corporations (table).
Ideally, U.S. companies would operate in a stable macroeconomic environment that offered access to a larger pool of savings for investment. A better-informed, broader base of shareholders would hold larger stakes and take a more active, constructive role in advising companies. Executives would know more about the businesses they manage and would base investment decisions not on numbers alone, but also on qualitative measures. Managers and owners would work toward the same goals, with both recognizing that parallel investment in "softer" items, such as employee training and supplier relationships, enhances the potential gain from spending on hard assets.
Utopian? Probably. Porter is unlikely to see the sweeping response he's demanding. For starters, getting from here to there entails leadership that the government shows few signs of providing. And it requires both management and institutional shareholders to yield some independence. Writes Porter: "Institutions should not expect to gain greater influence over management without giving up some of their current trading flexibility, for example, while management should not expect informed and committed owners without giving them a real voice in decisions." The temptation for both will be to seek sacrifice by the other but cede little themselves.
This report deserves better. By redefining an issue that will nag at Corporate America until something is done, it merits action or, at bare minimum, debate on a higher plane. The process begins on June 26, when Porter was set to testify before the Senate Banking Committee. The U.S. has nothing to lose, and everything to gain.PORTER'S KEY RECOMMENDATIONS
-- Allow institutions to hold equity and debt, as well as big stakes
-- Modify rules so that earnings reports reflect true performance
-- Expand public disclosure, remove restrictions on board membership
-- Provide stable macroeconomic policy
-- Seek long-term investors and give them a voice in governance
-- Avoid antitakeover devices that insulate management
-- Name shareholders, suppliers, and other outsiders as directors
-- Link incentive compensation to competitive position
-- Avoid unrelated diversification
-- Better evaluate investment in intangibles, such as training
-- Take larger and longer-term stakes in fewer companies
-- Learn more about holdings
-- Seek active, constructive discussions with management
-- Push for changes in corporate policies, such as accounting rules
DATA: HARVARD BUSINESS SCHOOL/COUNCIL ON COMPETITIVENESS, BW
Judith H. Dobrzynski