Sunday, August 4, 2013

Is maximal profit at any cost really what shareholders want?

Rajiv Sethi has a great post on the recent reprehensible behavior of Goldman Sachs.

What I'll add is this: There's the horrible argument that Goldman Sachs should do these horrible things because they should do whatever maximizes the profits of their shareholders – Sell crack, poison the streams children drink from, whatever, it must be good because invisible hand! But, of course, any trained and decent economist knows about all of the ways the pure free market and invisible hand can go horribly wrong, especially if you care about optimizing total societal utils, which I consider ridiculously more important than Pareto optimality. These ways include externalities, asymmetric, and just poor, information, monopoly power, relatively high transactions/negotiations costs, giant economies of scale, zero marginal cost idea/information goods,...

But here's something you rarely hear: Are you really optimizing shareholder utility, or doing what shareholders really want, if you do anything that maximizes profits? And the answer is often, of course not. Would the average shareholder of Goldman Sachs vote for these (and many more and far worse) horrible actions in exchange for what's sometimes just a relatively small increase in return (to their portfolio as a whole), if they had to spend the time to vote and were completely informed of what was going on, and the implications?

Many shareholders hold extremely diversified portfolios. So they can vote that none of the companies in Goldman Sach's industry do these horrible things, and thus the decrease in profits is much less than if Goldman Sachs is the only one acting ethically. And, even if it would hurt Goldman Sach's industry, it might (and very likely would) help other industries in a well diversified investor's portfolio.

And on top of that, any decrease in return would apply to everyone, and this is huge due to ginormous positional externalities. You basically don't lose prestige, position, context, due to falling behind others in wealth and consumption. Everyone's return is lowered the same amount.

Of course, the vast majority of shareholders hold only a micron of each company, and so it's not worth their time to vote, and if you own through a mutual fund, the mutual fund votes for you anyway. I've owned a piece of pretty much every company on every major exchange for years, at least through mutual funds and ETFs, but I've never voted. So, who controls tends to be rich individual major shareholders (often very greedy), pension funds, mutual funds, and other institutions and companies, and/or the managers themselves.

With regard to institutions, like pension funds and mutual funds, their managers basically consider it their fiduciary duty to vote however maximizes the dollar returns of shareholders, regardless of ethical/social issues. I was in an MBA program in the 90's and a finance Ph.D. program in the 2000's; the constant message was, a mangers duty is to do whatever maximizes shareholder wealth, or return. And I've seen a lot more evidence of this through the years in experience and study. It's a very, invisible hand, greed is good, message. The culture is very important and different from a generation or two ago. Because the policeman can't be everywhere, and the law can't cover every kind of situation and gaming that can come up, culture and norms are very important.

So, with regard to the shareholder voting of mutual funds, this quote from a 2006 Wall Street Journal article is consistent with my experience and study:
On proposals related to social issues, fund companies commonly vote against them or abstain, basing their decision on whether the measures would financially benefit shareholders.
Now, interestingly, you have the word, "commonly", as if sometimes the mutual funds do vote for social proposals. And you can see in that article that there are significant percentages of times when they do. And also here, with regard to global warming proposals. But I suspect that most of the voting for social proposals is for profit reasons, to protect the name of the corporation and its brands, something Apple may be making a mistake in not worrying about more (but remember, the managers may be long gone, with their huge bonuses, before the long term price is really paid). Of course, the argument that corporations will always be forced to act ethically to protect their reputation is very wrong. Amongst other problems, often the vast majority of the public won't know what's going on, and often the profits will outweigh the bad publicity, such as it gets known.

But the bottom line is that, the shareholders only care about money at any cost, greed is good, invisible hand, message is wrong, and the change in our corporate culture towards this has been extremely harmful. Maximal profit at any cost is not always what the average shareholder wants, even weighted by shares owned. The average shareholder, even weighted by shares owned, is often very willing to have a slightly lower return on his total portfolio to have his companies not doing horrible things.