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29 April 2019

Impetus of Change: From shareholder value to social responsibility

It is a generally accepted fact that public opinion is much less favorable towards businesses than it was two decades ago. We can see this opinion conversely related to the evolution of shareholder value over the past twenty to thirty years, associated with a general process of the ‘financialisation’ of business and an increasing orientation to financial metrics.  Professor John Kay, one of Britain’s leading economists, recently covered this topic in his keynote ‘Examining ESG Integration’ at a thought leadership forum hosted by Style Analytics on 26th March, entitled Reworking ESG.

Financialisation of business: Modes 1 vs 2

Prof. Kay examined how the trend towards financialisation came about by distinguishing two distinct ‘modes’ of business.  The first mode (Mode 1) was prevalent in the decades running up to the 1980s, when there was a recognition by company management of a number of different stakeholders, all forming a community in order to establish business advantage by either exploiting a company’s leading position or cost advantage.  Mode 2, on the other hand, began to occur during the 1990s, when businesses began to dedicate themselves solely to the creation of shareholder value, as well as the acquirement of other businesses rather than the creation of new ones.

Kay argues that this development was due to many different causes built up over time.  The first, was centered on the growth of the financial sector, which became a self-sustaining cycle fuelled by greater attention to commercial metrics within the business sector.  The world of hostile takeovers also played a major role in further focusing attention on share price.  In addition, there was an important academic contribution from the 1970s, with a move towards treating business as a set of principal agent problems, with solutions focused on devising various kinds of incentive structures for managers.  The declared object at the time was to align the interests of executives with the interests of shareholders, yet it is of great paradox that it would be these types of incentive schemes (including executive remuneration) that would actually be the largest single cause of friction between shareholders and executives.

The second cause was the diversion from the principle that profitable companies do not necessarily have to be profit-oriented.  A good example is the once-great British retailer, Marks & Spencer (M&S).  The business enjoyed an extraordinary competitive advantage in the UK retail market that was squandered in the years following the company’s reorientation towards creating shareholder value, squeezing customers and suppliers in the process.

The final cause was the so-called ‘indulgence’ of business towards the matter of corporate social responsibility.  It is not simply a matter of big companies making money from questionable practices, yet then trying to feel better about themselves by printing annual reports on recycled paper, or building a new wing in a national gallery.  Rather, corporate social responsibility is about creating businesses that serve society in the manner of ‘Mode 1’, not ‘Mode 2’.


Collective intelligence

According to Prof. Kay, the truth is that the shareholder value mantra was always absurd.  Employees are not going to build top-quality products with the predominant driver revolving solely around ‘shareholder value’.  Instead, firms need to first understand what the competitive advantages of the business are, and then apply these in order to meet business objectives, including the objective of making money for stockholders.  Likewise, the duty of a director is not to promote the interests of the shareholders, but to promote the success of the company.  The benefit of the members follows on from the success of the company, not from actions to maximise shareholder value.

Today, there are certain global corporations that exemplify extraordinary feats of modern economic organisation.  The pan-European Airbus demonstrates how a group, or community, can know far more than any individual – a collective intelligence if you will.  And it is precisely this collective intelligence that makes modern business a fundamentally social organisation.  It operates, not by dedicating itself to the creation of shareholder value, but by having a great many people within the company committed to the development of great business.  Making profits simply follows on from that.


Impetus for change

The tide is gradually beginning to turn away from an exclusive focus on shareholder value, back towards the incorporation of purpose into the day-to-day operations of business.  It is Prof. Kay’s belief that the impetus for further change should come both from the investment community becoming more involved with the competitive advantage and social relationships of business, as well as from business itself by promoting a better understanding of what successful business actually involves.