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JANUARY/FEBRUARY 2015 CORPORATE FINANCE REVIEW 5
IF WHAT
GETS MEASURED
GETS MANAGED,
What gets measur ed gets managed — even when it’s pointless to measur e and manage it, and even if it har ms the purpose of the or ganization to do so.
MEASURING
THE WRONG
THING MATTERS
PA U L B A R N E T T
M
anagement guru Peter Dr ucker is c re d ite d w it h t he much - u s e d phr a s e : “What ge t s me a su re d ge t s m a n - aged” — a truncated version of the full and much more powerful quote: “What ge t s me a su re d ge t s m a nage d — e ven when it’s pointless to measure and man- age it, and even if it harms the purpose of the organization to do so.” These words can be read as a warning that was ig nored. What we have mea- sured, and continue to measure, is not just pointless, but also dangerous — and played a par t in causing the global eco- nomic crisis of 2007–2008. But we have not yet learned the lesson. We continue to use pointless measures of the perfor- mance of businesses. Economist Mar tin Wolf of the Finan- cial Times said:
Almost nothing in economics is more impor- tant than thinking through how companies should be managed and for what ends. Unfor- tunately, we have made a mess of this. That mess has a name. It is shareholder value max- imization.^1
The ter m, of ten expressed as maxi- mizing shareholder value, or MSV, was the brainchild of economist Milton Fried- man, espoused in his book Capitalism and Freedom in 1962. As the authors of a recent report note, the mantra that the purpose of a com- pany is maximizing shareholder value “became ever more per vasive, taught as an ar ticle of faith in the world’s busi- ness schools,” and has been “asser ted in
PAU L BA R N E T T i s f o un d e r a n d C E O of t h e S t rat e g i c Ma n ag e m e nt Fo r um , a m e m b e r s h i p o r g a n i z at i o n t h at e x i s t s to a dv a n c e t h e p rof e s s i o n a l p ra c t i c e of s t rat e g i c m a n ag e m e nt a c ro s s a l l s e c to r s , a l l f un c t i o n s , a n d a l l l e ve l s. Ad d it i o n a l i n f o r m at i o n i s av ai l a b l e at : http://www.strategicmanagementforum.org.
corporate boardrooms as a non-nego- tiable.”^2 Prev iously, CEOs t y pically managed companies for the benefit of their stake- holders — not just shareholders. The Johnson & Johnson credo, w ritten by its chairman in 1943, is an ar ticulation of t he pre v iou s appro ach. It e ven l is te d shareholders last in t he list of st a ke- holders whose interests should be served. After ser ving customers, employees, and communities first, it said: Our final responsibilit y is to our stockhold- ers. Business must make a sound profit. We must exper iment w it h new ideas. Research must be carried on, innovative programs devel- oped and mistakes paid for. New equipment must be purchased, new facilities provided and new products launched. Reser ves must be created to prov ide for adverse times. When we oper- ate according to these principles, the stockholders should realize a fair return.^3
Rober t Wood Johnson II recognized the pr imac y of customer value as the first pr ior it y of a business. He recog- nized that delivering value depends on employees and that business can- not b e i ndep endent of t he com - mu n i t y i t s e r ve s. T h e s e a re ke y points that I hope the reader will con- sider. Also consider this: He thought shareholders should receive a “fair return.” He did not believe that the business should exist to maximize shareholder returns. The Johnson & Johnson credo no doubt determined what measures the business used to assess its performance, and we might expect that indicators of customer satisfaction would be high on the list. Since businesses don’t sur v ive w ithout them, putting customer interests first, and mak- ing customer satisfaction the first mea- s u re o f p e r fo r m a n c e , w o u l d m a ke common sense, but research by KPMG found that only 7 percent of companies provided performance data on customer focus or satisfaction in a survey of annual repor ts.^4 It does not mean that they do not collect the data, but I suggest that it does reflect the level of importance they attach to it since they do not consider it to be wor th sharing w ith investors. The point to be stressed is this: Max- imizing shareholder value as a measure of the performance of a business is, as
its past champion Jack Welch (former chief executive of General Electric) later said, “the dumbest idea in the world.” But, as Michael Skapinker of the Finan- cial Times said, it is “likely to endure as a powerful idea” because “it gives man- agers something against which they can be measured. Other managerial respon- sibilities — to employees, customers or the communit y — are numerically less precise.”^5 Operating companies w ith the aim of maximizing shareholder value leads to what Mar tin Wolf called misbehav ior. It does so by determining priorities and what gets managed. By effectively revers- ing the order in which stakeholder inter- ests are cons idered in t he Johns on & Johnson credo, the maximizing share- holder value concept pushes manage- ment to focus on the w rong priorities. This is in itself bad enough, but the dam- age is amplified by stock-based com- pensation for CEOs, designed to align their interests w ith shareholders. As Roger Martin explains in the Octo- ber 2014 issue of Harvard Business Review, “After 1980 it seemingly became essen- t ia l to mot ivate pe ople financia l ly to exercise their talent,”^6 and skilled lead- ers saw a major boost to their income as tax policy shifted dramatically, mean- ing they kept more of their money and t h e y b e g a n t o b e p a i d i n s t o c k a n d profits. These shifts were the result of t h e p u b l i c at i o n o f M i c h a e l Je n s e n and Wil liam Meck ling’s ar t icle in the Journal of Financial Economics. It argued that cor porat ions needed to alig n the interests of management and shareholders to keep agency costs from causing dam- age to shareholders and the economy in general.^7 But as Martin has shown, returns to shareholders have actually declined since maximizing shareholder value became the dominant paradigm. As a measure of performance it is “tragically flawed,” as Mar tin comments.^8 If stock-based compensation for man- agement amplified the problems caused by maximizing shareholder value, the 2 and 20 Formula turbocharged them. The for mula sees f und managers charge a 2 percent management fee and t ake a 20 percent cut of the profits they gener-
6 CORPORATE FINANCE REVIEW^ JANUARY/FEBRUARY 2015^ MEASURES THAT MATTER
OPERATING COMPANIES WITH THE AIM OF MAXIMIZING SHAREHOLDER VALUE LEADS TO WHAT MARTIN WOLF CALLED MISBEHAVIOR.
prov iding b oth hedge f und managers a nd C E Os w it h a s t rong i nce nt ive to stimulate managed volatility from which they can reap massive gains, as i l lus- trated by the Cisco Systems example. The retail supermarket giant Tesco is currently in the news after announcing it had overstated its anticipated profits by 250 mil lion. As one jour nalist r ig htly commented, “If analysts had focused more on cor porate culture and less on pre- dicted numbers, they might have had a bet- ter understanding of the dynamics of the business.” The same journalist goes on to note that “there have long been things in Tesco’s behaviour and business model that did not seem sustainable, and were possibly even toxic,” adding that: Companies are about people, not numbers, and the clues to these now-obv ious problems could be found in the company’s reputation. This was stellar in the Cit y because analysts w ill tell you the foundation of a great corpo- rate reputation is the abilit y to grow market share and profits year after year. But the cus- tomers, suppliers and communities where the company operates had a different perspective. Tesco’s reputation w ith these stakeholders was sometimes rather a contrast.^15
I am going to add further quotes from this same journalist because they illus- trate the point between what I w ill refer to as “grow th at any price” and “values driven value creation,” or what you might like to call “qualit y grow th.” He made the point that: Expansion was crucial to the business. What set Tesco apar t was not its offer to the cus- tomers, the range of its products or the price at which they were offered. It grew remorse- lessly because it had a machine that could build more stores in better locations than any of its compet itors. Then the inter net tur ned this plus into a minus almost overnight.
With the pressure it was under, the author notes that Tesco’s treatment of its suppliers was also causing increas- ing concern. In his damning criticism of the Cit y and “investors,” he says: A visitor from Mars would have looked at these sig ns of alienat ion in communit ies, of cus- tomers and of suppliers and think that Tesco had a problem — that this was not a sustain- able model and that sooner or later these issues would come together to undermine the busi- ness. But not so the Cit y ; it could not see past the numbers.
He notes that the reason for this was “perhaps because most fund managers tend to hold shares for a relatively shor t time, less than a year, and therefore feel no par t icular need to focus on a poten- t i a l l on g - te r m pro bl e m .” To t h i s l a s t comment he could have added that most C E Os h ave e ve r- de cl i n i ng le ng t hs of t ime in office so do not feel any need to focus on the long-ter m problems they cause either. In his final attacks on the role of the Cit y the journalist said: The Cit y asks how this could happen when it should ask how it missed or failed to heed the w a r n i n g s i mpl i c it i n a l l t h e ot h e r s i g n a l s , because this [the overstatement of anticipated profits] is simply the most extreme manifes- tation of behavior patterns that have been vis- ible for years. When the pressure to perform becomes intolerable, good people will often do bad things. It is the culture which is bad, not the people. But it is high time investment man- agers, who charge the public for their exper- t ise and judgement, paid more attent ion to that culture.
I take this to mean that he believes they should focus on indicators (measures) that matter. These comments, w ritten in Septem- ber 2014, may seem overly harsh to some readers, but not when you consider that Lord MacLaurin, former chairman of the supermarket, publicly attacked the per- formance of Sir Terr y Leahy as CEO. He did so at the company’s annual general meeting in 2013. This followed an annual fa l l in profit s of 5 0 p ercent , g row ing problems in a number of its markets, and a w r ite-dow n in proper t y invest- ments of €804 million, according to a report in The Guardian in June 2013.^16 On the day that Warren Buffett, one of the largest stakeholders in Tesco, admitted he had made a huge mistake,^17 Tesco’s share price was dow n nearly 50 percent on the year, and Buffett was looking at a $700 million loss. The jour nalist whose comments on the Tesco saga I quoted extensively talked ab out c u s tomers , employe e s , a nd t he com mu nit y as b e i ng t he v ic t i ms of a “machine” that was focused on grow th at any price as a means of satisf y ing the demands of the City. By the City what do
8 CORPORATE FINANCE REVIEW JANUARY/FEBRUARY 2015 MEASURES THAT MATTER
MOST CEOS HAVE EVER- DECLINING LENGTHS OF TIME IN OFFICE SO DO NOT FEEL ANY NEED TO FOCUS ON THE LONG-TERM PROBLEMS THEY CAUSE.
MEASURES THAT MATTER JANUARY/FEBRUARY 2015 CORPORATE FINANCE REVIEW 9
we really mean — not shareholders, but sharetraders , not investors but speculators? Could it be argued that maximizing shareholder returns would be fine if it were made clear that this really did mean shareholders not sharetraders? And per- haps if stock-based compensation were rethought or redesigned? Certainly these would be improvements. But I would also argue that shareholders should only ever get a “fair retur n,” as proposed in the Jo h n s o n & Jo h n s o n c re d o. I s ay t h i s b ecause to me other st akeholders are also either invested in the business in various ways or, in the case of societ y at large, grant it a license to operate for the purpose of producing social value, not only private profit. To those such as Peter Drucker and Charles Handy, and a grow ing number of entrepreneurs today, the wisdom of com- bining profit and purpose is just com- mon sense. And it is reassuring to know that the “fundamental question of the purpose of businesses is, once again, up for debate,” according to a study by Cran- field Universit y School of Management, which was commissioned by Coca-Cola Enterprises.^18 The repor t compared the opinions of current business leaders w ith those of future business leaders (an international g roup of re cent M BA g r adu ate s ) a nd found that 88 percent of current leaders and 90 percent of future leaders agreed that “businesses should have social pur- pose.” It would suggest that the notion of maximizing shareholder value may well be dead and buried in the future. In conclusion, I suggest that the biggest challenge in bringing about change was highlighted by Michael Skapinker in the Financial Times: “Other managerial respon- sibilities — to employees, customers or the communit y — are numerically less precise.”^19 But I do not think this is any excuse for not working out what the new metr ics should be. Thankfully several initiatives are focused on this, but the right measures should also be a mix that is s p e c i f i c t o e a c h c o mp a ny ’s b u s i n e s s model. In Beyond Performance Scott Keller and Colin Price, both of McKinsey & Com- pany, sum up the problem:
When it comes to achiev ing and sustaining excellence in performance, what separates win- ners f rom losers is, paradoxical ly, the ver y fo cus on per for mance itself. Per for mance- focused leaders invest heav ily in those things that enable targets to be met quar ter by quar- ter, year by year. What they tend to neglect, how- ever, are invest ments in company health — investments in the organization that need to be made today in order to sur v ive and thrive tomorrow.^20
Based on their large-scale and long- te r m re s e a rch , Ke l l e r a n d Pr i ce h ave developed an evidence-based framework to help managers balance performance and health, but fixing the problem must necessarily involve boards and investors addressing the problem of perverse incen- t ive s t h at a re cor r up t i ng t he s y s te m. I n h i s l at e s t Har vard Bu s in ess Re v ie w ar t icle, Mar t in sug gested that change could be triggered by the top 50 pen- sion and sovereign wealth funds as insti- tutional investors with control over funds of $11.5 trillion. Amongst other things, he suggests that they must stop supply- ing large amounts of capital to hedge funds, and that they should stop sup- por ting stock-based compensation.^21 I n t h e c o nt e x t o f Ma r t i n’s re c o m - mendations, the decision by California Public Employees’ Ret irement System (CalPERS), the largest U.S. public pen- s ion f und, to w it hdr aw a l l its invest- ments in hedge funds should be seen as a posit ive development. On the other hand, news from the U.K. that the grow th in directors’ total earnings was propelled by share awards rather than salaries is a real concern, although I understand that s o m e a re l o n g - t e r m i n c e nt i ve s h a re awards.^22 n
N OT E S (^1) Wolf, M., Opportunist shareholders must embrace commitment,Financial Times (Aug 26, 2014). Avail- a b l e a t : h tt p : / / w w w. ft. c o m / c m s / s / 0 / 6 a a 8 7 b 9 a - 2 d 0 5 - 11 e 4 - 9 11 b - 0 014 4 fe a b d c 0. h t m l? s i t e e d i t i o n = uk#axzz3OXiOBEFp. (^2) “ C o m b i n i n g p r o f i t a n d p u r p o s e : A n ew d i a l o g u e o n t h e r o l e o f b u s i n e s s i n s o c i e t y,” C o c a - C o l a E n t e r p r i s e s , ( O c t 2 014 ). Av a i l a b l e a t : http://www.cokecce.com/system/file_resources/210/ W21883_TL_Report_A4_FINAL.pdf. (^3) J o h n s o n & J o h n s o n C r e d o. Av a i l a b l e a t : h tt p s : / / w w w. j n j. c o m / s i t e s / d e f a u l t / f i l e s / p d f / j n j _ ourcredo_english_us_8.5x11_cmyk.pdf. (^4) “The KPMG survey of business reporting: Better busi- n e s s r e p o r t i n g ,” K P M G ( 2 014 ). Av a i l a b l e a t : h tt p : / / w w w. k p m g. c o m / G l o b a l / e n / I s s u e s A n d I n - s i g h t s / A r t i c l e s P u b l i c a t i o n s / D o c u m e n t s / k p m g - sur vey-business-reporting .pdf.
