ANOTHER BLOW TO PREVAILING WISDOM

 

Several issues ago I wrote an article lambasting the damage done by offering stock options as an incentive to leaders of companies. Well there is another take on having large stock ownership by the executives who run companies. The prevailing governance/financial theory is that if the leaders of companies including board members own lots of stock in the company, they will be more inclined to really want the company to do well and hence the stock price will go up.

 

It sounds reasonable, but unfortunately it is wrong. A recent article published in the Academy of Management Journal entitled Meta-Analyses of Financial Performance and Equity: Fusion or Confusion written by Dan R. Dalton, Catherine M. Daily, et al, from the Kelly School of Business at Indiana University disproves the prevailing wisdom. The authors start with the hypothesis that, Insider equity holdings will be positively associated with firm financial performance. They analyzed data from 229 studies, from the present back to the 1920s, that investigated the relationship between equity and financial performance. The companies covered in the study were in the Fortune 500 large companies. The results of their study disproved the hypothesis. Financial performance was not correlated with stock ownership of executives or board members. Furthermore, financial success was not correlated with stock ownership by large block owners such as mutual funds, pension funds, or major shareholders who control over five percent of the company stock.

 

The research did not cover small companies or those new companies resulting from Initial Public Offerings. But my hunch is that a study of these companies would generate the same conclusions. So why would this be? Here is my theory. Companies are systems made up of suppliers, customers, employees, leaders, boards, fixed assets, and processes.

 

When a person is hired to lead an organization, his/her job is to optimize the system. Rather than concentrating on surprising and delighting customers, and standardizing and improving processes, and growing their employees, top management is concentrating on how to get the numbers to make the stock price go up. In the process of doing that, they cause a great deal of variation to occur, you know - get this stuff shipped before the end of the month, defer maintenance, sell the customer more then he needs, cut training, book some of this revenue before we have the money in our hands, buy or don’t buy supplies to make budget, etc., etc.

 

My experience so far is that if you increase variation you will inevitably decrease positive results. By placing the emphasis on stock price, management increases variation and thus sub optimizes the system, and eventually, maybe years later, this affects the stock price in a negative way.

 

I know, it is a simple theory. It doesn’t deal with the myriad of things that go on in a company or any organization for that matter. But my experience has also been that the root causes of many of our woes in organizations are the result of simple things like personnel policies. Perhaps the emphasis on stock ownership by insiders is one of those root causes. Give it some thought.