Good resources on why shareholders stopped protecting their interests?

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Arthur_Tuxedo
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Good resources on why shareholders stopped protecting their interests?

Postby Arthur_Tuxedo » 2017-02-12 01:52pm

So I think I've got a pretty good handle on how the swindler and looter component of the 1% has captured the political process. Allowing private campaign finance means they can buy political power, leading them to lower taxes on themselves which gives them even more money to buy more power in an infinite loop until the populace gets sufficiently fed up.

What I struggle to understand is the failure of the other mechanism that's supposed to contain short-sighted bonus seeking and looting behavior: shareholder interest. The classic examples are leveraged buy-outs. You borrow a lot of money to takeover a company, slash personnel to the bone and stop investing in future growth, transfer the debt to the company, and then sell it back to the market for a higher price amid fanfare and enthusiasm. The classic question is why the market is willing to pay more for a more highly indebted asset with lower future cash flow. The greater fool theory where everyone thinks they'll be able to sell it for an even higher price only takes you so far and, in aggregate, the market cannot reduce risk. Every share of stock and every bond must be held by someone, after all. Looting behavior only serves to reduce the economic output of the nation and in fact the world, with the greatest absolute impact falling on the rich because they own the majority of the world's economies.

Perhaps an even starker example are cases where CEOs are not fired or coerced when they are clearly not looking out for the company's long-term interests. The current CEO of Ford is doing his level-best to get the Trump administration to gut emissions rules, a disastrous business strategy that would lead to the necessity of producing vastly different models for the US and Europe and thereby lowering economies of scale and more importantly allocating the company's resources toward production processes and machinery that are almost guaranteed to be obsolete in 4 years when the rules resume their historical course. This is also an open invitation for auto manufacturers from China and other countries to eat Ford's lunch just like Honda and Toyota did in the 1970's. Yet shareholders are not protecting their investment. The argument that they only care about quarterly results only gets you so far. Again, the market cannot reduce its risk in aggregate or move away from stocks (one of the many reasons why you can safely assume anyone who uses the phrase "cash on the sidelines" is full of shit). Even if a majority of shareholders really think that way and never learn their lesson, it should mean a lot of "dumb money" that smarter investors can take advantage of and move the market in a smarter direction over time as the dumb money is ablated away and transferred to smarter people.

I suspect that the reason we do not see shareholders protecting their own interests is not because of stupidity or short-sightedness but because the system has been rigged against them akin to the political system. I'd heard vague statements about voting shares and non-voting shares and how management gains control of the voting shares against overall shareholder interest, but I don't understand how the process works. Has anyone come across a good book or other resource that explains how corporate management has corrupted the internal systems that were supposed to allow owners to keep them in check?
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Re: Good resources on why shareholders stopped protecting their interests?

Postby Simon_Jester » 2017-02-12 05:19pm

The original model for the joint stock company was that the shares were held by private individuals who considered the company's welfare to be a significant fraction of their welfare. Thus, the shareholders would have a strong incentive to think critically and carefully about the choices made by corporate officials.

It seems to me that this model breaks down under modern conditions for two reasons:

1) If shares are held by mutual funds or other finance companies, or by stockbrokers on behalf of wealthy clients. These are people who use the market as a way to (in effect) store their money in a bank account, only with higher interest rates. They don't think of themselves as part-owners of a company that does XYZ, they think of the stocks as abstract assets whose purpose is to allow them to use various strategies to maximize their net worth. People who think this way have every reason to trade stocks whenever they see fit. Correspondingly, they have very little incentive to preserve the value of those stocks for the long haul- because if they want a long-haul investment they can easily buy something that has less intrinsic risk attached than stocks do.

2) If shares are held by people or organizations that own stock in many, many separate companies, in the name of "diversifying their portfolio." In that case, even if I have voting interest in a specific company, I lack the time and energy to exercise that voting interest in any of those companies. This results in a lot of people who might otherwise care deeply about the management of individual companies effectively bowing out of the company's decision-making process. There's not a lot of point in caring about the management of any single company if I've invested in the entire Fortune 500 list. Selling stock in companies I think is being mismanaged is a lot less work than trying to take an active hand in management and actually having impact.

I could be missing something here. But if I had to pick a culprit, I'd blame the problem on the shift away from stock held by individual people who trade shares in a relatively limited number of companies, with intent to hold them for an extended time. And over to the model of firms rapidly trading shares in all and sundry, with level of 'churn' that makes it pointless if not impossible to take an active hand in the management of any single company.

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Re: Good resources on why shareholders stopped protecting their interests?

Postby LaCroix » 2017-02-13 08:22am

One word.

Information.

The shareholders not protecting their interest are usually the small private investors. They usually do not know wnough to realize that they are buying an almost dead horse when they buy shares that have been increasing in value due to the leverage buy-out process. They think they managed to slip in during a brief lull in the race, while in fact, the market just stalled because everybody is waiting for them to finally make their move to complete the scheme.

Even if they are aware of that scheme (as brokers and some of the semi-skilled people are), they are gambling the system in hope to become the 'not-last' person in the chain of events, still making some dollars of it before dumping it on the latecomers. You can make a pretty dollar doing so, and thus they usually don't complain, even if they occasionally get caught and have to eat some losses.

The ones really eating the losses are the people barely into the game. That's why you see so many apps/websites offering access to stock markets very easy, and for really small fees - you need to get as many people into the game to make it profitable. (I also assume that the owners of said services use the customer orders to steer their own investments to profit of them.)
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Re: Good resources on why shareholders stopped protecting their interests?

Postby Phantasee » 2017-02-18 08:48pm

All of the above, plus how much of the money in the markets (and not just stocks, but real estate etc too) is invested by pension funds and the like? We're talking massive amounts of capital, like AIMCo in Alberta which manages the provincial savings funds, the pension funds, etc. CalPERS, the Ontario Teachers' Pension Plan, etc have massive amounts of assets in various markets, on behalf of millions and millions of people. This means there is significantly fewer people out there minding their retirement investments than we'd think. Private sector does their 401(k)s and RRSPs, but how many of those are just accounts managed by brokers (earlier points)? Most of them.

So not a lot of people out there actively managing any significant amount of money, and even fewer managing the significant amounts of money.
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Re: Good resources on why shareholders stopped protecting their interests?

Postby ArmorPierce » 2017-02-23 01:52am

I'll take a stab here. I suspect others have missed the main drivers.

Arthur_Tuxedo wrote:So I think I've got a pretty good handle on how the swindler and looter component of the 1% has captured the political process. Allowing private campaign finance means they can buy political power, leading them to lower taxes on themselves which gives them even more money to buy more power in an infinite loop until the populace gets sufficiently fed up.


What I struggle to understand is the failure of the other mechanism that's supposed to contain short-sighted bonus seeking and looting behavior: shareholder interest. The classic examples are leveraged buy-outs. You borrow a lot of money to takeover a company, slash personnel to the bone and stop investing in future growth, transfer the debt to the company, and then sell it back to the market for a higher price amid fanfare and enthusiasm. The classic question is why the market is willing to pay more for a more highly indebted asset with lower future cash flow. The greater fool theory where everyone thinks they'll be able to sell it for an even higher price only takes you so far and, in aggregate, the market cannot reduce risk. Every share of stock and every bond must be held by someone, after all. Looting behavior only serves to reduce the economic output of the nation and in fact the world, with the greatest absolute impact falling on the rich because they own the majority of the world's economies.


Each dollar of expense cut boosts profits and enhances profitability ratios more than an equivalent dollar in increased revenue. Reason why is taxes.

Total revenue of a company matters less to investors than the profitability ratios. A leaner more profitable company is superior to investors than a larger company with compressed profitability ratios. Diversification does not matter for investors because investors can achieve that diversity in their own through investing in other companies. See modern portfolio theory.

Perhaps an even starker example are cases where CEOs are not fired or coerced when they are clearly not looking out for the company's long-term interests. The current CEO of Ford is doing his level-best to get the Trump administration to gut emissions rules, a disastrous business strategy that would lead to the necessity of producing vastly different models for the US and Europe and thereby lowering economies of scale and more importantly allocating the company's resources toward production processes and machinery that are almost guaranteed to be obsolete in 4 years when the rules resume their historical course. This is also an open invitation for auto manufacturers from China and other countries to eat Ford's lunch just like Honda and Toyota did in the 1970's. Yet shareholders are not protecting their investment. The argument that they only care about quarterly results only gets you so far. Again, the market cannot reduce its risk in aggregate or move away from stocks (one of the many reasons why you can safely assume anyone who uses the phrase "cash on the sidelines" is full of shit). Even if a majority of shareholders really think that way and never learn their lesson, it should mean a lot of "dumb money" that smarter investors can take advantage of and move the market in a smarter direction over time as the dumb money is ablated away and transferred to smarter people.


Same reason why people make wrong decisions in politics and the economy. Not enough people who strongly disagree to compel the CEO otherwise. Additionally, investors may have portfolios that consist of hundreds or thousands of companies.

I suspect that the reason we do not see shareholders protecting their own interests is not because of stupidity or short-sightedness but because the system has been rigged against them akin to the political system. I'd heard vague statements about voting shares and non-voting shares and how management gains control of the voting shares against overall shareholder interest, but I don't understand how the process works. Has anyone come across a good book or other resource that explains how corporate management has corrupted the internal systems that were supposed to allow owners to keep them in check?


It wouldn't be corporate management that are responsible for releasing non-voting shares. That fault would lie with the original owners wishing to retain control of the company... who may also be corporate management through self selection.

Your example of Ford above, for insurance, has 40% voting shares retained by the Ford family through special class of socks.
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Re: Good resources on why shareholders stopped protecting their interests?

Postby Arthur_Tuxedo » 2017-02-23 11:29am

You've all made good points here, but I still feel there's a missing smoking gun. Every explanation for why the market is misallocating massive amounts of resources, as much sense as each one makes individually, still doesn't explain why informed market participants are not able to take the other side of these ill-conceived transactions. Over time, dumb money should dwindle and lose its ability to affect the direction of the overall market, especially as these trends have been going on for decades. Somehow the basic mechanisms of capitalism are broken, either because they've been subverted somehow or they relied on assumptions that were never really true.

It's still bewildering to me, though, because I've worked in institutional finance and it's not a rich boy's club in the way that politics is*. If someone comes to the table with lots of cash and not much sense, the financial companies are more than happy to gouge their eyes out, and they should be able to take money away from investors in companies that are making bad long-term decisions. Sure, most of the financial guys are driven by short-term quarterly profits just like the other companies, but that's taking the status quo as a given when it begs for an explanation. If short-term thinking is constricting profits, why have the long-term thinkers not squeezed them out? They've delivered superior results for decades.

The argument that mutual funds, especially passive funds, make each investor unlikely to know where their money is or care enough about each of the hundreds of companies is compelling but limited. Each of those funds still has a fund manager with a staff of people who are competing with every other fund for returns and Morningstar ratings. I suppose that's still a relatively small and more or less homogenous subset of the population and you could chalk it up to groupthink. So far that's the most compelling explanation for me.

*To be sure, it is a club for rich boys, but they don't take care of each other and are more than happy to cut each others' throats.
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Re: Good resources on why shareholders stopped protecting their interests?

Postby ArmorPierce » 2017-02-23 07:10pm

Arthur_Tuxedo wrote:You've all made good points here, but I still feel there's a missing smoking gun. Every explanation for why the market is misallocating massive amounts of resources, as much sense as each one makes individually, still doesn't explain why informed market participants are not able to take the other side of these ill-conceived transactions. Over time, dumb money should dwindle and lose its ability to affect the direction of the overall market, especially as these trends have been going on for decades. Somehow the basic mechanisms of capitalism are broken, either because they've been subverted somehow or they relied on assumptions that were never really true.


Your example mostly conforms to modern portfolio theory which posits that investors seeks to maximize returns for the lowest risk.

Cutting expenses maximizes profitability ratio and minimizes risk.

The CAPM model (Capital Asset Pricing Model) posits that investors need to be compensated for two factors:
1. Time Value of money
2. Risk

A company that cuts expenses and boosts profitability ratios have lower risk than a company that is speculating in future growth. The company possessing the worse valuations are speculating that they will have higher returns in the future, but it's not guaranteed.

It's still bewildering to me, though, because I've worked in institutional finance and it's not a rich boy's club in the way that politics is*. If someone comes to the table with lots of cash and not much sense, the financial companies are more than happy to gouge their eyes out, and they should be able to take money away from investors in companies that are making bad long-term decisions. Sure, most of the financial guys are driven by short-term quarterly profits just like the other companies, but that's taking the status quo as a given when it begs for an explanation. If short-term thinking is constricting profits, why have the long-term thinkers not squeezed them out? They've delivered superior results for decades.


This is a bit of a separate matter than equity valuation.

Academic research tends to show that both the so called informed and uninformed money managers don't generate alpha (returns above the market rate for that class of assets).

The argument that mutual funds, especially passive funds, make each investor unlikely to know where their money is or care enough about each of the hundreds of companies is compelling but limited. Each of those funds still has a fund manager with a staff of people who are competing with every other fund for returns and Morningstar ratings. I suppose that's still a relatively small and more or less homogenous subset of the population and you could chalk it up to groupthink. So far that's the most compelling explanation for me.

*To be sure, it is a club for rich boys, but they don't take care of each other and are more than happy to cut each others' throats.


This is an open question. It also is related to the agency problem. What is best in the best interest for management is not necessarily what is in the best interest for investors.
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Re: Good resources on why shareholders stopped protecting their interests?

Postby Simon_Jester » 2017-02-23 11:38pm

Arthur_Tuxedo wrote:You've all made good points here, but I still feel there's a missing smoking gun. Every explanation for why the market is misallocating massive amounts of resources, as much sense as each one makes individually, still doesn't explain why informed market participants are not able to take the other side of these ill-conceived transactions. Over time, dumb money should dwindle and lose its ability to affect the direction of the overall market, especially as these trends have been going on for decades. Somehow the basic mechanisms of capitalism are broken, either because they've been subverted somehow or they relied on assumptions that were never really true.
This. More on this in a bit.

The argument that mutual funds, especially passive funds, make each investor unlikely to know where their money is or care enough about each of the hundreds of companies is compelling but limited. Each of those funds still has a fund manager with a staff of people who are competing with every other fund for returns and Morningstar ratings. I suppose that's still a relatively small and more or less homogenous subset of the population and you could chalk it up to groupthink. So far that's the most compelling explanation for me.
Another point is that there's really no compelling reason for a mutual fund manager to adopt "buy and hold" tactics. Their staff of highly competitive finance wizards aren't in it to strengthen the companies they invest in. They're in it to make high returns on their investments. Which they do by predicting whose stock will increase in value the fastest, not which companies are still going to be around in thirty years' time.

It doesn't make very much difference whether the company's still around in thirty years, if you were able to make 15% every year for three years and get the hell out while the getting was good, then move on to the next up-and-coming investment opportunity to do it all over again.

There isn't really an "other side" to this transaction (referring back to your underlined passages). The assumption that there's always a way to make money by taking the other side of a losing bet isn't true, if the definition of what constitutes a "losing bet" becomes divorced from the numbers by which the investors are measuring financial success. If the S&P 500 can skyrocket while the fundamentals of the American economy are being hollowed out, then there is no "other side" of the transaction you can use to 'bet against' the policies of Wall Street as a whole.

Well, strictly there is, but it boils down to 'invest in very long term assets whose value is tied to foreign countries and hope they pay off... eventually. It's a very indirect way of betting against an irrational market, it doesn't have the effect of damping down bad corporate policies in America, and it falls afoul of one of Keynes's maxims. Namely, that the market can stay irrational longer than you can stay solvent.


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