(Brief note: This post is, as will be obvious to her, inspired by a conversation I had with a dear friend very recently. I note this only so I can clarify that the purpose of this post is not to get the last word on her, but, rather, to articulate some ideas that our sparkling and sharp conversation helped to generate.)
Here’s a thought experiment: Suppose there is a world we shall call “World A.” In World A, there is an incorporated public company, called “Company A.” (Still with me?) This company has within it two main ventures: a grocery retailer which is much like this world’s version of Stop-n-Shop, and a digital-technology venture which is much like an early version of this world’s Apple. Right now, the grocery retailer is making decent profits, while the digital-technology venture is making a slight loss. In this world, the population is no longer really growing much, and a number of innovative startups have started delivering groceries directly to people’s doors, sopping up demand for, and cutting the margins of, the grocery retailer; there are also a lot of other traditional grocery retailers competing with this retailer, keeping prices very low; more, the people in this world are sober utilitarian types when it comes to food, so it seems unlikely that the retailer could win exorbitant market share just by making itself a ‘hip’ brand. Sober, dispassionate, outside analysts predict that the grocery retailing industry can’t really expect much growth, or extraordinary returns and profits. But Company A’s technology venture may be a different story: in this world, technology is advancing really fast; middle-class consumers will throw two full weeks of wages into the latest pocket-sized gadget. Not only that, but Company A is lucky to have happened upon a really sleek, attractive, distinctive design for its gadgets, which is already giving it an awesome brand, and hence an outsized market-share in this nascent industry.
Last year, the grocery retailer made $10 billion in profits; the digital-technology venture took a $2 billion loss. Problem question: What should the company’s board of directors and management decide to do with the $8 billion in total profit?
It seems pretty obvious, given this setup, that the directors and management should reinvest the cash in the technology venture specifically, funneling the whole $8 billion in profits into new R&D, hiring new designers and programmers, etc., in the hopes of making the tech venture into this world’s Apple. The investors won’t mind foregoing dividends for a year when the company has such good prospects for what it can do by reinvesting this capital. As long as the grocery retailing venture is making decent returns, it makes sense to keep it around, and keep receiving normal profits and a normal rate of return on the capital investments it has already made. But it wouldn’t make sense, given the grocery market’s overall prospects, to invest a lot in massive advertising campaigns, major capital investments in new trucks or stores in high-profile or low-density areas, etc., particularly given the excellent prospects of the alternative destination for that capital. So it seems pretty clear that the board of directors and managers should reinvest as much capital as possible in the technology venture, while just doing basic upkeep on the grocery retailer. That’s what will ultimately provide the highest return to its shareholders. It will also land them on the cover of World A’s Forbes in a few years (but, really, their responsibility is not to worry about personal fame, but to focus on the shareholders).
Now, here’s the cool, somewhat cheesy, thing that you so frequently come across in economic reasoning: What’s best for the shareholders, reinvesting the profits in the technology venture, is also what’s best for society. The fact that the grocery retailing market is not growing very quickly is proof that society is saying, “Our grocery needs are more or less satisfied already — thank you very much.” If there’s already a couple of satisfactory and competitive grocery retailers in every town in World A, and even new innovative online-grocering startups, then the world cannot really benefit that much from new capital investments in grocery stores. And society, by being willing to pay so much for the latest pocket-sized digital gadget, is telling us that it has strong desires and needs for novel products in that space. They’re trying to pull capital in, by paying so much. In a very real sense, an estimation of a return on any particular investment is a rough measure of the strength of society’s future need for it.
So I’ll hope you’ll agree with me, that the best thing for Company A — its management and shareholders — and for World A as a whole is that the capital be reinvested in the digital technology venture. This should be obvious.
Now, let’s make things interesting. Suppose we have a world we shall call “World B.” It is exactly like World A in every way except for one: Instead of having a single Company A with two ventures (grocery retailing and digital gadgetry), World B has these two exact same ventures under two different incorporated companies, which we shall call Company G (for groceries) and Company T (for technology).
Everything else from above maps onto World B directly: Company G made $10 billion in profits last year, but its long-term prospects look steady but unremarkable. Company T took a $2 billion loss, but it has great future prospects.
Problem question: What should Company G do with its $10 billion in profits? Well, hopefully my setup makes clear what I’m trying to do here. The two problem questions here are fundamentally the same. The only thing that really separates the two worlds from each other is legal artifice — in World A we conceive of the two ventures as a single company; in World B we conceive of the two ventures as two companies. But the real, fundamental economic considerations are the same. But since in World B, Companies G and T are legally distinct, under legally distinct ownership and management, Company G can’t just reinvest the cash in Company T. Instead, the most reasonable thing for Company G to do is to return the $10 billion in profit to its shareholders, either in dividends or in share repurchases. The shareholders can themselves take the cash and invest it in new stock offers from Company T, which has enormous growth prospects. This is, once again, best for everybody. Company G’s shareholders wouldn’t have gotten a higher-than-the-market-rate return on any new capital investments in grocery stores anyways; the company can coast on the capital investments its already made, and any aggressive investment effort would be in vain. So Company G’s directors have an obligation to return the cash to shareholders, for the simple fact that Company G could not make an above-market-return on new internal capital reinvestments, and also, more explicitly, so that those shareholders can choose to invest their new cash elsewhere, where they think it can get a higher return — Company T seems like a really good bet, so that’s likely where much of the capital will go. Company T can use the extra $10 billion invested in it to pay down the $2 billion in debt it had incurred the previous years, and make $8 billion in those R&D investments, and hires of programmers and designers.
Everything that happened here, in World B, is fundamentally the same as what happened in World A. Only the legal characterization of the entities involved has changed. And so all the same moralistic reasoning from above applies as well: The world is asking for, and will most benefit from, more investment Company T’s business, and doesn’t need any new capital investment in Company G’s business. So the social responsibility of Company G in World B is to accept its relatively modest status in the business world, and to return as much profit as possible to its investors as dividends or share repurchases, so that they can go out and invest that capital in other, more worthy, more promising, ventures.
The only significant difference between these worlds is that, in World B, the self-esteem of the management of Company G will be much lower than in the alternative World A where they were part of the senior management of a company that oversaw both the grocer and the Apple equivalent. They won’t end up on the cover of Forbes magazine; they won’t get status by association. They won’t be able to use some story about how they oversaw enormous growth to help them get another great job. Pity them. Nevertheless, I submit that it is their obligation as managers, and as responsible and realistic human beings, not to invest society’s and their shareholders’ resources in vainglorious attempts at expansion in a legacy industry that technological progress and demographic changes are rendering less important. Their obligation is to accept a relative decline that generates the best realistic returns for their investors, who can thence invest that capital where it is more needed and will be more profitable.
The interesting and fun thing I get out of this thought experiment is a gestalt shift which I find amusing because it seems to so discordantly mix tripping hippie “everything is connected” and neo-liberal/evil capitalist ways of viewing the world: In modern shareholder capitalism the boundaries and distinctions between different corporations are actually pretty meaningless and insignificant. We should try not to think about them so much. We should look at the whole business world as a grid divided by not by corporate charters, but divided into particular projects and ventures requiring investment. We should always be thinking about how to get investments to those projects, rather than worrying too much about which management or corporate name will be attached to them. In a world in which small tech companies are all looking to be bought out by Google or Facebook or a private equity firm, from which they may later be spun off, and in which major companies have their own proprietary investment and M&A divisions, and most publicly-listed companies are significantly owned by mutual funds which blend the savings of million small investors, this is a more sensible way to look at the business world: A place where potential projects seek potential investment, and the name we apply to these projects, the ‘corporation,’ is an insignificant transitory legal artifice. It’s a mistake to anthropomoprhize particular companies, to get personally involved in their narratives, or to hope for success for this particular company, or lament the decline of this particular long-standing company of historical significance. The only question that actually really matters is: “Is capital getting invested in ventures where it will produce things that will meet human needs now and into the future?”
But wait! This idea has more significance than as a fun gestalt shift for socially dysfunctional intellectuals such as your correspondent. This has real, practical import. It means we humans are, given our tendency to anthromorphize legal entities and understand the world in narrative, are probably doing some things wrong. We’re doing too much to idolize “turn-around” managers, many of whom probably just got lucky. We’re too harsh on management that oversee companies in decline (sometimes that’s exactly all that company can and should do) and doing too much to pressure them to turn it around — if an industry is mature, the best thing those managers can do with spare cash is probably to return it to investors. Investors should demand that sometimes their managers should just be boring and bourgeois — and just continue to skim modest profits to be returned as dividends — and resist the temptation to make a shot for a Forbes cover story.