Shareholder value – Robert Bischof

Shooting the Messenger

Exports row masks corporate governance issues

Liam Fox, the British secretary of state for international trade appointed by Prime Minister Theresa May to lead post-Brexit trade negotiations along with Boris Johnson and David Davis, put his finger squarely – but not fairly – on the biggest headache Britain has had for years last week.

In comments to the right-wing Conservative Way Forward group, he referred to the anaemic export performance of Britain’s major companies, calling their bosses ‘fat’ and ‘lazy’, and claiming they would rather play golf than open up new markets with new products. The Times, which first published the comments, accompanied an opinion piece with the headline, ‘Don’t shoot the clumsy messenger‘.

The comments prompted an expected backlash from business leaders, but the facts themselves are evident. Former Chancellor of the Exchequer George Osborne’s ‘march of the manufacturers’ and the goal he set of doubling exports to £1tn by 2020 look further away than ever – exports of £510.3bn in 2015 were below 2014’s figure of £511.7bn.

Will Brexit make a difference? Sterling’s approximate 10% devaluation since 23 June has prompted hopes of a boost to UK exports. But while there may be anecdotal evidence to suggest this has already happened, the decline will have only a limited effect if sterling’s 25% fall in 2008-09 has any lessons for today.

British managers are not lazier than their German counterparts. But in many ways they have a much harder – if not impossible – job. They do not spend their time on golf courses these days, but rather use it to present quarterly return figures in such a way that they satisfy shareholders and/or optimise their profit- and often share price-related bonuses.

Many of the best British companies sit on large cash piles. They do not spend them on product development or opening up export markets in the Far East, for fear of an adverse reaction affecting their share price. They prefer to ‘return cash to shareholders’ through share buy-backs or look for mergers and acquisitions, rather than growing their companies organically. If all else fails, they can ‘bring the company into play’ and sell it at a premium.

The Anglo-Saxon corporate governance model puts British businesses at a disadvantage compared with their European and Asian competitors. More than 85% of German businesses – the famous Mittelstand – are not quoted on the stock market. Managers can afford to think and act long-term without fear of a takeover, being dismissed or losing out on remuneration.

Chief executives of listed companies are shielded by their supervisory boards, which include worker and frequently customer representation. This acts as a practical defence against takeovers and over-adventurous board directors, and is a useful tool for communicating with workers.

May – like Angela Merkel, the German chancellor, a scientist by training – appears to have a better handle on the root causes of the UK’s export malaise than Fox, a medical doctor with no business experience. She fired a first salvo in the right direction shortly before taking office by suggesting worker participation on company boards, as well as an overhaul of the UK company takeover code and remuneration practices in British boardrooms. It is ironic that, just as the UK turns its back on Europe, its prime minister wants it to adopt a more continental-looking business model.

Changing the UK’s shareholder value model will not be easy. Tony Blair talked in 1995 about the stakeholder economy model, similar to Germany’s social market economy or ‘Rhineland capitalism’, and was very quickly stopped in his tracks. Let’s hope May’s attempts to address the root causes of the problem, rather than its symptoms, are more successful.

Co-determination has served Germany well since the war

This letter appeared in the Financial Times on July 14 2016

Sir,

Ursula Weidenfeld paints a one-sided and negative picture of co-determination (“Beware of imitating the German model, Mrs May”, July 13). As an essential part of the social market economy model, it has served Germany incredibly well after the war and is supported overwhelmingly by business. In particular, Ms Weidenfeld’s assertion that it hinders innovation couldn’t be further from the truth — just look at Siemens, Bosch or the car industry, and the leading position Germany holds with patent applications.

Apart from the obvious advantage of communicating with your workforce, co-determination also acts as a safeguard against the kind of takeovers that are for the benefit of shareholders and management only. It forces companies into long-term thinking and more concern for market share than for short-term profit maximisation, with the survival and wellbeing of the company being paramount goals.

Clearly Theresa May will have huge opposition to backing something like a stakeholder model, as Tony Blair experienced when he made his famous speech in Singapore in January 1996. Rupert Murdoch stopped him in his tracks. The first salvos have already been fired.

Bob Bischof
London SW1, UK
Vice-President, German British Chamber of Industry & Commerce; Chairman, German British Forum

Invensys Sale: UK Manufacturing On the Fast Track to Oblivion?

This article was published in the Daily Mail on 7 August 2013

The sale of Invensys, one of the last remaining substantial engineering companies in the UK, to the French industrial giant Schneider Electric simply beggars belief.

The declared aim of this Government is to rebalance the economy towards manufacturing. In reality short-term shareholder value rules and the Brits will sell anything and everything to please the City.

As a German living in this country, I am aghast at this. Germany’s manufacturing prowess is founded on a much more long-termist approach. But Invensys is, sadly, a typical British industrial story.

The company was created out of the merger of two engineering companies Siebe and BTR in 1999. The new company was debt-laden and poorly managed, going through a £2.7billion debt restructuring exercise in 2004. In 2005 the board appointed Ulf Henriksson as chief executive, who restored the company to financial health. Enter Sir Nigel Rudd as new chairman.

In March 2011 he fired Henriksson, an engineer, because ‘he could not see the big picture’ and replaced him with the chief financial officer Wayne Edmunds. The share price subsequently halved in 2012 because of technical problems. It only bounced back when the break-up of the company was announced and set in motion with the sale of the signalling business to Siemens.

The rest is now on its way to being swallowed by a French company for £3.4billion – well done, Sir Nigel. Does anybody get the message that these deals are a sure way to manufacturing oblivion in the UK?

My own experience bears this out. I arrived in the UK 40 years ago to set up a UK subsidiary of a German lift truck maker. Our main European rival was the British company Lansing Bagnall, based in Basingstoke. Their market share in the UK was around 45 per cent and they exported 60 per cent of their production worldwide. They were the envy of the industry.

Some 20 years later a large German industrial conglomerate bought them. A few years later they were sold on with the rest of the lift truck division to private equity, who closed the Basingstoke factory and moved the production to Germany and France.

In 1994 my company bought the last remaining British lift truck manufacturer Lancer Boss, invested huge sums for a while, but then had to give up, close the plant in Leighton Buzzard and moved the production to Germany.

One of the reasons was that they could no longer get cold-rolled steel sections for the lift masts of their trucks in the UK, as the Corus plant in the North East was ‘restructured’ – the other was that there was a cyclical downturn in the sector.

There are dozens of industries and companies where the same or similar happened. Mergers, acquisitions, de-mergers and break-ups of companies are a favourite game in the UK to enhance so-called shareholder value. It promises faster returns for shareholders and bonuses for the board members rather than following the slower path of growing their companies organically. They would rather ‘return cash to the shareholders’ by share buy-back programmes and high dividends than invest in the future of their businesses and the prosperity of UK Plc.

What is the Government doing to change this pattern? The slogan needs to change from ‘It’s the economy, stupid’ to ‘It’s the real economy, stupid.’

Accounting for Business Survival

When Paul Polman, CEO of Unilever, recently echoed the words of Jack Welch about shareholder value being the”dumbest thing in the world” and by adding that “it’s easy to be a short-term hero. It’s easy for me to have tremendous results very short term, get that translated into compensation and be off sailing in the Bahamas”, he re-started an old argument that was considered to be settled long ago.

When Paul Polman, CEO of Unilever, recently echoed the words of Jack Welch about shareholder value being the”dumbest thing in the world” and by adding that “it’s easy to be a short-term hero. It’s easy for me to have tremendous results very short term, get that translated into compensation and be off sailing in the Bahamas”, he re-started an old argument that was considered to be settled long ago.

When he described the shareholder value model as a “misguided and potentially harmful goal for companies to pursue”, he was really saying that a narrow interpretation of the shareholder value concept, based on short-term profit and share options and annual bonuses can be harmful.

However, if one is looking after all stakeholders – including customers, suppliers, employees and the environment – shareholder value is optimised as a result.

Such enlightened perspectives on a company’s aims need to be translated into clear guidelines for managers, and the adoption of a different incentive structure to reflect this. If the bottom line alone is no longer the basis of a steering mechanism for the company and its top management, what is? What kind of incentive system should be put in place to make management target sustainable economic profit growth over short-term profit maximisation to drive the share price up?

The undisputed aim of companies all over the world is to make a profit for owners by increasing value and paying dividends.

Privately owned and managed businesses look automatically more to the long-term survival of their companies and seem to adhere to the formula per se. There has always been anecdotal evidence that these companies have a systemic advantage over the share-price-driven public companies. Recently there has been proof that privately owned companies have better allocation of capital than public companies. New York University examined almost 100.000 companies with the help of a database compiled by Sageworks and found that the privately owned companies invested more than twice as much as quoted companies and were more responsive to investment opportunities.

So how could public companies be encouraged to behave more like privately owned ones?

Creating an alignment of a company’s aims with the aspirations of its management is the job, in publicly quoted companies, of the board’s remuneration committee. As the worldwide economic crisis has thrown a harsh spotlight on the shortcomings of a number of companies and sectors, there appears now more than ever in the last 20 years a willingness to re-examine the old ways and look for alternatives.

The recent banking crisis provides some examples. Did it make sense to pay gargantuan bonuses on revenue and profits without regard to the risk that was taken to achieve them? Did it make sense to pay such bonuses based on single-year results? Most would agree that it did not. The remuneration committees in all banks are looking at three to five year rolling bonuses schemes at present and if they are not yet, they should.

Economic profit and “bonus banks”

One problem with simple profit-related schemes is that they rely on the company’s audited profits defined by accounting standards rather than by economic considerations and can therefore be subject to short-term manipulation or “gaming” of results. We therefore advocate economic profit as the basis for remuneration because it includes all revenues and operating as well as capital costs. We also advocate the use of a bonus bank so that in good years some portion of bonuses are held back and remain at risk to encourage sustainable performance improvements over future years.

However, even when profit as the criteria for remuneration is taken over a longer period than the accounting year, the potential of misalignment remains. It can have many guises.

In capital intensive industries where depreciation of plant and equipment is a significant expense, the temptation to postpone – or totally avoid – new investment is strong, and, as a consequence, they continue to work with outdated machinery. It improves the bottom line and the managers’ earnings in the short term, but “savings” of this kind clearly affect the long-term competitiveness of the business. Over time the costs of maintenance and repairs increase, quality falls as the machinery ages and the proportion of rejects and unproductive downtime increase.

Large parts of the indigenous car industry in the US and UK were examples of such behaviour, where depreciation had sunk to near zero to make these companies appear better than they were and allow their managers to still pocket bonuses – until they were bought by unsuspecting foreign investors or filed for Chapter 11.

The lesson from Europe

We recommend therefore to learn from what many European manufacturing companies already do. Their definition of economic profit includes notional depreciation on the replacement value of all production plant and machinery independent of age and residual value on the balance sheet, thus making the decision free from accounting rules and solely subject to economic considerations. If the difference between accounting standards depreciation and notional depreciation on replacement value were deducted, many companies’ annual results would look quite different.

In sectors where prospects depend greatly on Research and Development (R&D), like the pharmaceutical industry, amortizing R&D over a multi-year period versus the accounting approach of expensing it in the current period ensures that R&D is truly treated as an investment. It removes the incentive to cut R&D in any single period just to “make the numbers.” In other words, here economic profit would be greater than the accounts profit and more equally spread.
The same goes for the “investment” in product development, particularly important in all fast-moving consumer goods producing sectors.

The important thing is to look at every company and sector individually, when designing incentive systems for the longer term. Of course there is a trade-off in making these adjustments that must be considered, as every adjustment needs to be tracked over time and made transparent to the participants of an economic profit-related incentive scheme. So ideally they need to be kept to a minimum, be tailor-made for the company’s aims and be as transparent and cost-effective as possible.

By approaching the definition of economic profit in a flexible manner, one can get management support for it and drive the right behaviour to ensure not only the long-term survival but also sustainable economic profit growth of the company. This approach needs not only chairmen of remuneration committees who are truly independent in their dealings with executive directors but who are also able to communicate the companies’ aims to their shareholders.

There has been a lot of talk about re-balancing the economy and the new government in the UK wants to make a difference – as the last one intended – and at least arrest the decline of manufacturing industries and narrow the trade gap. For the Obama administration the task is not dissimilar – just so much larger. Changing economic behaviour would be a starting point.

This article is from Bob Bischof in London and Patrick Furtaw in Los Angeles writing for SCCO INTERNATIONAL