01 Dec 2012
Reassessing investors' functionsTopics:
What are shareholders good for? Maybe not as much as most people think. Basically, shareholders are supposed to provide three functions: money, information, and discipline. Let's examine each.
Money. In theory, shareholders are supposed to be a source of capital for public companies. In practice, if one excludes new start-ups, most new capital is provided by debt. Of course, liquidity in the stock market does enable investors to capture gains on their investments, and it also enables
mergers and acquisitions.
To provide adequate liquidity, however, an asset market needs a lot of fickle short-term investors: A market of buy-and-hold investors wouldn't be very useful. However, a market composed of mostly short-termers presents its own problems, and today they have too much impact on the market. The more influence short-term traders have on market prices, the more volatile those prices will be—because they are less rooted in the fundamental value of the corporations whose shares are being traded. Sure, some volatility is good because it gives people a reason to trade, thus keeping markets liquid. But too much volatility can kill liquidity.
Information. One source of information is company share prices. However, scholarly studies suggest these are not reliable indicators of companies' true economic value. In a similar vein, the late Paul Samuelson said financial markets are "micro-efficient and macro-inefficient." This is one explanation of why executives complain about the short-term nature of the stock market, while financial scholars find evidence that financial markets look deep into the future. But markets are only one source of information. Another is direct contact between boards and executives on the one hand, and shareholders on the other. A problem here is Regulation FD, which impairs the
free flow of information between
companies and their owners.
Discipline. Selling can be said to discipline managers by driving the stock price down, but it's hard for one shareholder to have a discernible impact. Voting has its weaknesses, too. The biggest issue is that many investors are short-termers, and they aren't as good as long-termers at disciplining and guiding managers. Another issue is that big institutions, which hold the lion's share of stock, own shares in hundreds of companies, making it
difficult to focus on the governance
of any of them.
Most institutional investors lack the motivation and time to effectively discipline or otherwise oversee management. And investors all have differing time frames, priorities, and objectives. Top corporate executives, meanwhile, as highly skilled full-time professionals, will find it easy to outmaneuver or outlast disgruntled investors.
Giving a favored role to long-term shareholders, such as more voting power than for short-termers, could be one way to combat this. Closer, more constructive relationships between shareholders, managers, and boards should also be a priority. So should finding roles for others in the corporate drama—boards, customers, employees, lenders, regulators, nonprofit groups—to enable those actors to take on some of the burden of providing money, information, and especially discipline. This is stakeholder capitalism—not as some sort of do-good imperative but as recognition that today's shareholders aren't quite up to making shareholder capitalism work.
—Jay W. Lorsch is the Louis E. Kirstein Professor of Human Relations at HBS. Justin Fox is editorial director of the HBR Group. The preceding is adapted from a longer article that appeared in the July–August 2012 Harvard Business Review.