Connecting the Dots: Financial and Stakeholder Theory

1. Connecting the Dots:Financial and Stakeholder Theory Lloyd Kurtz Regional Meeting of SRI Investment Professionals May 23, 2007

2. Owners vs. Managers • “The ultimate power in a company must rest with the shareholders.” - Jean-Paul Page. Corporate Governance and Value Creation, Research Foundation of CFA Institute, 2005. • “[T]oday shares are held, on average, less than 10 months. Should managers really regard such investors, whose investment horizons are shorter than the most nearsighted of managers, as stakeholders whose value they ought to maximize?” - Clayton Christensen and Scott Anthony. “Put Investors in Their Place.” Business Week, May 28, 2007.

3. A Playbook for Social Investors • Economic strategy  Exit • Sell the stock • Moral/Ethical strategy  Voice • Engage with management • This choice is mediated by Loyalty – a rational assessment of the prospects for change.

4. At the Center… Stakeholder theory can be viewed as a constellation of ‘Hirschman relationships’ between a Control Group and a variety of groups...

5. Commercial Relationships "There is only one boss. The customer. And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else." - Sam Walton

6. Commercial Relationships In the 80s and early 90s it was popular to say that if you took care of these groups, you didn’t need to worry about much else.

7. You Mean There Are Others? A McKinsey & Co. study...found that up to 8% of shoppers had stopped patronizing the chain because of its reputation. [CEO Lee] Scott wondered, “If we had known ten years ago what we know now, what would we have done differently that might have kept us out of some of these issues or would have enhanced our reputation?” Fortune, 7/31/2006

8. Community: Hercules Chooses Exit The Hercules [California] City Council voted unanimously Tuesday night to take the unprecedented step of using eminent domain to prevent Wal-Mart from building a big-box store on a 17-acre lot near the city's waterfront. The vote caused most of the 300 people who had packed Hercules City Hall for the meeting to break out in cheers and applause... [A] resident, Anita Roger-Fields, expressed concern for small businesses in the city, saying... “(Wal-Mart is) the worst thing that could happen to our community.” San Francisco Chronicle, 5/24/2006

9. Government Clears Its Throat “Now, Wal-Mart finds itself under attack for what critics see as its miserly approach to employee health care... “[A] survey by Georgia officials found that more than 10,000 children of Wal-Mart employees were in the state's health program for children at an annual cost of nearly $10 million to taxpayers. “A North Carolina hospital found that 31 percent of 1,900 patients who described themselves as Wal-Mart employees were on Medicaid, while an additional 16 percent had no insurance at all.” New York Times, 11/1/2004

10. Social Relationships

11. The Environment: Silent No More “[I]t just became obvious that sustainability was an issue that was going to be more important than it was, let's say, last year, and the years before. “I had embraced this idea that the world's climate is changing and that man played a part in that, and that Wal-Mart can play a part in reducing man's impact. “We recognized that Wal-Mart had such a footprint in this world, and that we had a corresponding part to play in sustainability.” Interview with Lee Scott, Grist, 4/12/2006

12. Stakeholder Relationships

13. Financial Claims/Hirschman Relationships With the notable exception of the environment, these are voluntary relationships mediated by loyalty.

14. Which Leaves a Question… Who gets what’s left?

15. After Everyone Else is Paid, There are Two Claimants • Shareholders • Dividends • Retained Earnings • Management • Executive Pay

16. There’s a Lot Left:Stakeholders Are Not Killing Profitability

17. And Yet Payouts Are Down.. S&P 500 Payout Ratio

18. Dividends, Billions of Dollars 700 700 600 600 500 500 400 400 300 300 200 200 100 100 Undistributed Profits, Billions of Dollars 800 800 700 700 600 600 500 500 400 400 300 300 200 200 100 100 80 82 84 86 88 90 92 94 96 98 00 02 04 06 And Retained Earnings Are Piling Up Dividends and Undistributed Profits Historic high Source: CRANDALL, PIERCE & COMPANY, Corporate Profits, 4/07

19. Arnott on Retained Earnings "[R]etained earnings are often not reinvested at a return that rivals externally available investments; earnings and dividend growth are faster when payout ratios are high than when they are low, perhaps because corporate managers are then forced to be more selective about reinvestment alternatives." Arnott, Robert, and Peter Bernstein. “What Risk Premium is ‘Normal’?“ Financial Analysts Journal. March/April 2002.

20. A Cynic Might Say • E – D = Executive Compensation ?

21. CalPERS Governance Program • Brad Barber finds a “small, but reliably positive” +0.25% effect on announcement date. • “My best estimate, based on conservative short-term market reactions, indicates CalPERS activism has resulted in total wealth creation of $3.1 billion between 1992 and 2005.” Barber, Brad M.  "Monitoring the Monitor:  Evaluating CalPERS' Shareholder Activism." Working Paper, Graduate School of Management, UC Davis.  March, 2006.

22. Long-Term Impact Source: Barber (2006)

23. Private Equity:Can the Patient Survive the Cure? • Positives • Captures economic value of cash on the balance sheet and other retained value. • Re-aligns owners’ and managers’ interests. • Pushes short-termers out of the game. • Negatives • Eliminates transparency and public accountability. • Reduces public participation in economic benefits of business. • Makes it more difficult for non-financial stakeholders to express their views.