About managerial capitalism

Managerial capitalism is the sector comprised by public companies with such a high degree of capital dispersion that in practice shareholders have little or no control over management and the profit motive is often discarded.

Managers' capitalism developed not as the result of any specific ideology but from the natural growth of companies.

So, all non-stated owned big firms are by nature part of this sector as long as their capital grows beyond the resources of a small group of shareholders. For instance, even if the three wealthiest billionaires in the world were to invest all their fortunes to buy a large cap stock like Apple they would own only 30% of the company.

In the managerial sector it is often useful to distinguish three types of firms. Those that operate in regulated sectors and often resulted from the privatization of state monopolies, those that have grown to a dominant position in their sector and the conglomerates.

The emergence of big firms is not a new phenomenon and since the late XIX century there has been a fear that business concentration threatens free markets, the rule of law and the profit motive indispensable in a capitalist society. The concern has always been that business concentration would lead to the abuse of market power, the collusion with politicians would result in an uneven playing field and tax arbitrage for the benefit of a few and the separation between ownership and management would erode the profit drive and encourage waste and self-aggrandizement.

Today’s novelty resides solely on substantial transformations in the governance system. While in the age of the Trusts and the so-called “robber barons” these were still mostly capitalists who paid professional managers a salary of about 20 times that paid to the other professionals, nowadays there is a new layer of professional money managers between the ultimate owners and the managers and these now earn about 300 times the average salary in their companies. For example, it is now possible to find CEOs who earn more in compensation than what they pay in dividends to a shareholder who owns more than 2% of the business.

So, the modern day CEO-cracy has little capital invested in their companies and a strong incentive to maximize the company size and his compensation at the expense of profitability. Indeed, finance theory has contributed for such behavior by replacing profitability with a more ambiguous concept of shareholder value and by promoting a culture of stakeholders responsibility instead of stockholders.

Moreover, the average tenure of Fortune 500 company CEOs was 9.7 years in 2013, with many being recruited internally and going straight into retirement. That is, nominations often are the result of political and internal power struggles as in any bureaucracy rather than business performance.

In fact, the growing mix of business and politics is evident not only in the regulated sectors but also in the remaining sectors of managerial capitalism because of the role played by banks and institutional investors in corporate control. This places the managerial sector somewhere between the state enterprise sector and the market capitalism sector.

Through political favoritism and managers’ desire for size it is not surprising that managers' capitalism has continued to grow despite its inefficiency. For instance, in the two groups referred to below the top 50 managerial firms used twice as much capital as the bottom group.

This raises the question of knowing whether the managerial sector is beneficial for its investors. For this, one needs to know if returns are greater in the managerial sector. Using as a proxy for managerial capitalism the free float, we did a cursory analysis of the top and bottom 50 companies in the S&P500 Index. It revealed that last year firms in the managerial sector had a median return on equity which was lower than in firms with a lower float by three percentage points. Furthermore, the annualized return of stock prices over the past three years was also lower by two percentage points.

Surprisingly, managerial capitalism does not seem able to extract any rents for its own shareholders despite being protected by the political sector. Overall, the system endangers competition, the profit motive and social mobility necessary to keep capitalism a mild Darwinian system where the stronger takes over the weak for the benefit of both.

That is, although there is some truth in the statement that “when we have strong managers, weak directors, co-opted accountants, and passive owners, don’t be surprised when the looting begins (Bogle, J.C. (2003))”, the problem with managerial capitalism is not simply a question of generating some “bad apples”. It is really a cancer that sooner or later compromises free markets, the rule of law and the profit motive.

Yet this should not be the inevitable result of growth. One could still benefit from company size as long as the agency problems had been tackled head on. Unfortunately, the emergence of institutional investors who were supposed to represent a dispersed constituency of individual shareholders has aggravated the problem rather than solve it. For instance, in the USA the 100 largest managers of pension and mutual funds represent the ownership of about 50% of corporate America.

However, they hardly even attend annual meetings. And, quoting Bogle again: “the focus of the mutual fund industry has gradually shifted—from management to marketing, from stewardship to salesmanship, and—just as in the case of corporate America—from owners capitalism to managers capitalism”.

So, with the money managers riddled by conflicts of interest and governance problems similar or even worse than those of the corporations they are supposed to oversee a rising managerial sector can only end in inefficiency.

However, since the alternative to state owned enterprises is often its transformation into a managers’ corporation one has to assess their relative merits. Likewise, since size and job security often come together, for those employed in such firms the managerial model seems similar to many of the ideals of the XIX century utopian socialism.

Warren Buffett on Dividends and Management Capitalism

Every year I wait eagerly Warren Buffett´s letter to Berkshire shareholders to benefit from his wisdom on investment. I consider him one of the great champions of shareholder-oriented policies and usually agree with him. However, this year I fundamentally disagree with his contradictory statement on dividends. Let me explain why.

Although concluding that “We like increased dividends, and we love repurchases at appropriate prices”, he relegates the payment of dividends for last, after share repurchases (a form of earnings distribution that he opposed in the past). His view replicates the logic of the so-called pecking order theory of financing which states that firms prioritize the various sources of funds on the basis of how easily they can be accessed. Likewise, Buffett advocates that CEOs should first look to deploy the company earnings on current operations, after look for acquisitions unrelated to their current businesses, then consider repurchasing their own shares if the price-to-book value is below 1.2 and finally pay a dividend.

This use of earnings will inevitably transform CEOs into asset managers and strengthen what I call management capitalism. I define management capitalism as a system where managers may choose the investors rather than the other way around.

Management capitalism is mostly found in the regulated sectors of the economy (banking, transportation, utilities and other former state-owned companies), but also among public companies where capital has been so diluted that the former owners or their heirs no longer have a controlling interest in the business. For example, Berkshire is the single largest shareholder in Coca-Cola but owns only 8.98% of the company and appoints 2 of the 22 directors.

To simplify we may include in the management capitalism sector all public companies whose float exceeds 80% and the largest shareholder owns less than 15% of the total stock. Using these criteria, 3/4 of the 41 companies in Berkshire´s portfolio of listed companies are in the management capitalism sector. This bias in his portfolio is partly explained by the fact that he only invests in large cap stocks. Equally, his preference for CEOs with the profile of a private equity fund manager may be reasonable in his special case. Since he runs his huge portfolio with a team of only 23 people (including support staff) it is obvious that he has to rely on his CEOs as a kind of portfolio managers.

However, managerial capitalism is inferior to market capitalism because it relies on collusion with government policies (namely to inhibit the payment of dividends and distort competition), carries excessive governance costs, is highly exposed to agency problems, undermines competition and has fewer shareholder-oriented CEOs. Those that do not pay dividends often aggravate these problems.

Unfortunately, the alternative to dividends advocated by Buffett does not solve these problems. He argues that instead of receiving an annual dividend, investors pursuing an income objective would be better off by selling annually the number of shares needed to cash in an amount equivalent to the desired dividend. He gives an example assuming no-taxes and constant returns on equity and price-to-book ratios. Under such conditions the sell-off is obviously better. He adds two more advantages of sell-offs, namely that sell-offs do not impose a cash-out policy upon all shareholders and are more tax-efficient.

However, with rising capital expenditure one must expect diminishing returns on equity. For illustration, in the Buffett example, if the return on reinvested earnings after 10 years had fallen to ¼ of the starting return, the sell-off advantage over dividends (about 4%) would be halved. Given the overriding tendency to grow big at all costs there is a major danger that such returns may even turn negative.

Buffett himself, in his 1989 letter, recalling the lessons learned in his first 25 years as an investor, alerted that: “(2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops”.

There is a possibility of controlling this trend, acknowledged by Buffett in his 2012 letter as the pursuit of intrinsic value. That is, to require that net worth grows faster than investment. I checked how his current portfolio of listed stocks had performed on this count over the past four years and the result is not brilliant – less than half (17/41) had a positive elasticity of net worth in relation to capital expenditure and only two companies had an elasticity greater than one. So, if a major shareholder like Buffett cannot enforce this rule imagine how hopeless the average investor is.

Overall, the (uncertain) advantage of sell-offs over dividends is too small to compensate for the greater inefficiency of management capitalism in relation to market capitalism (the present value of his 4% estimated advantage is less than 1.6%). Moreover, it does not justify complacency with the frequent collusion between management capitalists and tax authorities to discriminate against dividends.

So, I am left wondering whether the recent softening of Buffett’s stance in relation to share repurchases and dividends has contributed for his weakening performance and if we risk losing a supporter of shareholder-oriented managers. However, I still hope that he will prove me wrong.