Passively invested funds now account for 45% of all assets of U.S. stock-based funds, up from 25% a decade ago, according to Bank of America Merrill Lynch. Indexed funds also account for 25% of bond funds. Between them, three large investment managers, BlackRock, Vanguard and State Street, manage over $20 trillion of assets and they are all dedicated to the “woke” ESG (environment, social and governance) mantra. If these trends continue, how is such a capitalism supposed to work; indeed, will it be capitalism at all?
In order to function properly, capitalism requires shareholders who have a sufficient stake in the company to make it worthwhile to monitor it, and for the company’s management to take notice of their interests. When companies still had their founding families involved, this was not a problem. Even if the families controlled only a small percentage of the capital, the arrival of a stately octogenarian family matriarch at the annual general meeting would ensure that management shaped up and did the right thing for the shareholders.
That is the central tenet of capitalism. If all parties in a market act in a profit-maximizing way, with shareholders ensuring that corporate management does not become lazy or too keen to pursue its own political goals, then the system will optimize for everybody, and wealth and productivity growth will be maximized. Yet in modern business life, it is clear that in most places, the proper capitalist incentives do not operate.
The most obvious disjuncture between theory and practice comes in the interaction between management and shareholders. The great majority of modern shareholders are not acting on behalf of themselves, with profit uppermost. Mutual funds, ranked at the end of the year by performance, are perhaps the purest capitalist group of shareholders beyond the individual. Traditional corporate “final salary” pension funds, where the corporation befits from good investment performance by the fund, are also mostly traditional in their incentive structure. Maybe some insurance company funds, where the profitability of the institution depends largely on the returns on its investments, are also mostly capitalist in their outlook.
But that’s pretty well where it ends. Indexed investments, now such a large percentage of the fund universe, are by definition not profit seeking for the investments they hold; their objective is only to match the broad based index, and that index is matched through an algorithm, whether or not the companies in the index are well managed. Indexed investment managers still have voting power at shareholders’ meetings, but they are free to exercise that power in any interest they choose – which most often means in the interest of witless wokery, damaging to the returns of other shareholders of their investee companies, as well as to the economy in general.
Similarly, fund managers voting the shares held by the oligopolistic investment institutions: BlackRock, Vanguard and State Street are far more inclined to follow the bizarre political beliefs of their bosses (the globalist Larry Fink of BlackRock being most egregiously eccentric) in order to curry favor at bonus time. Finally, to make things worse, the proxy advisory services, ISS and Glass, Lewis impose their own brand of wokery and climate change alarmism on the investment process – many investment managers are too idle to think for themselves, so blindly follow the proxy advisors’ recommendations.
With shares held primarily by institutions for whom maximizing returns is well down the priority list, we are already far away from the theoretical capitalist model. But within the corporations themselves, there are additional forces steering them away from return-maximizing activity, and towards foolish investment and unnecessary overhead.
One such force is the decision-making structure of the corporation itself. Almost all business problems are handled by committees, containing the people responsible for various aspects of the problem, together with a chairman who is a more senior member of management. However, countless studies have shown this to be a sub-optimal method of decision-making.
The best way to arrive at a decision, the Delphi method, requires the members making the decision to be entirely independent and out of communication with each other when they put forward their initial ideas, so that each initial contribution to the decision is made from the member’s own original ability and experience. The committee structure, conversely, tends to penalize non-consensus thinking and miss factors that should be fully considered but which are not obvious and might annoy the committee chairman. In general, the future arrives initially by small deviations from an expected trend that invalidate the current consensus; those deviations will be annoying to top management and will thus in a committee structure be suppressed by any junior who notices them. This is even more the case if the committee’s discussion is moderated by an internal “thought police” from HR. Thus, the internal decision-making structure of the modern corporation is itself anti-capitalist, valuing internal consensus over what may be relatively faint signals from the market that reflect the future.
A further structural factor removing the large corporation’s operations from true capitalism is the rise of the over-powerful Human Resources department. By definition, this has no responsibility for the company’s interaction with its markets, nor any interest in the company’s results, beyond hoping that a short-term boost to profits will goose its stock options. Instead, it seeks to maximize its influence by imposing fashionable “woke” policies on the company’s hiring and ensuring that any minor deviation from those policies can result in instant dismissal. The Stalinist uniformity of thought that is thereby imposed is as fatal to market success as was the Soviet Union’s GOSPLAN planning system.
A third non-market anomaly in corporate behavior is the plethora of mergers and acquisitions activity. Countless studies have shown that the great majority of these subtract value, yet corporations continue to undertake them, which cannot be in the long-term interests of shareholders. The explanation is that they are strongly in the interests of management, which is rewarded by excessive amounts of stock options; an acquisition at a premium boosts the options values of seller company management (and often entitles them to large payouts without doing any further work) while buyer company management fattens its corporate empire, thereby justifying ever more Pharaonic remunerations packages at their next renewal.
These failures have all been exemplified in the recent history of the Walt Disney Company (NYSE:DIS) under Bob Iger, its CEO for most of the period since 2005. Disney has undertaken a series of acquisitions, most of which have not worked; its share price is up only 162% since 2007, in a roaring bull market in which the S&P 500 index is up 207% (this comparison is a silly metric, but it is the one by which modern corporate top management, excessively remunerated with stock options, seeks to be judged). It pushed diversification into “streaming” services, which have proved to be a margin-squeezer on making new movies. Then in 2022, it entered an entirely unnecessary political dispute with the government of Florida, which had passed a modestly socially conservative “Florida Parental Rights in Education Act,” on which dispute Disney has subsequently doubled down, endangering its excessively favorable land deal with the state negotiated in 1967. Disney has also produced a succession of “woke” blockbuster movies, most of which have been increasingly embarrassing flops.
Both Disney’s business decisions and its political activism have been thoroughly anti-capitalist, alienating its core audience, which skews family-oriented, in favor of “woke” political activists, most of whom have no money to spend on Disney products and services. It has exacerbated the problem with its core audience by jacking up the prices of its theme parks, more than doubling prices in real terms in the last 30 years, putting the parks out of reach of the increasingly stretched ordinary consumer’s budget, and attempting to appeal to a “luxury” market, woke or not, that is nowhere near large enough to fill them. One can never be certain until much time has passed, but Iger’s tenure at Disney appears to rival that of “Neutron Jack” Welch at GE, about which this column has written frequently, in its long-term destruction of an iconic business.
To get back to capitalism, we must reorient the economic system so that it atomizes, favoring small organizations and penalizing large ones. That is also true among institutional shareholders; index fund managers must not be allowed to vote the shares they control, since their incentives differ from those of capitalist shareholders. Having done that, most of the anti-capitalist behavior seen in today’s market will disappear – small organizations cannot afford sub-optimal decision making or spurious wokery, because it endangers their survival. Antitrust regulation must be reoriented to discourage corporate empire-building – Judge Robert Bork’s findings that consumers were not hurt much by acquisitions failed to take account of the destruction in market function that those acquisitions would produce.
But until we find a replacement for committee meetings, the market’s victory will be incomplete.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)