|Creating Shareholder Value: BY Mutual Funds or FOR Mutual Fund Shareholders?|
Keynote Address by John C. Bogle, Senior Chairman and Founder, The Vanguard Group
The Annual Conference of the Investor Responsibility Research Center
October 26, 1998
It is an extraordinary honor to be invited to give this keynote address as the IRRC begins its second quarter century of service to the shareholders of America's publicly held corporations. In fact, as I understand it, I am the first senior executive of a mutual fund firm to be so honored. Clearly our industrynow representing the largest single pool of institutionally owned equities in the nationhas been conspicuous by its absence from participation in your annual conference.
While there are some valid reasons for why you might not have sought our participation in the past, there areparadoxically enoughalso some disturbing reasons why we might not have been particularly enthusiastic about participating in discussions regarding the creation of shareholder value in Corporate America. For reasons that I look forward to discussing with you today, our self-interested modestyif that is not an oxymoronis now at the inflection point of change.
The creation of "shareholder value" as the explicit focus of corporate strategy is largely a phenomenon of the 1990s. It has been driven, in part, by the leadership of large institutional investors, notably the states of Wisconsin and Florida, CALPERS, and the New York City funds, supported by the vigorous advocacy of the Council of Institutional Investors. The important research provided by the IRRC and others has also been invaluable. This handful of heroes fully deserves the accolades of America's shareholders who arelest we forgetthe owners of our publicly held corporations.
Enhancing Corporate Value<BR>
As the responsibility to enhance economic value has become the prime article of faith in corporate America, it has often been codified in Mission Statements of Boards of Directors. For example, the mission statement of the Mead Corporation, the Fortune 500 papermaker, on whose board I've served as an independent director for 20 years, states:
The mission of the Board is to achieve long-term economic value for the shareholders. The Board believes that the Corporation should rank in the top third of peer companies in the creation of economic value which is created by earning returns over full cycles which are higher than the cost of capital, usually reflected in total return to shareholders.In Mead's case, total return is measured by Return on Total Capital, with our ROTC then compared with the average ROTC of both our peers and Corporate America in the aggregate. In addition to serving as the benchmark for the evaluation of corporate success by the Board, this joint measurement serves as the basis for Mead's incentive compensation system.
The focus of the Boardand Mead's Board is hardly unusual in this respectis on the creation of additional economic value, measured by achieving an ROTC that exceeds the cost of capital. If we cannot earn the cost of capital for our shareholders, so the essential logic goes, why should they entrust us with it? As Fortune magazine put it: "The true cost of equity is what your shareholders could be getting in price appreciation and dividends if they invested instead in a portfolio about as risky as yours."
The idea that companies must recover their cost of capital is not new. According to a recent article in The Financial Times, the eminent British economist Alfred Marshall stated it clearly a century ago. "But," the article added, "it was not systematically applied to management until the 1980s." One current fashion is to cast the issue in the form of "economic value added," or EVA®.*
EVA can be simply described as the amount by which the corporation's return on total capital exceeds the weighted market value of the corporation's cost of capital, measured by the capitalization-weighted average of the interest rate on its debt and the market return on common stocks as a group (adjusted to reflect the riskiness of its stock, using Beta, the conventional measure of the volatility of a company's stock price relative to that of the Standard & Poor's 500 Composite Stock Price Index®). In a simple example, if the return of the S&P 500 Index was 15%, a corporation with 100% of its capitalization represented by equity (i.e., without debt) and a Beta of 0.90 would have a cost of capital of 14%.** EVA, therefore, would depend on investing capital only in new projects earning, say, significantly more than 14%. While the precision of this statistical measure is subject to well-deserved skepticism, the concept represents rather elementary common sense.
*While it may seem anomalous that such common words can, in effect, be patented, EVA® is a registered service mark of Stern Stewart & Co. The logic of U.S. patent law never ceases to amaze me.
**Risk-free rate + Beta (stock market return risk-free rate) = Cost of capital. Therefore: 5% + 0.9 (15% 5%) = 14%.
Time Horizons and the Sources of Investment Return
But if we all can agree that the creation of shareholder value is the critical responsibility of the business corporation, a second important issue remains: how to measure value, and over what period? In the long run the returns on a corporation's shares in the stock market are determined by its investment fundamentalsearnings growth and dividend yields. For example, the real earnings and dividends (after inflation) of U.S. corporations have aggregated just short of 7% over the past two centuries, almost precisely equal to the real return of 7% in stock prices. Over the long pull, investment fundamentals, not market valuations, are the piper that calls the tune.
Over the short run, however, the fundamentals are often overwhelmed by the deafening noise of speculationthe price at which the stock market values each dollar of earnings. This noise can be surprisingly durable. On a one-year basis, as shown in the chart below, the gap between annual fundamental rates of return on stocks and their market return can be staggering, exceeding 10 percentage points (!) in more than two-thirds of the 125 rolling ten-year periods since 1872, and exceeding 5 percentage points in more than eight out of ten periods. On a ten-year basis, the gap shrinks considerably, almost never exceeding 10%, but exceeding 5% in one-fourth of all periods, and 2% in two-thirds. Over 25 years, however, the gap shrinks radically, exceeding 2% in fewer than one-quarter of all periods and never exceeding 5%. *Note: A +5% gap, for example, would mean that if the fundamental return were 10%, the market return might be more than +15% or less than 5%.
Examining 125 Years of Market History
*Note: A +5% gap, for example, would mean that if the fundamental return were 10%, the market return might be more than +15% or less than 5%.
One need look no further than the 1970s and 1980s to see that wide variations can take place during decade-long periods. As shown in the table below, during the 1970s the fundamentals of investment, measured by earnings growth and dividend yields on the S&P 500 Index, provided a return of 13.3% per year, but the total stock market return was but 5.9% annually. The reduction in valuation of 7.6% per year reflected a drop in the price/earnings ratio from 15.9 to 7.3 times. During the 1980s, by contrast, the fundamental return of 9.6% came hand-in-hand with a valuation increase of 7.8%, as P/E ratios more than doubled, from 7.3 to 15.5 times, bringing total annual return to 17.6%. While, measured in nominal terms, Corporate America's performance was worse in the 1980s than in the 1970s in terms of fundamentals (+9.6% vs. +13.3%), it was far better in stock market terms (+17.6% vs. +5.9%). Turnabout, apparently, is fair play. For during the two decades combined, the fundamental return of 11.5% was virtually identical to the market return. The cacophony of speculation was, on balance, conspicuous by its absence.
The Golden Decade Follows the Tin Decade
(1) Earnings Growth + Dividend Yield.
(2) Annualized Impact of Change in P/E Ratio.
We knowwe knowthat in the long run, market returns represent the triumph of investment fundamentalsearnings and dividendsover speculation in the market's valuation of these returns. Yet I have no doubt that during recent years it is speculation that has been in the driver's seat. This trend would not have surprised the worldly wise Lord Keynes, who concluded (in the early 1930s) that the powerful role of speculation in the markets was based on " the conventional valuation of stocks based on the mass psychology of a large number of ignorant individuals." Unable to offset the mass opinion, he predicted, professional investors would try to "foresee changes in the public valuation."
His conclusion has been reaffirmedand then some! In the past three decades, expert professional investors have come to dominate the financial markets. Managers of pension funds and mutual funds have largely replaced ignorant individuals in the investment marketplace. Rather than endeavoring to place appropriate values on business enterprises, these pros are, in a real sense, focusing their professional careers on attempting to foresee changes in the public valuation of stocks. In the long run, of course, precious few will succeed in doing so.
The Consequences of Using Market Returns as the Standard
What is more, there are some deeply troubling aspects in the acceptance of the returns generated in the stock market as the sole ingredient of the cost of equity capital. The stock marketas recent wild fluctuations have demonstrated yet once againis a fickle, flighty investment in the short run"a tale told by an idiot, full of sound and fury, signifying nothing," to borrow a phase from the Bard. In the long runas every intelligent investor, from Alan Greenspan to Peter Bernstein to Peter Lynch knowsit is the sum total of earnings and dividends that controls market returns. Nonetheless, in the short run it is the valuations that speculators place on these investment fundamentals that drive market returnsfrom day to day, and even from decade to decade, before the fundamentals finally reassert themselves and the market reverts to its long-term norm. But only until the next cycle begins.
Because of these periodic swings between optimism and pessimism, between greed and fear, the considerable success of corporate managers in building earnings and dividends at a 13% annual rate during the 1970s was translated into a shabby total market return of less than 6%. While corporate managers were less successful in the 1980s, providing a return from earnings and dividends of less than 10%, investor emotions took a 180° turn and valuations more than doubled, carrying the market to an outstanding 17% return.
The reliance on market returns as the ultimate standard gives rise to an important issue in corporate governance: the emergence of stock options as the driving force in executive compensation. During the second half of the 1990s, this system has provided huge rewards to managers of corporations whose stocks have soared to new heights in the great bull market. Leaving aside the issues of paying executives on the basis of what often prove to be market whims, and accounting for option costs without diluting reported earnings, there is the critical question of what to do when the law of gravity in the financial marketsreversion to the meanstrikes, and stock prices tumble, even in the face of uninterrupted earnings growth.
When this happens, it must not be unheard of for management to tell the directors: "our options are so far underwater that we have no incentive to improve. We need motivation; we need our team to stay; we need to enhance shareholder value. So please reprice the options." And the directors are apt to do just that. It is a perverse sort of argument, but the practice is taking hold. Nearly 10% of the 1,500 large companies tracked by IRRC have repriced options in the past two years. And given the precipitous drop in the prices of so many stocks in recent months, repricing seems certain to expand in the months ahead.
Repricing is clearly an emerging corporate governance issue. Necessary as it mayor may notbe, this creation of wealth without risk (a nice way to live!) clearly dilutes shareholder value. I believe that institutional shareholders should take a firm stand with the companies whose shares they own, demanding that such repricings be submitted to shareholders for approval. At the same time, the terms and conditions of repricing should be monitored, for repricing schemes range from "grossly unfair" to "reasonable under the circumstances." We should oppose the former and accept, however reluctantly, the latter. The time is nowwell before the 1999 proxy seasonfor institutional investors to communicate their position to the directors and managers of their portfolio companies.
The whole stock option process, moreover, based as it largely is on simple price appreciation, needs serious reconsideration. Why shouldn't options be related to the extent to which the corporation earns returns in excess of its cost of capital, or to its performance relative to its peers, or even to the performance of its shares relative to the stock market as a whole? Targets that are too easy to hit result in the disproportionate sharing of corporate value between the corporation's management and its shareholders, and distort our financial system.
I hope that institutional investors and individual investors alike will recognize the folly of applauding corporate managers solely on the basis of evanescent market returns, without due regard for the hard work involved in generating the underlying investment fundamentals that are required to deliver returns that exceed their cost of capital over the long run.
The Rise of the Institutional Investor
The fact that market return seems to have taken the place of fundamental investment return in measuring shareholder value has had important implications for corporate governance. Surely the fact that shareholders must be served is as it should be, but the responsibility of focusing on the nature of returns, and the time frame over which they should be measured, will devolve largely on the institutional investor.
Today, institutional investors have the power to make a difference in corporate governance. When the 1950s began, institutions controlled less than 5% of all U.S. equities. Pension funds were just coming into being, and mutual funds, then the largest institutional investor, accounted for just 2% of the stock market's value. By the time that 1970 rolled around, the institutional share had risen to 27%, growing to 43% in 1990. Today, institutional investors own more than 70% of all U.S. stocks. In fact, the 100 largest financial institutions alone now own more than half of all U.S. corporate equities, valued at about $5 trillion. It is this handful of firms that can be the force that controls Corporate America.
The latent power represented by these institutions has the potential to reverse the trend toward the separation of corporate ownership and control that so concerned Adolf Berle and Gardiner Means in the early 1930s.*** As then-Comptroller Ned Regan of New York told this convocation a year ago, financial institutions have "sent a wake-up call to American business." He described this wake-up call as the third such call to rouse corporate CEOs, following the force of global competition, and then the explosion in corporate takeovers. The call from institutional investors, eager to enhance returns and bound by their fiduciary duty to prudently maximize returns for their beneficiaries and shareholders, may well be the final wake-up call that American business needs to receive. Final call or not, it surely has a ring whose intensity has risen measurably over the years, and it is now a call that cannot be ignored by Corporate America.
Institutions have the power to make their will be done. The three principal classes of investors alonemutual funds, state retirement plans, and corporate pension fundshold fully 40% of the market value of the nation's publicly held corporations today, eight times their 5% share in 1980. But the relationship of the holdings of these three groups of institutions has changed substantially during this period. As shown in this table, 15 years ago, long after mutual funds had relinquished their leadership, corporate pension funds held sway, holding 68% of these institutional assets. But that share has since been cut by one-half, to 34%. State and local retirement plans have increased their share from 17% to 25%. Fastest growing of all has been the group's previously deposed leader, for mutual funds have leaped from 15% to 41% of the group's aggregate, and now represent its largest single unit.
Assets Held by the Three Major Institutional Pools
The response to corporate governance issues by the trustees and managers of these three institutional asset pools has traditionally been so different in degree that it can easily be mistaken as a difference in kind. The public funds have been, dare I say, in the vanguard of corporate activism, while the private fundscorporate pension plans and mutual fundshave been conspicuous by their absence from the fray.
***"The Modern Corporation and Private Property."
The Changing Focus of Institutional Voting Activism
It is relatively easy to understand why the private investment sector stood back when significant institutional activism emerged in the early 1970s. Most of the early issues related to proxy proposals by small shareholders on social and ethical issuesminority hiring, pollution, recycling, and the like. Many institutional managers had either a sort of "ho-hum" reaction to these proposals, or a view that it was up to the corporation's managers to resolve them. So far as I know, none of these proposals ever received a significant portion of shareholder votes.
In the late 1970s, however, the first issue to receive compelling public attention arose: South Africa. The rigorous separation of races under the doctrine of apartheid caught the investment world's attention, and shareholder proposals that corporations divest themselves of business interests in the Union of South Africa were rife. Without, I think, adequate consideration of whether U.S. corporations were part of the problemor, instead, could be part of the solutionthis pressure, especially from public funds and college endowment funds, caused many corporations to withdraw from South Africa, even as it brought others to adopt the Sullivan Principles for acceptable practices in doing business there. Ever quick to spot an investment opportunity, many institutional managers ducked the issue by offering "South-Africa-Free" portfolios. (Even index fund managers offered "S&P 500 Lite" portfolios.) Changes in South Africa, however, have now made this issue substantially moot.
But as we moved into the 1980s, issues of corporate performance, corporate governance, executive compensation, and mergers and takeovers rose to the fore. These issues get to the heart of the question of the corporation's determination to enhance shareholder value, and the extent to which shareholders can influence corporate policy, strategy, and management. These issues are not going to vanish any time soon.
The institutional community has had a split response to these new, bottom-line-related issues. On the one hand, the members of all three poolsprivate plans, public funds, mutual fundshave generally proved ready to respond at a moment's notice to a merger proposal, or a takeover bid offering a steep premium over the current market value. "Analysis of long-term prospects be damned, let's tender first and ask questions afterward," was the implicit response.
On the other hand, the large public funds, almost alone, became corporate activists, seeking greater management focus on the creation of shareholder value, and in some cases placing proposals in the proxies of corporations whose managements appeared not to get the message. The large public fundswith long-term investment horizons, low portfolio turnover, and a market indexing orientationalso took initiatives with managements of corporations deemed to be underperforming in the stock market, even demanding changes in boards of directors. The record would seem to confirm, in particular, that the handful of large state retirement plans that I applauded at the outset have enjoyed some success when they have undertaken initiatives to influence the policies of major corporations.
The Silence of the Mutual Funds
During those corporate battles, mutual fund managers in general (Michael Price being a rare exception) were well behind the lines. Few, if any, made proxy proposals. Many, if not most, performed their proxy voting on a rote basis, failing to carefully attend to the issues raised and automatically voting in favor of management recommendations. Why is it that mutual funds, now with the most potential power of the three groups, have been the quietest, almost absent from the policy debate?
There are lots of reasons. First, improving shareholder value is a long-term proposition, and most mutual funds are short-term investors. The industry's annual rate of portfolio turnover is 85%, suggesting an average holding period of about 1.2 years for a given security. (The average turnover rate for the highest quartile of funds is 196%barely a six-month holding periodwhile the large state retirement funds are estimated to have turnover in the 10% to 20% range.) As Columbia Law School Professor Louis Lowenstein expressed it in a recent article, mutual fund managers "exhibit a persistent emphasis on momentary stock prices. The subtleties and nuances of a particular business utterly escape them."
Happily, there is every reason for this situation to improve. For there is, by definition, one type of equity strategy that is ironbound to invest for the long term. This strategy precludes both the short-term "I don't care" approach, and the longer-term but threadbare "If I don't like the management, I sell the stock" approach. It is called market indexing, and mutual fund investors are increasingly embracing this approach. A decade ago, index funds, then as now largely targeted to the S&P 500 Index, represented barely 1% of equity fund assets. Today, thanks to a combination of excellent index performance and strong cash flow, index funds now represent nearly 8% of equity fund assets. Given that this year index funds are accounting for fully 25% of equity fund cash flow, it would not be unreasonable to expect index fund assets to reach a 15% share of mutual fund assets well within the next decade.
With that penetration, index mutual funds would be on their way to approaching the present 22% share that indexed equities represent in public and private pension plans. This number, however, has grown at a snail's pace; in 1990, the index share was 20%. Thus it may be that, through index mutual funds, the fruition of the long-delayed participation of the public in the indexing strategy will add considerable weight to the dominant role that indexing now plays in the retirement plan world. Since the growth in indexing by retirement plans since 1990 has been glacial (up only from 20% to 22%), it is not a moment too soon for the average investor to adopt this remarkably successful investment strategy, and at the same time add momentum to its growth.
Indexing strategies now represent 17% of the total assets of the combined institutions, up from 12% in 1985 and 16% in 1990, yet even now only about 8% of the market value of all equities (including individuals, endowments, and bank trust accounts owning stocks directly) is committed to this approach. Surely much more growth lies ahead. The chart below highlights this growth:
Indexing as % of Equity Assets ($ Billions)
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