Year of the Fat Cats

One of the standard year-end rituals is to assess the stock market's performance for the year. Many people noted the Dow Jones index rose a respectable 7.5 percent in 2007. Before anyone celebrates this modest achievement, it is important to remember the Dow includes just 30 blue chip stocks. The much broader S&P 500 index rose by just 3.5 percent, slightly less than the rate of inflation in 2007. In other words, the real return for most stockholders was roughly equal to what their stock paid out in dividends, not a terribly good story.

In fact, poor stock returns are not a new phenomenon. If we go back ten years, we find the S&P 500 has risen by a cumulative total of 52.6 percent from December 1997 to December 2007. After adjusting for inflation, the increase was 17.3 percent, which translates into real growth of just 1.6 percent a year. Add in a dividend yield of approximately the same size, and we get that the average real return on stocks over the last decade has been 3.2 percent, a bit lower than the yield that was available on inflation-indexed government bonds ten years ago.

This is rather striking. It is unlikely many people invested in stock for the sort of return that is typically associated with government bonds, which are much less risky. At least for the last decade, stockholders have not been rewarded for taking this risk.

This brings us to the topic of CEO pay. We saw an explosion in CEO pay that began in the eighties and has continued into the current decade. While the ratio of the pay of CEOs to an average worker had been around 30 to 1 in the sixties and seventies, by the end of the eighties it stood at more than 70 to 1. It crossed 100 to 1 in the early nineties. The ratio has been perched between 200 to 1 and 300 to 1 since the late nineties, with CEOs at major companies routinely pulling down pay packages in the tens of millions, and running into the hundreds of millions in good years.

This explosion of pay at the top was justified, by many economists, based on the returns CEOs produced for shareholders. The argument was that even these incredibly high salaries still were just a small fraction of the value the CEOs generated, so their pay was money well spent. These exorbitant salaries gave the CEOs the necessary incentive to produce extraordinary returns.

While this argument may never have been terribly compelling (it would have been hard to keep a company's stock prices from rising in the nineties bubble), it clearly is not true today. The typical CEO is not producing great returns for shareholders. The average return is weak, and in many cases shareholders are incurring loses due to CEO mismanagement. Even in the disaster stories, the CEOs still seem to get extraordinary pay packages.

The poster child for this new trend is Robert Nardelli. In five years as CEO at Home Depot, he lost shareholders 40 percent of the stock's value, more than $25 billion. When he was eventually pushed out the door, he walked away with a compensation package worth more than $200 million. Call it "pay for nonperformance."

In the fifties and sixties, it was common to think of corporations as bodies that served a variety of stakeholders. In addition to shareholders, corporations were also seen as having responsibilities to their workers, to the communities in which they were located, to their consumers, and even the larger society. This diverse group of stakeholders sometimes meant that a company should sacrifice short-term profit maximization in order to meet some broader goal.

In the eighties, we got the shareholder revolution, which said corporate management should focus simply on maximizing shareholder value. If this meant mass layoffs of workers or abandoning communities where a company had deep roots, so be it.

As a result of the shareholder revolution, the range of constituencies the corporation was expected to serve was drastically narrowed. Concerns for workers, communities, and the larger society were jettisoned, with shareholder value being the only true concern for the corporation and the CEOs that run them. This single-minded concern for profit maximization and shareholder value was supposed to be best for society in the long run.

It turns out, the range of constituencies has been narrowed even further than we realized. With recent evidence on returns, it doesn't look like shareholders fit in the equation anymore. At least the CEOs are still doing well.