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Shareholder Value

October 24, 2011

This is a guest post by Mekon:

It was late August, 1990. The barely-above-mediocre Boston Red Sox (record: 73-57) led the definitely-mediocre Toronto Blue Jays (record: 67-64) by 6½ games in the American League East. Unsure his team could hold off the hard-charging Jays with a month left in the season, Sox general manager Lou Gorman decided to shore up his bullpen. He offered the Houston Astros a young minor league prospect named Jeff Bagwell for aging-but-competent relief pitcher Larry Andersen. The Astros, long out of the race, said yes.  What happened next is the stuff of legend, sort of:

  • In September, the Sox went from flirting with mediocrity to wrapping it in a loving embrace (a 15-17 record down the stretch), but still managed to hold off the mighty Jays by 2 games.
  • As the Sox staggered to the division title, Andersen chipped in 22 innings in 15 games with 1 save and a good ERA (1.23). If you believe in the Win Shares statistic they quote here, Mr. Aging-but-Competent contributed the equivalent of about 1 win.
  • In the playoffs, the 88-74 Red Sox faced the defending World Series champion Oakland A’s (record: 103-59). The A’s won all four games, by an aggregate score of 20-4. Andersen pitched three innings and gave up two runs. He was charged with the loss in the first game when he gave up a run in the 7th inning of a 1-1 game just before the A’s broke the game open.
  • The A’s, overwhelming favorites to repeat as World Series champs, lost the Series to the 91-71 Cincinnati Reds in four straight. You never know, do you, baseball fans?
  • Andersen was declared a free agent after the season ended. He left the Sox, signed with the San Diego Padres, and pitched in the majors for another four years. Somewhere along the way, “aging-but-competent” became just “aging,” as he compiled an aggregate record of 8-8.
  • The Astros promoted Bagwell to the major leagues in 1991. He was the 1991 rookie-of-the-year, the 1994 MVP, and the face of the franchise for 15 seasons. He retired with an exceptional lifetime OPS (On-base Plus Slugging average, today’s batting statistic of choice) of .948, as well as 449 home runs, currently 35th of all time. In his first year of Hall of Fame eligibility (2011), he got about 40% of the vote, a figure dragged down by suspicions of steroid use.
  • In later years, Gorman appeared to look back on the trade with pride: “I called Bob Watson and made the trade, Bagwell for Andersen.  Andersen would strengthen our bullpen and help us win the Eastern Division title, and we’d go on to face the A’s,” Gorman would write. “He was exactly what we needed to bolster the pen at a critical juncture in our run at the division title.”
  • Red Sox fans and ownership agreed. At the Sox’ 1990 holiday dinner, owner and chair Jean Yawkey announced a $2.5M bonus for Gorman for “enhancing ticketholder value” by getting the team to the playoffs. Grateful fans gave him a loud ovation on Opening Day the following April. While a few cranky Boston Globe writers made fun of the Bagwell-for-Andersen trade over the next few years, the public didn’t buy it. As the Sox finished well out of the running each of the next four years, fans always found comfort in the thrilling playoff run of 1990.

OK, I made that last one up: everyone, except apparently Gorman, realized almost from the outset that trading away Bagwell for Andersen was a disaster. As the Sox stumbled through the next several years (see, I didn’t make it all up), poor Lou, who had actually had a pretty good career as a major league GM, became a laughingstock, finally losing his job in 1993. His name still shows up near the top of any “Worst Trades Ever” list that baseball writers feel obligated to make every year around the trading deadline. You could even argue that teams became more cautious about holding on to their minor league prospects after seeing how badly Gorman and the Sox screwed up.

All well and good. But what if I told you that outside sports, in the world of business and finance, the little piece of fiction I put at the end of the Bagwell-for-Andersen story actually isn’t fiction at all?

Shareholder value. Google the phrase and you’ll find almost 5 million links. Virtually all of them (or at least the first five I checked) equate it with the value of the firm or the share price. If you think that’s just a shortcut, it’s not: at the end of every year, companies whose stock grew in price that year give their CEO’s hefty bonuses for – you guessed it – boosting shareholder value. The trouble with all this is that it misses the dimension that Sox fans demanding Lou Gorman’s head understood very well: time.

Say you’re a shareholder in IBM. Maybe you bought (or received) your stock outright, or maybe you gave some money to a manager and had them buy the stock, either directly in your name or pooled with money from other people just like you (i.e., through a fund). Either way, you are, in financial parlance, an asset owner (as distinguished from an asset manager, who manages what you, the owner, hold).

But step back a bit: why do you own this asset, anyway? You’re not going to consume it, like you might a gallon of milk or a car. You don’t get any pleasure from it, like you might from a piece of art that hangs on the wall. The only reason to own a share of IBM is so you can sell it. Hopefully at a high price. And if you own IBM stock now to sell it later, you have to think about time. When will you sell it? Five minutes from now? Five years from now?

When you’ll sell is driven by why. Essentially, there can be two reasons:

  1. You want to spend the money. You sell your IBM shares and use the proceeds to buy a car, or a house, or a nice picture, or to send your kids to college. A variant of this is that you expect to need the money soon (your kids are going to college next year), and you don’t want to risk IBM decreasing in value, so you sell your shares and put the money in the bank (or in another low-risk asset) until you need it.
  2. You (or an asset manager acting on your behalf) decide to replace IBM with an asset you like better. Time is embedded implicitly here too: if you’re selling IBM to buy AAPL, you expect AAPL to do better than IBM over some time horizon. Which could be until you need the money, or it could be sooner. For example, I might plan to hold AAPL for a year (over which time I expect it to do better than IBM), and reevaluate what I hold after that.

Asset owners who sell because of (1) are called buy-and-hold investors. Asset owners who sell because of (2) are called traders. Rebalancing, where you hold assets for some period of time, then decide whether to replace them, is essentially a disciplined form of trading.

Now that we know why asset holders sell, we can talk about when. Take buy-and-hold investors first. If you’re selling assets to fund expenses, you’re usually either buying something big (a house or a car, not a gallon of milk) or you no longer have income (you’re retired).  Now, truly large expenses are rare, and people usually retire late in life, so asset sales by buy-and-hold investors are spread out across time. In any given year, only a small minority of buy-and-hold investors need to sell assets to raise funds.

Traders initially seem more complicated, and probably are. But we can capture them pretty well by saying they sell when they see a new asset they think will get them better future returns. The more they like the return profile of an asset they already hold, the more they behave like buy-and-hold investors.

Now let’s ask again: what is true shareholder value? Given what we know about asset owners, what is in their best interest? A related question: who benefits when the stock price goes up? Shareholders, surely. But that’s only half the answer. The full answer is shareholders who sell.

Let’s look at buy-and-hold investors first. If the stock price goes up over a year, it benefits investors who sell that year. The remaining investors realize the gains only to the extent that those gains persist when they sell. Since they sell at different times, there’s only one way to benefit them as a group: enhance the value of the company consistently over time.

Of course, once you realize that boosting the share price over the short term doesn’t actually enhance value for most shareholders, you also see that immediate stock price gains are a terrible measure of a CEO’s performance. Red Sox fans understood this right away, and did all they could to run out of town the guy who boosted the short-term stock price (likelihood of making the 1990 playoffs) at the expense of long-term value (Jeff Bagwell’s career).

If you don’t believe me, here’s Warren Buffett making a related point:

“If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period?  Many investors get this one wrong.  Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.  This reaction makes no sense.  Only those who will be sellers of equities in the near future should be happy at seeing stocks rise.  Prospective purchasers should much prefer sinking prices.”

Now, this doesn’t mean you should manage a company to make the stock price drop, in part because there’s a big difference between existing shareholders and prospective ones. But the intuition is the same: investors should worry about the stock price when they buy and sell, and at no other time, and CEO’s should worry about shareholder value across time, not in the short term.

We know, though, that not all asset owners are buy-and-hold investors. Does the presence of traders – whether disciplined rebalancers, day traders, or high-frequency hedge funds – change things? Should it make management pay more attention to short-term stock price movements?

Let’s start with the basics: when you own an asset, its price matters only when you sell, and traders sell when another asset has a better return profile (or when they need to raise funds). Ignoring the latter, and assuming other assets’ profiles don’t change, we conclude that a rising stock price benefits traders if it comes with a worsening future return profile. (By the way, rapidly rising asset prices do usually mean worse expected future returns – but that’s a longer discussion.) That’s clearly no way to run a company, but it’s worth articulating two important reasons why:

  1. It harms the rest of their shareholders, who plan to keep their shares for longer and want a good future return profile (duh).
  2. In the aggregate, it even harms short-term traders.  Remember, we’re taking asset owners’ points of view here, and even asset owners who are traders need to get their long-term returns from somewhere!

In a little more detail, imagine a world where all companies are managed for the (supposed) benefit of short-term traders, maximizing short-term stock price growth and (purposely or not) making longer-term growth prospects less attractive. So now a year (say) goes by, and all stock prices have gone up a bunch (i.e., there’s a bubble). Asset owners who are traders want to take their profits and invest in another asset that’s more attractive in the long-term – but what? If all companies focus on short-term profit, then all assets are worse in the long term. So, as an asset owner, you’ve made some money, but what are you going to retire on?

Put another way, there’s no way to trade out of the economy – from a global point of view, everyone’s a buy-and-hold investor. If companies manage for the benefit of short-term traders, even traders lose.

So why do we keep rewarding CEO’s for short-term stock price boosts? Every Red Sox fan knew Lou Gorman was mismanaging the team, so why can’t the best minds in business and finance see it? Or does something about the system pervert perspectives and incentives? I’ll take that on in another post.

Categories: finance, guest post, news
  1. JSE
    October 24, 2011 at 8:48 am

    “Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

    Can you unpack Buffett’s argument a little more here? I’m confused by it. If stock prices are roughly Brownian motion, or Brownian motion + a drift, or whatever — as I understand the prevailing theory to be — then a 20% drop now means an 20% drop in expected value for the shares I’ll sell thirty years from now, right? And the same holds for my future purchases — yes, I can buy shares 20% cheaper tomorrow, but those shares will be worth 20% less at sale, no matter how long from now that is.

    Buffett’s argument makes sense if you think that stocks have a true long-term value (or true trend) around which the price fluctuates, and that a short-term drop is likely to be followed by an upward correction; if THAT were the case, then indeed a long-term investor would be cheered by a price drop, because the shares she holds would retain their long-term value and she could purchase yet more shares, with the same long-term value, at a discount.

    But I thought nobody believed it worked this way!


    • Mekon
      October 24, 2011 at 9:42 am

      Fantastic question! What you’re saying (about Brownian motion vs. mean reversion) is exactly right, and you’re already anticipating the next part. Which is that it’s not Brownian motion in the long term (definitely not if people are specifically managing to the short-term stock price!), and it’s a bad idea to pretend that it is.

      I’d better get going on writing the next post, but here’s a good article to look at in the meantime:



      • JSE
        October 24, 2011 at 11:09 am

        I look forward!

        Also, calling a 73-57 record (a 91-win pace over a full season) “barely above mediocre” is something only a spoiled Red Sox fan could do….


        • Mekon
          October 24, 2011 at 12:21 pm

          It was a bubble. Their record was a lot better than mediocre, but the team wasn’t. Seriously, check out the roster (AKA the company fundamentals):


          And they reverted to a more pedestrian 88-74 by season’s end. Mmmm, mean reversion…


    • October 25, 2011 at 5:03 pm

      From what I have seen about the way Buffet trades, he ensures that the stocks in which he invests do have a ‘true long term value’. Firstly he doesn’t buy stocks in a company unless he thinks he understands the underlying business of the company he is buying. The underlying long term value he is looking for isn’t the value of the stocks it is the value of a business (ie turnover and profit), Secondly he doesn’t just buy a few stocks in a company, if he buys stocks he buys enough to give him some clout in the way the underlying business is run. Finally after he has bought the stocks he closely watches the underlying business and, if he disagrees with management decisions he takes action to help the board see thing his way: if phoning them every day doesn’t persuade them, he escalates to making comments to the press, and if that doesn’t work he bulk dumps the stock – depressing the share price and losing them their bonuses.

      Note that in the last case he is taking ‘a loss’ on the stocks he is selling, but he frightens the hell out of the boards of the other companies, so he is tightening his hold on the other businesses. He reminds them that he is not ‘the investor’, he is ‘the owner’.

      In short Warren Buffet doesn’t invest in stocks he invests in businesses and he doesn’t want to hold bits of paper he wants the businesses run his way.


  2. Dan L
    October 24, 2011 at 1:59 pm

    There is a slight problem with the analogy, in that a rise in share price means that the market does not even know that a bad decision was made. For the analogy to work properly, Bagwell’s potential greatness would have to be something that was only well-understood by insiders (and thus the stupidity of the trade would only be seen in retrospect). The only “bad” upticks in share prices are the ones that involve management taking advantage of inside information to fool the market into raising the price.

    But all of this presupposes that corporations are run for the benefit of the shareholders in general—a presupposition I do not readily accept.


    • Mekon
      October 24, 2011 at 3:03 pm

      I cheated a bit — I don’t remember exactly how much Gorman was criticized at the time he made the trade. It definitely grew over time, as it became clearer how valuable Bagwell was. But, yes, don’t take the analogy *too* literally.

      More to come on (1) what factors might cause up/down ticks, and (2) *should* companies be run for the benefit of shareholders?


  3. wlm
    June 17, 2013 at 2:57 pm

    Mekon, very interesting. I look forward to your future posts.

    Regarding this one, you had me until this:
    “Ignoring the latter, and assuming other assets’ profiles don’t change, we conclude that a rising stock price benefits traders if it comes with a worsening future return profile.”

    I don’t see the logic behind this. It’s true that traders are assured of getting the *best possible* outcome if they sell at the peak price and the price declines afterward. However, as long as they sell for more than they bought, they still make money (excluding transaction costs, etc).

    So I don’t understand that statement, and thus the rest of the post.


  4. Mekon
    June 18, 2013 at 11:04 am

    I’m glad somebody’s still reading this!

    Let’s take an example. Say you’re a trader with a time horizon of up to a year. You own stock ABC, which you think will go up 20% over the next year. There’s another stock XYZ that you think will go up 15% over the next year. Now stock ABC goes up 10% in a day. If you still think ABC will go up a *total* of 20% over the entire year, counting the 10% already made, then you expect it to go up only 10% more from its current level. So then you should sell ABC (take profits) and buy XYZ, which you expect to go up more. That’s the worsening future return profile scenario. On the other hand, if you now expect ABC to go up *another* 20% from its current level, then you should hang on to it. (Note that in that scenario, the impact for you of going up 10% in a day is just to change the expected value a year from now from 20% to 30% — you get no special benefit to having a big part of the change come from a short term jump.)

    In other words: the (idealized) point of trading is to make as much money as you can, and there’s no reason to take profits from a particular trade unless you think you’ve made what you can from it.

    I guess I really need to write that follow-up post I promised! 🙂


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