There’s a lot to like about the U.S. economy. Corporate profits are at their highest level in fifty years. The Dow surged past 20,000, continuing the second longest bull market run in history. And the unemployment rate is currently inching towards its lowest level in a decade.
But there are headwinds that have roiled the American electorate. The US economy grew only 1.6 percent in 2016, continuing a generally downward trend over the past 30 years. Real wage growth remains stubbornly elusive, income inequality is at its highest level since the Great Depression and customer satisfaction with the nation’s goods and services is just beginning to recover from a ten-year nadir reached in 2015.
These dichotomous results call into question our national and corporate priorities: why isn’t corporate prosperity translating into broader societal well-being? The answer lies partly in two pervasive management practices that have unwittingly compromised long-term national growth and tilted the scale towards corporate benefits at the expense of consumer and employee welfare:
The Economist reports that a $10 trillion acquisition binge since 2008 has contributed to increasing concentration in two-thirds of the US economy’s roughly 900 industries, including cable television, railroads, pharmaceuticals, industrial chemicals, telecom, media, hotels, health insurance and hospitals. Not surprisingly, the resulting decrease in competition has conveyed greater pricing power to many bulked-up incumbents, helping to drive up corporate profits. Take the airline sector for example, long considered an unattractive industry that failed to earn its cost of capital in the thirty years following industry deregulation. As Richard Branson once quipped, "if you want to be a millionaire, start with a billion dollars and launch a new airline." But a wave of mergers between 2008 and 2012 allowed the three remaining legacy airlines (American, Delta and United) to reduce capacity, raise fares, increase load factors and dramatically improve profitability, despite chronically abysmal customer satisfaction. Since 2012, a weighted index of U.S. airline industry stocks has grown three times faster than the S&P 500. And last year, Branson’s Virgin America agreed to be acquired by Alaska Airlines, further thinning the ranks of U.S. air carriers.
Ordinarily, rising profitability would be a cause for celebration, but for two nagging concerns. First, increasing the concentration of corporate profits in fewer oligopolistic hands can stifle innovation, limit consumer choice and increase prices. As a case in point, after AT&T’s proposal to acquire T-Mobile was blocked by the Justice Department in 2011, T-Mobile used its breakup fee windfall to upgrade its network, introduce a number of creative, customer-pleasing rate plans and cut prices. As a result, T-Mobile has increased its market share by 60 percent over the past five years, at the expense of industry market leaders. In pressing for the merger, AT&T had argued that it couldn’t justify investments to upgrade its own 4G-network without first spending $39 billion to acquire T-Mobile. But in reality, intensifying competition, not greater concentration induced AT&T to upgrade its wireless infrastructure over the past five years. And Verizon just announced it would offer unlimited data plans to match popular rate plans offered by T-Mobile and Sprint. Given robust competition, US wireless rates have come down and customer satisfaction has gone up since the AT&T/T-Mobile acquisition was blocked.
Often, large horizontal mergers are defensive responses by companies mired in mature, low or negative growth industries. In such cases, mergers are perceived to provide opportunities to “buy” growth, to exploit cost-reducing synergies, and to improve profits as a result of reduced competition and higher price realization. But the resulting corporate behemoths often become even more wedded to status quo business practices, preventing investments in disruptive new products and business models that might cannibalize current market leading positions.
A related concern with growing industry concentration is that fewer firms are earning more cash flow than they are able or willing to invest in organic growth. As a result, more capital has flowed to share buybacks of dubious value, and to executive compensation, exacerbating already high levels of income inequality.
With growing profitability in the short- to medium-term, corporations have increasingly allocated corporate capital to value extraction activities – share buybacks and dividends – at the expense of value creating investments in R&D, growth-driving capital expenditures and worker training. Over the years 2006-2015, the 459 companies in the S& P 500 Index publicly listed over this period expended nearly $4 trillion on stock buybacks, representing 54 percent of net income, plus another 37 percent of net income on dividends, raising legitimate concerns as to whether too many large enterprises have been under-investing in innovation and corporate capabilities to sustain long-term profitable growth.
Many corporate executives have personal incentives to boost EPS and short-term stock price over investments in long-term growth. Recent research indicates that executive compensation currently yields an executive-to-average-worker pay ratio amongst the 500 highest paid U.S. executives of almost 1,000:1. At a time when worker pay has been stagnant for decades, when overall corporate revenue growth has been anemic, and when the rates of returns on assets of U.S. firms been declining for a half-century, this highly skewed distribution of benefits raises troubling questions about whether the U.S. has been enjoying profits without prosperity.
While big corporations have been getting bigger, the rate of new business formation in the U.S. has been steadily declining for decades. This trend poses significant problems for the U.S. economy for two reasons. First, startups have traditionally been a hotbed of innovation, increasing growth and productivity. And second, young businesses have accounted for nearly all net new jobs created in the U.S in recent years. Older, larger businesses, by comparison, have been shedding almost as many workers as they’ve added, and this trend is likely to be exacerbated with increasing industry concentration.
As an example of the limits of large acquisitions to drive profitable growth, consider the case of Pfizer. Entering the new millennium, Pfizer recognized that its weak product pipeline left it vulnerable to the looming patent expirations on its blockbuster drugs. In response, Pfizer went on an acquisition binge, spending $357 billion (all figures in 2016 dollars) between 2000 and 2016 to buy several large pharmaceutical competitors, including Warner Lambert, Pharmacia and Wyeth. But Pfizer’s acquisitions also faced declining drug discovery productivity, which worsened under Pfizer management. A 2014 analysis of R&D productivity found that Pfizer was the only top ten pharmaceutical company to experience negative net income returns on R&D investment.
As a result, over the past five years, Pfizer’s real revenue and net income has declined by 25 percent and 33 percent respectively. To offset weak earnings, Pfizer escalated its stock buybacks, allocating $42 billion to buy back shares since 2012. Over the same period, Pfizer reduced its inflation-adjusted investments in organic growth: R&D spending by 11 percent and capital expenditures by 18 percent.
Pfizer’s situation offers a cautionary tale of the limits of large acquisitions and stock buybacks to generate long-term profitable growth. Despite its massive acquisitions and stock buybacks since 2000 at the expense of investments in organic growth Pfizer has emerged as a smaller, less profitable company whose market value has declined by $160 billion (-45 percent).
Is there is a better way to manage for long-term profitable growth? This question has been hotly debated for years, with many observers asserting that too many companies have been managing for short-term results, emphasizing cost control and stock buybacks at the expense of investments future growth. New research, led by a team from the McKinsey Global Institute found that companies that operate with a true long-term mindset have considerably outperformed their industry peers since 2001 across almost important every financial measure.
The research team analyzed the operating metrics of 615 non-finance companies that reported continuous results from 2001 to 2015, and whose market capitalization exceeded $5 billion in at least one year. To distinguish between companies that exhibited a short- and long-term management mindset, researchers analyzed five operational and business performance indicators.
The analysis concluded that 27 percent of the sample were managed for the long-term relative to their industry peers over the entire study horizon or clearly became more long-term oriented between the first and second half of the study horizon. The remaining 73 percent of companies exhibited evidence of short-term management priorities. The preponderance of management short-termism reflects growing pressure executives feel to hit near-term targets. A recent executive survey reported that 87 percent of executives and directors feel most pressured to demonstrate strong financial performance within two years or less, 65 percent say short-term pressure has increased over the past five years, and 55 percent of executives and directors in companies lacking a long-term culture say they would delay a new project to hit quarterly targets, even if it sacrificed long-term value.
But this bias for short-term results is misguided. The difference in financial performance between companies managed for short- and long-term growth is striking. Among the firms identified as focused on the long term, average revenue and earnings growth between 2001 and 2014 were 47 percent and 36 percent higher, and market capitalization grew 58 percent faster as well.
The returns to society and the overall economy were equally impressive. Companies that were managed for the long term added nearly 12,000 more jobs on average than their peers over the study horizon. MGI calculated that U.S. GDP over the past decade might well have grown by an additional $1 trillion if the whole economy had performed at the level the long-term stalwarts delivered — and would have generated more than five million additional jobs.
Nearly 65 years ago, GMs CEO Charlie Wilson stated “what was good for the country was good for General Motors and vice versa.” But Wilson’s equivalence between corporate and national welfare is only true if executives effectively manage their enterprises with a long-term mindset committed to continuous innovation, meaningful product differentiation and a corporate culture that promotes corporate agility and market responsiveness.
 Data for four year period, 2011-2015, latest full year for which capex data is available
After 40 years in management consulting and venture capital, I joined the faculty of Columbia Business School, teaching courses in business strategy and corporate entrepreneurship
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