This is the ninth in a series called Books We Trust.
A devastatingly important book was published last year, one that I think got lost in all the hue and cry of the market crash. I want to do my bit to fix that.
The book is Fixing the Game, by Roger Martin. Roger is Dean of the Rotman School of Management at the University of Toronto. Named the 6th top management thinker in the world by Thinkers 50 in 2011, his ideas are as clearly articulated as they are broadly based. Fixing the Game is his 6th book.
Capitalism and Major League Sports: Fixing the Game
Charlie Green: Roger, this strikes me as a huge book in management theory, and it reads beautifully. But it has not sold as well as it deserves. Do you agree?
Roger Martin: That is hard to say. It is a policy book more than a self-help or methodology book, so that has a somewhat smaller audience I think. I was disappointed that the sports press didn’t take notice! I gave them a lovely bouquet and they largely ignored it. But policy makers and in potential pension fund managers have taken lots of note.
Charlie: That’s good to hear. About the sports press, you start out with a great metaphor. The NFL has outperformed Major League Baseball on every dimension. That’s because football has been run for the fans, while MLB was run for the owners and players. In the long run, everyone wins if you manage for the fans.
The analogy in business would be to serve the customer. But rather than do that, as Peter Drucker suggested, we have bought into the shareholder value view of the world. We run companies for the owners and players, not the fans. And you show with real data – real companies like Google and Cisco, decades of shareholder performance across all industries – how this approach has failed.
We have fundamentally, basically, gotten it wrong. And we need fundamental, basic fixes. Is that right? And where did we first go off the rails?
Roger: We started off the rails with an innocent-sounding theory by way of a paper by Mike Jensen and Bill Meckling in 1976. It argued that we should align the interests of managers and shareholders by giving managers stock-based compensation. The simple and compelling idea was that with stock-based compensation if shareholders do well, so will managers and if shareholders do badly, so will managers.
That produced perfect alignment – or so we thought. Unfortunately, it had an unintended consequence of focusing management on the firm’s stock price rather than its real operations.
There are two important markets in the life of a firm – one is the real market in which it produces real products/services which they sell to real customers who pay them real money and they earn a real profit or loss. The other is the expectations market in which investors imagine what will happen in the real market in the future and on the basis of that make a decision to buy or not buy the firms stock – which results in a stock price.
Before stock-based compensation, the real market and the expectations markets were largely separate; with stock-based compensation, they became tightly linked.
There is a parallel in the world of sports. In the NFL, teams play a real game with real passes and runs, field-goals and touchdowns. There is a real score with a real winner and a real loser. There is also a linked expectations market – betting on football. In this game, the betters form expectations about what will happen on the field on the coming Sunday and bet accordingly. To balance the betting on either side of the game, the book-makers create a point spread which gives points to the underdog.
The point spread is the exact analog of a stock price. It is the level that results in equal money being wagered above and below the stock price/spread.
Charlie: The sports metaphor continues. Bettors on a game bet the spread; but we’re horrified if players play for the spread, not the game. In business, however, we’ve gotten to the point where management is incentivized by the spread – not the real game. Is business really a casino in that sense?
Roger: It has become one – and not for the better of the world, that is for certain.
In football, we know that teams can’t keep beating the spread forever. As they do well against the spread, the spread widens until the team will no longer beat the spread – as happened to the 16-0 New England Patriots. They beat the spread the first 8 games of the season and then went 2-6 against the spread while they won the remaining 8 games of the season on the field.
Stock-based compensated executives figured this out. They could only drive expectations and with them the stock price up for a relatively short period; then expectations would come crashing back down. So their personal profit-maximizing route was to drive up expectations until the breaking point and then get out before the expectations come crashing down – and then do it again and again.
That has made the market a casino and the CEOs are the house: they always win.
Charlie: Haven’t there been some warning signs along the way?
Roger: There were many – all ignored. The first was subtle. It had to do with beating analyst earnings expectations.
During the late 1980s and into the beginning of the 1990s, large American public companies met or beat earnings expectations 50% of the time – which is what would be expected. But by the mid-1990s, they were beating expectations 70% of the time, which was only possible only if CEOs and CFOs were manipulating expectations and earnings.
Then we had the dot.com bubble and bust, driven by option compensation. Then we had massive accounting fraud (Enron, WorldCom, Adelphia) that was designed to drive expectations. Then we had massive options backdating fraud, that was designed to help executives cash in on expectations.
We ignored all of this at our peril and the consequence of ignoring it was the subprime meltdown of 2008 – yet another expectations-based meltdown.
Why the Game of Capitalism is Broken
Charlie: This is larger than just individual greed, isn’t it? What are the aspects of business today that keep us locked in this casino mentality?
Roger: The focus on shareholder value maximization has sapped the authenticity of executives. They have become more focused on Wall Street analysts than on their customers. And they have become willing to sacrifice the welfare of their employees to attempt to meet the expectations of Wall Street.
This has resulted in increasingly cynical and distant customers; all who know they come after the shareholders in the pecking order. And the worst thing is that all of this manipulation of expectations has facilitated massive growth of the hedge fund business and hedge funds simply contribute to the casino mentality.
Charlie: Is this casino mentality of betting on the spread rather than the game partly responsible for the horrendous global economic situation we face now?
Roger: Indeed it is. The banks at the center of the subprime crisis all had senior leaders who knew very well the game that they were playing; as Chuck Prince put it, they all “danced until the music stopped.” And dancing meant taking ever-greater risks to meet expectations that were already so high that they couldn’t be met with normal business.
In the face of this situation, the banks created the world’s first infinitely-sized market: synthetic financial derivatives. Unlike all other markets, there is a limit to their size. There is only so much that can be produced and only so much demand because the product in question is real.
But synthetic CDOs can be created out of thin air – almost forever. That is how the banks forestalled the failure to meet expectations by several precious years – precious for their personal compensation. The problem was that in doing do, they created the worst bubble the world has ever seen – and we have been living with the consequences ever since.
Charlie: George Soros recently gave a speech that got a lot of play. He said we’ve failed partly because we thought we could think our way into success; we need to recognize that humans are fallible and design our world accordingly. Do you see a parallel with our obsession with shareholder value?
Roger: This is standard Soros stuff. He is a falsificationist who closely follows the work of Karl Popper and Imre Lakatos. So he doesn’t believe there is any absolute truth out there, just the best theory that has yet to be found wanting. And when the flaws of the best theory are found, they will provide the seeds for a still better theory – which will automatically be found wanting in due course.
As a consequence, whenever George sees everyone thinking the same thing, he thinks that it is probably, if not certainly, wrong. I assume that he is applying that thinking to the world of the quants at the banks who think their models are perfect but really aren’t.
I think he would argue that once everyone thinks that shareholder maximization is the ‘right’ approach, it almost certainly is wrong – and I certainly agree!
Charlie: Your insights are huge. Do you see them as supported by or integrated with other major thinking going on nowadays? Realignment of strategy? Global integrated reporting? Other thinking you find grounds for optimism?
Roger: Old theories die hard. I liken it to the story of peptic ulcers. For decades, the theory was that they were caused by excess stomach acid and patients were prescribed bland diets and anti-acids; and if that didn’t work, peptic ulcer surgery.
Two Australian researchers, Marshall and Warren, came to the conclusion that the reason that the treatments rarely worked was that peptic ulcers were caused by a bacterial infection – h pylori. Their views were wildly dismissed for the better part of a decade while patients continued to have their stomachs carved apart.
Only when Marshall ingested h pylori, grew a peptic ulcer and cured himself with antibiotics did the world decide to stop ruining patients’ stomachs with needless and damaging surgery. And twenty years after ingesting h pylori, Marshall (and his colleague Warren) won the Nobel Prize in Medicine.
Shareholder value maximization combined with stock-based compensation is an old and beloved theory that will probably take a decade to die because its proponents will continue to argue as they do today that the theory is sound; there are just problems with implementation. That is always the refuge of theory scoundrels!
Charlie: I wonder what is the financial equivalent of h pylori…Roger, many thanks for taking time with us, I do appreciate it.
Roger: And thanks to you as well.