Stakeholder vs. Shareholder Capitalism: What Is Ideal Today?

Watch our analysts debate whether Milton Friedman's views hold up

Haywood Kelly, CFA 29 December, 2020 | 4:28AM
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Haywood Kelly: At Morningstar, we're proud that our research teams not only operate independently but that our analysts are encouraged to explore ideas and raise contrarian viewpoints. The enemy of any research organization is groupthink. A research organization needs to hire people who aren't afraid of challenging the status quo and who are always thinking about how to foster a culture where people feel comfortable speaking up and encouraging us all to think harder and sharper.

And we debate just about everything. Is the market overvalued? Should private equity be allowed into retirement plans? What categories are most suited to active investors? How much should an annuity cost? And I'd say one of the hottest areas of debate these days is ESG. Does ESG help or hurt investing performance? What ESG risks are truly material to cash flows? What should be included in a "globe rating," and on and on.

Within the field of sustainable investing and with it evolving so rapidly, there is really no facet that we don't debate. And today, we've asked a group of researchers from across Morningstar to represent opposing sides of a particular ESG argument. But we didn't have to look far for one that's taken centerstage in 2020. 

Today, we're going to be debating the merits of stakeholder capitalism on the one hand and shareholder capitalism on the other. Stakeholder capitalism is the idea that companies should look to serve all stakeholders, not just shareholders but also customers, employees, suppliers, and local communities. Shareholder capitalism, on the other hand, is the view that companies should focus exclusively on serving in the interest of shareholders, the owners of the stock of the company.

In our debate today, we're going to focus on the most famous articulation of shareholder capitalism, an article by economist Milton Friedman from the University of Chicago, which appeared in The New York Times in 1970. Friedman said in that article, and I quote, "The discussions of the 'social responsibilities of business' are notable for their analytical looseness and lack of rigor. In a free‐enterprise, private‐property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom."

So, on the one hand, you have Friedman arguing for shareholder capitalism and on the other, many would argue for a form of stakeholder capitalism where the interest of other stakeholders--like I said, employees, customers, communities--receive as much attention as the interest of shareholders. 

The question to our debaters today is do you agree or do you disagree with Friedman's sentiment? Today, we're going to settle that matter once and for all--well, maybe not once and for all, but we'll try.

We've assembled two teams today. The first team, Team Agree, will take the side of Friedman in this debate arguing that shareholder capitalism is the ideal. And Team Disagree, on the other hand, will argue against this notion and for stakeholder capitalism. Now, first, we'll have our debaters introduce themselves. Let's start off with Preston on Team Agree.

Preston Caldwell: Hi, all. I lead economics research for Morningstar Equity Research.

Kelly: Next up, on Team Disagree, we have Wilco.

Wilco van Heteren: Thanks, Haywood. My name is Wilco van Heteren. I'm from Sustainalytics, recently acquired by Morningstar. I head up the enhanced ratings team, which focuses on Sustainalytics' flagship product, the ESG Risk ratings.

Kelly: Thank you. And back to Team Agree, we have Nizar.

Nizar Tarhuni: Thanks, Haywood. I'm Nizar Tarhuni. I'm director of research & analysis at PitchBook Data, and I lead the institutional research groups focused on private equity, venture, M&A, and emerging technologies.

Kelly: And then, finally, for Team Disagree, we have Alyssa.

Alyssa Stankiewicz: Thank you, Haywood. My name is Alyssa, and I've been a manager research analyst on the multi-asset and alternatives team for nearly a year. Prior to that, I completed my MBA in sustainability. So, I'm very much looking forward to today's discussion.

Kelly: Great. Thank you, participants. Now, each of you will have two minutes to make your opening remarks and then we'll enter into a question period when I'll ask questions to each team. Then each team will ask the opposing team a question they've devised ahead of time. Debaters will have one minute for closing remarks. All right. So, first off, each of you will have two minutes to give your opening remarks. I've got a timer on my phone here. So, we're going to keep to a strict time limit. So, Nizar, why don't you kick us off for Team Agree?

Tarhuni: Thanks, Haywood. As Haywood mentioned, Milton Friedman advocates that the sole responsibility of a corporate executive is to act in the best interest of her employers, which generally will be to maximize shareholder value. However, we feel there appears to be a common misperception that these efforts leave no room for social responsibilities to be considered in the mind of the corporate executive. While we do believe that fewer social responsibilities should not be the primary focus of an executive to the extent that they reduce shareholder value, we live in an expanded business climate where executing on social initiatives can serve as key growth strategies that can indeed ensure higher returns to shareholders and corporations enacting such activities. In fact, Milton Friedman does provide multiple examples of this in his initial doctrine, specifically he states and I quote, "It may well be in the long‐run interest of a corporation that is a major employer in a small community to devote resources to providing amenities to that community or to improving its government."

We argue that there appears to be a false dichotomy present, and that the achievement of social responsibilities and corporate profit responsibilities are not actually mutually exclusive in present day economics. Milton Friedman rightfully also recognizes that the situation of the individual proprietor is somewhat different, then he explains that, should a sole proprietor act to reduce returns in order to exercise his social responsibility, he is spending his own money and not someone else's. Yet today, the owners of many companies, both public and private, include significantly more ownership layers than in the times of which this doctrine was initially written. Fund structures, both those that invest in public and private securities, are backed by diverse investor groups that are investing on behalf of municipalities, colleges, university endowment schemes, blue collar pension systems, and teacher and public servant retirement schemes in addition to many charitable foundations looking to grow wealth in order to benefit their various social activities.

And so, as a result, in today's environment, the social good is more baked into the fabric of corporations now than what may have been the case through the mid-20th century. And as there are today a plethora of shareholders who are leveraging their investments to directly fund their public or nonprofit activities, we argue that corporate activities on maximizing profit actually help the social good.

Kelly: Thank you, Nizar. Next, we're going to turn to Alyssa on Team Disagree and, again, two minutes.

Stankiewicz: Thank you. I'd like to argue that Friedman's remarks aren't really relevant to what sustainable investing and stakeholder capitalism are about today, and in a few minutes, you'll hear my colleague question whether or not they were ever relevant. There are three main reasons for my position.

First, what Friedman and his supporters usually argue against is more appropriately termed values-based investing. These are the strategies that screen out "sin stocks" such as pharmaceutical companies that manufacture birth control but are no expense to investors. But what we see today is that sustainable investing has evolved far beyond that to focus on the combined interests of shareholders and stakeholders. 

ESG strategies target the relevant risks and opportunities that aren't discernible from earnings reports. That's why you're hearing so much about financial materiality. As Khan, Serafeim, and Yoon wrote in a 2015 paper from Harvard, the research shows that "firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues, suggesting that investments in sustainability issues are shareholder-value enhancing." To reiterate, investments in sustainability issues are shareholder-value enhancing. Engaging stakeholders and minimizing externalities is not about feeling good; it's simply good business.

Third, bringing it back to Friedman, there's no concrete proof that prioritizing stakeholders such as employees, your supply chain, or the environment has ever led to a reduction in shareholder value. Rather, those companies that proactively engage with stakeholders are those that innovate ahead of the competition, driving strong shareholder returns for years to come.

Kelly: Super. Thanks, Alyssa. Now, we're going to turn back to Team Agree and Preston for your comments.

Caldwell: Well, first off, I would state that based on the first points made by the opposing team, I'm not sure if they have anything to disagree with Friedman about. I mean, if ESG is about financial outperformance and creating shareholder value, then it sounds like they're in perfect agreement with Friedman.

Now, I think we drastically undersell what the unabashed pursuit of profit or shareholder value can achieve. So, let's talk about some of the things that we care about in the social world. First, cheaper and better products. The pursuit of profit motivates companies to offer cheaper and better products so they can beat their competitors, and that benefits everyone. Second, innovation. Virtually the same argument applies, and yes, innovation can be disruptive to certain so-called stakeholders--maybe it puts some employees out of work. But innovation is indispensable to long-term economic progress. If Henry Ford had been worried about all of the horse-drawn carriage workers he was going to make unemployed thanks to his creation of an affordable automobile, maybe he would have never done it.

Next, how about higher real wages? The only way to generate sustainable growth in real wages is growth in productivity, and that entails reallocating labor and other resources to their best use, and that's best incentivized by the pursuit of profit. 

Finally, how about boosting diversity? Pursuing profit means that we reward workers according to how well they can do the job, not according to personal characteristics, and managers who discriminate and violate that principle are actually failing their shareholders.

Underlying all of these points is a common theme, and that's in our free market system, pursuit of profit delivers positive-sum outcomes that in general are in the best interest of society as a whole. And that's what's wrong about the stakeholder view is that it tries to make the economy into a zero-sum game, where always one side wins and another loses. That runs in contrast to our entire historical experience of rising economic outcomes for society as a whole. It's not about shareholders winning at the expense of stakeholders. It's about how do we deliver the most long-term prosperity for everyone, and pursuit of profit or shareholder value is the best single means we have to accomplish that.

Kelly: Right on time. All right. Finally, we're going to turn back to Team Disagree and Wilco for his opening comments.

Van Heteren: Thanks. Thanks for the interesting contributions so far. The way it was formulated in the 1970s is a form of shareholder capitalism that I don't agree with. So, Friedman suggests that companies and societies are disconnected spheres almost, and of course, they are not. Society consists of individuals. These individuals relate to each other informally--family and friends--or formally--like governments or courts or companies. And in my view, every single actor in society, be it an individual person or a company, an institution, can and should act in the interest of society.

So, moving from companies to shareholders, in classical economic theory, the purpose of investing was to generate economic activity. The focus on shareholder return is much newer. Too much focus on shareholder return puts too little emphasis on the classical purpose of investing and that was to generate economic activity--to which I would add--economic activity that is beneficial to society.

Now, time is an important factor, so there is short term and there's the long term. Shareholders with a long-term horizon like pension funds want to make sure that they have a universe of companies to invest in, let's say, 50, maybe even 100 years from now. Focusing on short-term returns forces investee companies to focus on the short term as well, and that might not be good for that universe of companies 50 to 100 years from now. We've seen examples of where short-termism leads to disasters like Enron 20 years ago or look at what happened with the financial crisis in '08 and thereafter and look how disturbing that was for society.

Kelly: Very good. Thank you, Wilco. All right. Now, we're going to turn to myself asking each team a question. I'm going to start off with Team Agree, so the team that agrees with Friedman. Picking up on Wilco's last comment, you often hear that shareholder capitalism might lead to too much focus on short-term profits and the short term, whereas stakeholder capitalism is more long-term-focused. And some of the most trenchant critics, I'd say, of shareholder capitalism argue that it's led to some perverse outcomes, so some managerial compensation schemes, for example, that claim to align managers of companies with shareholders but really just give a lot of stock options, say, to executives and really incent them to focus on, say, quarterly profits to jack up the stock price and get those big options awards.

Let's hear from Team Agree. Do you agree that shareholder capitalism is more short-term than stakeholder capitalism?

Caldwell: I'll go and kick this off. So, I don't agree with that premise at all. I think if you're maximizing shareholder value, you're considering the full long-term path of cash flows, and that's something that many investors and many people in the investment community like Morningstar focus a lot on is, How do we maximize not only short-term profits but long-term? So, there's nothing in focusing on the long term that's inconsistent with the Friedman view. And the notion that this Friedman view is a license to infamous episodes like Enron is ridiculous, I think.

And I would make the contrary point that if we're worried about governance, then I am very much worried about the idea that we're going to dispense with profit standard. I think the idea we're going to look at profit in conjunction with these other goals is very risky because, with maximizing shareholder value, we have a clear and simple standard to hold managers accountable and one that is in general optimal for maximizing welfare for society as a whole. And this shouldn't be taken for granted. I will tell you for much of U.S. history, corporate governance was atrocious, and it's still a problem in many emerging economies today. And so, I'm worried that corrupting the shareholder value standard will give a license to corporate manager malfeasance and incompetence and undermine a key part of the engine of our economic progress.

Kelly: Thank you, Preston. All right. Well, turning to Team Disagree and picking up on Preston's last point: One advantage you could argue of shareholder capitalism is it's a pretty clear yardstick in terms of measuring success, whereas stakeholder capitalism, maybe it's a little fuzzier. And just to name a few examples: If a company is faced with a decision to build a nuclear power plant, is that good or bad? There's debate around that. Is laying off workers in one country bad if you hiring an equivalent number somewhere else? If you're an oil company, should you scale back production to protect the environment, even if that means laying off people and harming the local communities where those refineries or whatever are located? So, it's just tougher to judge success there. 

To Team Disagree, those of you who disagree with Friedman: Stakeholder capitalism--does it give companies any clear guidance on how to actually behave?

I can take this. So, thank you. I think it's a great question. I think that most often you see this in an example such as an oil and gas company, or another example I thought of recently was Philip Morris, and how should a company management operate when they recognize that their core business operation might be in direct disagreement with stakeholder capitalism and there's obvious risks associated with their company operations. And I think what I would suggest to the leaders of a company like Philip Morris is not that you think in the short term, sort of, as Wilco is mentioning, but think in the longer term and look at all of the direct financial implications of your current business model and look for a way to innovate ahead of the competition.

I think the idea that stakeholder incentives and what Preston was talking about with the lack of clear guidance, I don't think that that's necessarily a fair dichotomy to suggest. And I would reiterate, or sort of, retort: You mentioned that in the majority of U.S. history, corporate governance has been atrocious. And I guess I'm curious to know how you think Milton Friedman helped on that topic, because I think that taking into account the broader stakeholders actually leads to a much clearer picture of a long-term strategy for a company.

Kelly: All right. We're at time. Thank you, Alyssa. All right. Now, we're going to move into the section where we allow each team to ask the opposing team a question. And then, you have, let's see, 30 seconds, I think, to respond. 

Let's start off with Team Disagree, so those that disagree with Friedman, can you please ask your question to Team Agree?

Stankiewicz: I'd be happy to. So, along the same lines that we've been talking about, there's always this question of whether or not prioritizing stakeholders is disadvantaging--or sorry--prioritizing shareholders is disadvantaging stakeholders, and I feel like that's clear. But in the reverse, can you talk about a time when prioritizing stakeholders actually led to a reduction in shareholder value? Where is the proof of that trade-off?

Caldwell: Well, I would just say it depends on how you define "stakeholders." Again, if stakeholders are the blacksmiths that are being unemployed in your local community because you're making advancement in metallurgical technology, then that would be an example. If it's assembly-line workers here being cut out by automation, which leads to productivity, which leads to long-term economic growth and higher real wages, then that's an example where the interests of a few privileged stakeholders actually runs against not only the interests of shareholders but the interests of society overall. And so, those are pretty clear examples in my mind.

Tarhuni: I'd just add that one of the arguments we make and I think that gets misconstrued from Milton Friedman himself is that it's not that all social good or focusing on the stakeholders is necessarily poor, but focusing on that in places where shareholder value is going to be eroded, that's where that shouldn't be a thing. And I think there's countless examples also where social good and stakeholders are being put forth as long as that also helps the profit motive of the corporation, and I think that added scale across the economy actually adds a lot more value for various stakeholders in the economy.

Kelly: All right. Based on those answers, Team Disagree, would you like to respond?

Van Heteren: I can respond to that. I still think in the end "What is the interest of the shareholder" is still an open question. So, I think economic returns are often, too often, I think, still understood as monetary returns, and I think it's about to shift to a paradigm where we also look at societal impacts on our planet. And there will certainly be alignment. And I think discussion already shows that there's maybe much more alignment today with all these interests than maybe in the '70s where there was like a big stride to oppose capitalism from communism, for instance, there's a big historical component to that. But I would say an economic system that looks at any impact an economic factor has on the planet and on society and defines shareholder return around that impact too is the way forward.

Kelly: Thank you, Wilco. Now, let's turn it over to Team Agree to ask their question of Team Disagree.

Caldwell: The question is: Let's get into the nitty-gritty. How do you propose to weight these other goals than shareholder value, and who in a corporation decides what the weights are, and who gets the privilege status of being a stakeholder?

Van Heteren: I think that I can start responding to that, too. That's a great question, and that's a whole field of economic thinking that is highly in motion. And I think I can further to my previous argument around trying to measure impact that a company has on society, on the planet, and also define shareholder interests around that type of impact. And indeed, if you look at sustainable investing, how it's moved from screening out companies to getting involved in with the company that you're investing in, et cetera, also, the entire space of what topics you're looking at has also evolved. So, I think, classically speaking, stakeholders are employers, are local communities where companies are operating, suppliers. So, there's a list of classical players, if you will. But you can also add to that the consumers, politicians, lobbyists, whatever. I would say sustainability is about lifting the entire platform higher where the actors on the platform are all these stakeholders, like companies, employers, suppliers, basically everybody. We should make an effort to, together, lift the platform higher so that all benefit.

 Thank you, Wilco. Team Agree, would you like to respond?

Caldwell: I would just respond that it happens that we already have a pretty good standard for evaluating the needs of various connected actors in society, which is profit, because it sends a signal of the various interests and welfare of everybody in the society. And look, I'm not trying to argue that the pursuit of profit is always perfect. In fact, I'm very supportive of the idea there are certain problems that have to be addressed not by the market, but by government. Climate change is a textbook example. It's what in economics we call a "market failure." But the best way to address that is with government policy, ideally a carbon tax.

The way not to deal with problems like climate change, I think, is to create a bubble of inflated expectations about what private economic actors can do on their own because the bubble won't last forever. And once it bursts, what are you left with? You don't have a sustainable policy to address this issue.

 Thank you. All right. Well, we're in the final stretch now. Debaters, you'll now have one minute each to make your closing remarks. 

So, Alyssa, why don't we start off this time with you and Team Disagree?

Stankiewicz: Thank you, Haywood. In closing, I would like to reiterate that stakeholder engagement isn't just about feeling good--it drives innovation and superior shareholder returns. Let's take, for example, Ben & Jerry's whose loyal customer base isn't driven by the ice cream itself, but instead by the social initiatives the company supports. All of the milk for their ice cream comes from farms in Vermont, many of which are struggling from soil degradation. So, Ben & Jerry's is leading research on regenerative agriculture. It supports the community they operate in, and it ensures the viability of their supply chain in the long term. Furthermore, there is no negative impact to investor returns. While oil and gas companies have a myriad of ways to inflate returns in the short term, investors care about the long term, and like it or not, our society is becoming more interconnected. Better to engage those stakeholders sooner than later for the sake of investors.

Kelly: Thank you. All right. Let's turn it over to Nizar.

Tarhuni: Thank you. So, I think corporate growth has undoubtedly underpinned both global economic and public sector growth for decades. And while the idea that corporate earnings can only be achieved at the expense of broader social or sustainable responsibilities, you know, we argue that our economies and financial markets have never been more connected than they are today in present day. So, as a result, we see the focus of executives on corporate earnings and shareholder value actually is the most clear and best strategy to maximize the funding for social and sustainable initiatives in public good. It's imperative that we recognize that there is this false dichotomy present that exists between financial and social incentives and as well as a dispersion of shareholders that rely on corporate earnings so that we don't fall into a trap that actually hinders the various social activities that we can help fund with corporate profit.

Kelly: Thank you. All right. Let's go back to Team Disagree and Wilco.

Van Heteren: Yeah, thanks. Thanks everybody for the debate. It makes me rethink a few of the things that I had in mind before. So, thanks for your contributions. My conclusion is that any economic actor from consumers, businesses, investors, us analysts, always have the choice to take a long-term holistic view on what in the end is good for society. And the 1970s' interpretation of shareholder capitalism has resulted in short-term thinking, which had itself damaging effects on the planet and on society--think of exhaustion of natural resources, biodiversity, think of the financial crisis again. So, it's time that we all see each other as being living beings on the planet, as human beings, everything else as being part of one holistic network. And as I said before, new economic theories are emerging based on that thinking, less adversarial "shareholders versus society" but more holistic.

All right. Thank you. And now, last but not least, Preston.

 Well, I would just observe we've had financial crises for at least 200 years and we've had much worse of a problem in terms of pollution, energy intensity, economy in the past, and noncapitalist economies have had far more problem with pollution like the Soviet Union and China's semicapitalist, semisocialist economy today than free market economies have. And I want to make a simple observation. Today, in 2020, the average U.S. citizen is roughly 6 times richer than they were 100 years ago, perhaps 25 times richer than they were in 1800. And likewise, for the world, I'll quote Brad DeLong, who is far from a free market ideologue. He says, "Even lower middle-class households today in relatively poor countries have standards of living that would make them the envy of the powerful and lordly of centuries past." Suffice it to say, our lives have changed beyond recognition for the better, and at the heart of that growth, which has made everyone better off, is the pursuit of profit, which today translates into shareholder value. Imagine how much better things will be 100 years from now. Do we really want to forsake the principle that has been at the root of that progress? I think not.

Kelly: All right. Thanks, Preston. And thanks to all our debaters for a very thoughtful discussion. It was great. We hope all of those watching were able to learn something about each of the different philosophies here.

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Haywood Kelly, CFA  Haywood Kelly, CFA, is vice president of equity research at Morningstar. He'd love to hear from you, and promises to read all your e-mail (even if he can't respond to it all).

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