Load up our investee companies with more costs – for higher returns

2018’s value creation working group ended the year by settling on a definition:

value creation is an increase in the stock of monetary and non-monetary resources used to create future wealth and well-being for stakeholders, as judged by observers, mindful of the passage of time.

There is a lot in that definition and here is not the place to unpick it (the interested reader can refer to our paper, Mission critical). What I do want to explore here is whether at least one aspect of value creation might be counter-intuitive: – could more cost lead to higher returns?

Just as success has many fathers, this thought also has several contributors. In addition to the working group mentioned above, there is Larry Fink’s 2019 letter to CEOs[1] and, back in 2014, the work of Eric Beinhocker and Nick Hanauer[2].

The Fink letter

In his seventh annual letter to CEOs[3], Larry Fink raises a number of noteworthy issues, but I will focus on only one of them. Fink exhorts the CEO recipients to step up, noting that “the world needs your leadership”. He acknowledges that companies “cannot solve every issue of public importance, but there are many – from retirement to infrastructure to preparing workers for the jobs of the future – that cannot be solved without corporate leadership.” In particular Fink singles out retirement, stating that “companies must embrace a greater responsibility to help workers navigate retirement … [to] create not just a more stable and engaged workforce, but also a more economically secure population in the places where they operate.” For the purposes of this thought piece I am going to read this as a call for companies to voluntarily increase their costs.

The Hanauer contribution

Nick Hanauer had the good fortune to be born into a wealthy family, and the even better fortune to be friends with Jeff Bezos – allowing him to become the first non-family investor in Amazon. Refreshingly, Hanauer recognises this good fortune and acknowledges that, had the accident of his origins been different, he would likely be selling fruit at the side of a road in Africa. His contention is that the current extreme inequality shows that capitalism isn’t working (as well as being dangerous for him and his fellow ‘zillionaires’). A polarisation of an economy into a small number of extremely rich people and a vast number of poor people guarantees that most businesses will have few customers.

In 2013 he wrote an article entitled The Capitalist’s Case for a $15 Minimum Wage[4] (approximately double the US federal minimum wage at the time). The backlash was predictable: if the price of labour goes up, the demand for labour (employment) will go down. Hanauer’s reply was that CEOs used to earn 30 times the median wage, but now earn 500 times and yet there are no fewer of them; in fact, there are probably more senior executives now. The typical capitalist wish is for rich customers and poor workers, which might work at the micro level, but at the macro level the workers are the customers[5]. About a year after his article the city of Seattle passed a $15 minimum wage and, contrary to predictions, the restaurant trade flourished; – waiters could afford to go out for dinner. So again, this is about raising costs on companies for the benefit of the economy – albeit through compulsion.

Are we aiming at the right goal?

The Fink and Hanauer contributions are suggesting there is a positive payoff to increasing costs (sounds a bit like investing now for future returns!). Yet this appears so counter-intuitive because it does not fit with the prevailing assumption that success is about efficiency and productivity; making more with less. But surely success is more about prosperity – the wealth and well-being in our opening definition.

If prosperity is the right goal, then we are changing the role of the corporation away from Milton Friedman’s view that its social responsibility is to increase its profits. Can those of us subject to fiduciary duty consider such a shift? While the financial return must come first, investment has always been a three-dimensional problem of risk, return and impact. Business and economic decision making has always had moral and ethical impact even if we have chosen (or been forced) to exclusively consider the monetary impacts.

By viewing the production of portfolio returns in a wider frame and over a longer horizon, we can quickly see that driving up the return on capital by driving down the cost of labour is unlikely to be long-term successful. The workers, the customers and the end savers are, at the macro level, the same people. We do not benefit the end saver by giving them a higher short term return if we weaken their human capital. This could be presented as a moral case. Fortunately, given the requirements of fiduciary duty, it can also be presented as a case of enlightened self-interest for any investor seeking to produce long-term sustainable returns.