The Evolution of Capitalism

Last month was the 50th anniversary of Milton Friedman’s influential report titled ‘The Social Responsibility of Business is to Increase its Profits’, a mantra often heralded as the basis of the capitalist model used globally since, and now quite widely criticised as a cause of social inequalities and environmental externalities. The concept, as we are all aware of, was that business leaders should focus on creating as much value as possible for the owners of the company rather than on improving outcomes for a broader set of stakeholders.

Despite the growing concern about the impact of this form of capitalism, it still garners much support from corners of the investment and business community and not without some merit. As argued in a recent article by Alex Edmans, Professor of Finance at London Business School, Friedman never advocated that companies exploit stakeholders, but that it is legitimate for a company to focus on increasing profit because the only way to achieve this over the long term is through the consideration of all stakeholders. However, herein lies the first issue; investors’ time horizons have fallen significantly from multi-year periods in the 70s to a matter of months now. Inevitably corporate strategies will have been affected by investors who care more about short-term returns than long-term value.

The second challenge identified by Edmans is that Friedman assumes that it is possible to calculate the impact an investment in stakeholders has on company profit. Business theory covers well the decision-making process behind investing in, for example, a new factory – calculations can be made to come up with a Net Present Value (NPV) with reasonable confidence. This may not translate so well to whether to invest in a new gym for employees. The costs are simple to calculate, the benefits less so. Will the gym help to attract new talent? Will it result in greater encounters across teams and thus more effective teamwork? Will there be fewer sick days as a result of a healthier workforce? With the many greater uncertainties around this type of calculation, the hurdle for investments in stakeholders becomes too high.

The third issue is that Friedman’s theory assumes well-functioning governments. You only need to look at the deforestation in Brazil or the poor air quality in major cities in India to question this assumption. Governments cannot always be relied on to sufficiently price externalities such as pollution or finite resources such as water.

The result of these issues is that many corporations have been managed to achieve short term targets rather than long-term value, investments in stakeholders fall short, and companies have been able to pollute without paying for the damage. These issues with the prevailing model have fuelled increasing support for a new stakeholder model of capitalism, where companies are managed to create value not just for shareholders but for all stakeholders.

Last year the concept received high profile support from 181 CEOs of the largest corporations in the US through a statement of the Business Roundtable committing to ‘lead their companies for the benefit of all stakeholders – customers, employees, suppliers, communities and shareholders’. There has been much criticism of this statement since it became apparent that none of the companies involved had sought board approval for this so-called fundamental change, suggesting it was more a communication strategy than anything else.

This may be true, but it is not to suggest that the model is not making headwind. Many private companies already successfully pursue this paradigm, such as the family-run US snacks business Mars whose founders argued that the company’s sole purpose was the generate a ‘mutuality of benefits’ for the consumers, staff, suppliers, distributors and communities on which it depends. We recently wrote about Danone becoming the first listed company in France to become a so-called ‘enterprise à mission’, cutting through the rhetoric of sustainability and into accountable action.

What does remain a question is whether the motivation for the companies involved in the business roundtable statement, and others who support the stakeholder model, is to simply have a positive impact on stakeholders, or to have a positive impact on stakeholders in order to have a positive impact on long-term shareholder return? If it is the latter, then we have come full circle; companies understand that their impact on stakeholders will affect their long-term value and ultimately the value for shareholders. Stakeholder capitalism is this form is not so far from the original model outlined by Friedman, but adapted to correct for the flaws we have just outlined. For many investors, we believe, there is an element of both motivations in the pursuit of more sustainable investment, with many investors happy to limit their investment universe to exclude companies that make profits by stripping value from other stakeholders, no matter how profitable they might be for shareholders.

A final point is that throughout these evolutions, the most influential stakeholder remains the shareholder. Without the support of asset owners and managers in this evolution to consider all stakeholders, we are sure progression would be much slower, if happening at all. We as investors have a responsibility to invest with consideration of, and engage companies on, factors that affect all stakeholders. We do this because we are confident that companies that consider all stakeholders will create more value over the long-term, and that long-term investment best serves our investors as well as society.