Roger Martin is the Dean of the Rotman School of Management at the University of Toronto, in Canada. In 2011, Roger Martin was named by Thinkers 50 as the sixth top management thinker in the world. He is the author of several best-selling books like The Design of Business: Why Design Thinking is the Next Competitive Advantage (2009), The Opposable Mind: How Successful Leaders Win Through Integrative Thinking (2007) etc. His latest book is Fixing the Game, Bubbles, Crashes, and What Capitalism Can Learn From the NFL (2011) in which Martin argues that there is a lot capitalism can learn from the world of sport. In this interview he speaks to Vivek Kaul.
Your book “Fixing the Game” is essentially a criticism of western capitalism. What’s the central idea behind the book?
The central idea is that capitalism made a conceptual error when it asserted that the interests of executives would be aligned with those of shareholders if executives were given stock-based compensation. It was a simple and elegant theory – that if shareholders did well, so would executives and if shareholders did poorly, so would executives – but it turns out to produce the exact opposite. Overall, shareholders have done less well and CEOs have done spectacularly better. There has been dis-alignment, not alignment. The current theory threatens the future of capitalism. It produces inauthenticity in management, volatility in the capital markets and contributes to the strength of forces detrimental to broad prosperity – in particular the hedge funds.
What is the game that needs to be fixed? And why?
The title is double entendre. It means that there are people manipulating, or in the betting parlance, ‘fixing’, the current game of democratic capitalism and we need to fix it in the sense of repairing it. It needs to be fixed now because the current game of democratic capitalism is being undermined. Capitalism can only take so much undermining until it is irreparably damaged.
One of the things that you talk about in your book is a real game and an expectations game. Can you take us through that?
The real game is the one in which real companies build real factories (or service operations), to make real products (or services), to sell to real customers, to earn real revenues and a real profit (or loss). The expectations game is the one in which investors look at the real market and, on the basis of that observation, form expectations as to the likely performance of the real companies and, on the basis of those expectations, buy or sell shares which collectively sets the prices of those companies in the stock market. Since stocks tend to sell for a large multiple of present earnings – 15 times earnings for the SENSEX over the long term – most of the value of a given stock is in the expectations of future earnings rather than the reality of the current earnings.
What can capitalism learn from sport?
Capitalism can learn a lesson from all of modern sport – whether American football or Indian cricket for that matter. Each major spectator sport actually involves a real game and an expectations game. In the real game of cricket, batsmen, bowlers and fielders take a real pitch and play real wickets, make real outs and score real runs. Eventually there is a real winner and real loser. There is an associated expectations game: betting on cricket matches. In this game, betters imagine what will happen when the teams take the field and on the basis of those expectations place their bets. On the basis of those bets, bookmakers adjust the odds against the favorites and for the underdogs to balance the amount of money bet on either side.
So what are you trying to suggest?
The betting odds in a cricket match are identical to the stock price in capitalism – both are products of the expectations market. But that is where the similarity ends. The world of sports is clear about the relationship between the expectations market and the real market: they must be kept separate. If they are not kept separate – i.e. if players in the real game are allowed to participate in the expectations game, they will wreck the real game. Cricket fans know that from the 2010-1 betting scandals in cricket in Pakistan. There key players were accused and tried for influencing the results of real games to aid bettors in making illegal profits in the expectations game. In great contrast to the world of sport, capitalism not only allows, it insists on the key players in the real market also playing in the expectations market. CEOs and other key executives are forced to take a significant portion of their compensation by way of stock-based compensation. In doing so, capitalism threatens the health of the real game. On this front, capitalism is not as smartly managed as cricket.
How does this entire idea of “real game and expectations game” contribute to the kind of volatility we have seen in the last ten years?
When executives have substantial stock-based compensation incentives, they focus on managing expectations rather than managing the real operations of their company. If an executive is given a stock option with an exercise price at the existing trading price of the stock (the way the vast majority of stock options are priced and given), the only way that option will have any value for the executive is if he or she raises expectations of the future earnings of the company to a higher level than what they are at the time of the stock option award. That means if expectations are already high, then the executive needs to take actions to prod those expectations even higher still – even it is takes extreme actions. And because expectations cannot rise forever because they get ahead of reality, executives know that the most profitable thing that they can do for themselves is jerk expectations up and then leave before they come plummeting back down. This creates wild swings in the capital markets of the sort we have seen in the past decade.
Could you give us an example on how this real and expectations game would play out in a company like Google and Microsoft for that matter?
At Microsoft, its stock dropped dramatically after the dot.com meltdown like many other technology stocks. But thereafter, Microsoft spent the next decade doubling its sales and tripling its profits for an entire decade. Despite that spectacular performance, Microsoft stock price stayed flat over the entire decade. That is because expectations were already high at the start of the decade and even with impressive growth and profit increase, Microsoft couldn’t increase expectations. Similarly, Google recently reported a large increase in sales and profits yet experienced a drop in its stock price because it didn’t meet its expectations. Both demonstrate how the real and expectations markets often diverge.
What about a company like Procter and Gamble?
Like all companies, P&G faces similar schisms between expectations and reality. At times, expectations get too high and then fall too low. However, this is less pronounced at P&G because it has a culture of focusing more on the real market than the expectations market which has served it well over time.
So how do we separate expectations and reality in business?
It is impossible to completely separate expectations from reality. Humans cannot help but form expectations; even animals do. If you feed a pet dog at the same time of morning for a week, it will be pawing at your bedroom door at that exact time the next time you sleep in past the usual time. However, one form of expectations is dramatically more damaging and those are the expectations of hordes of investors, especially hedge fund managers and high frequency traders. Only publicly-traded companies are exposed to the detrimental effects of that form of expectations. The best way to avoid exposing your company to the expectations market is to be a private company – like Cargill or Koch Industries. Facebook prospered for a number of years as a private company, then went public and felt the wrath of the expectations market. It is unclear whether Facebook will be able to pursue its strategy as a public company in the way it did as a private company as it faces investor wrath for having its stock price plummet after its IPO.
One of the things that comes out in your book is that despite all the regulations that have been put in place after the crisis of 2008, you still feel that it’s only a matter of time before another crisis hits us. Why do you say that?
I do not believe that the regulations that have been put in place or are being put in place the cause of the last two crashes. The theory of Sarbanes-Oxley was that lax boards and audit committees and conflicted auditors caused the dot.com crash and the Enron/WorldCom/Aldephia, etc. scandals. And theory of Dodd-Frank is that excess bank leverage and mixing of commercial banking and investment banking caused the subprime meltdown. I do not believe that those theories are even remotely accurate. In my view, inappropriate mixing of the real market and the expectations market contributed centrally to both crashes and neither Sarbanes-Oxley or Dodd-Frank address that problem. For that reason, I think that the risk of another crash continues to build. All I am confident of is that the next crash won’t be because of an Internet-bubble or sub-prime residential mortgages. Any other cause is as likely to precipitate a bubble/crash as it was before the various regulatory changes.
This entire about paying CEOs well in terms of the stock of the company was put forward by Michael Jensen in the 1970s. And it was lapped up left right and centre. What was the reason behind its popularity?
I believe that it was lapped up because it was incredibly simple and compellingly logical. The alignment theory sounds so lovely – shareholders and executives win together and lose together. It was so easy to understand that people gobbled it up rather than first asked themselves to work through the consequences of it in a more sophisticated way. Essentially they ignored a logical fallacy. The theory held that executives were gaming the system to their own advantage but implicitly assumed that they would stop gaming the system to their own advantage after the proposed change. There is nothing to suggest that such a behavioral change would occur – and indeed they have kept on gaming!
How was it responsible for the current state of things?
The central thrust of the Jensen argument was that the real market needed to be wedded directly to the expectations market through stock-based compensation. The minute those two markets were tied together, democratic capitalism was changed from an enterprise that was primarily focused on building value in the real market to one primarily focused on trading value in the expectations market.
What went wrong with that idea?
The tool was wrong. Attempting to increase shareholder value over the long term is not a bad idea. Utilizing the short term stock price as a perfect measure of long term shareholder value was the error. This enabled craven executives and hedge fund managers to exploit the schism between the short term measure of shareholder value and the long term creation of shareholder value.
So is banning stock options a way out? Has any company done it?
Many companies have moved from utilized stock options as their form of stock-based compensation to deferred share units or restricted share units, which are in essence synthetic versions of the underlying stock which go both up and down with the movement of the underlying stock. They are an improvement over stock options because they result in the executive feeling both the downside and upside of stock movements rather than only the upside. However, it still focuses the executive on the expectations market. There is a trend toward deferring them for longer periods which also makes it harder for the CEO to exploit short-term movements. But no public company of which I am aware has banned stock-based compensation entirely.
So what is way out? You talk about boards rewarding their employees based on real outcomes and not expectation oriented outcomes. Could you elaborate through an example?
Real outcomes are things like market share, return on invested capital, customer satisfaction, etc. The most important real outcomes vary by company and depend on the company’s context. Most companies use these measures as part of their compensation structures. What needs to happen is for companies to raise these measures from part of their incentive compensation packages to 100% of them.
The interview was originally published in the Daily News and Analysis on October 8,2012.
(Interviewer Kaul is a writer. He can be reached at [email protected])