{"id":1000,"date":"2012-10-08T01:18:39","date_gmt":"2012-10-07T19:48:39","guid":{"rendered":"http:\/\/teekhapan.wordpress.com\/?p=1000"},"modified":"2012-10-08T01:18:39","modified_gmt":"2012-10-07T19:48:39","slug":"capitalism-is-not-as-smartly-managed-as-cricket","status":"publish","type":"post","link":"https:\/\/vivekkaul.com\/2012\/10\/08\/capitalism-is-not-as-smartly-managed-as-cricket\/","title":{"rendered":"\u2018Capitalism is not as smartly managed as cricket\u2019"},"content":{"rendered":"

\"\"<\/a>
\nRoger Martin<\/strong> is the Dean of the Rotman School of Management at the University of Toronto, in Canada. In 2011, Roger Martin was named\u00a0by 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<\/em>\u00a0(2009),\u00a0The Opposable Mind:\u00a0How Successful Leaders Win\u00a0Through Integrative Thinking<\/em>\u00a0(2007) etc. His latest book is Fixing the Game, Bubbles, Crashes, and What Capitalism Can Learn From the NFL<\/em>\u00a0<\/em>(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<\/strong>.
\nYour book \u201cFixing the Game\u201d is essentially a criticism of western capitalism. What\u2019s the central idea behind the book?
\n<\/em>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 \u2013 that if shareholders did well, so would executives and if shareholders did poorly, so would executives \u2013 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.\u00a0 The current theory threatens the future of capitalism.\u00a0 It produces inauthenticity in management, volatility in the capital markets and contributes to the strength of forces detrimental to broad prosperity \u2013 in particular the hedge funds.
\nWhat is the game that needs to be fixed? And why?
\n<\/em>The title is double entendre.\u00a0 It means that there are people manipulating, or in the betting parlance, \u2018fixing\u2019, 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.\u00a0 Capitalism can only take so much undermining until it is irreparably damaged.
\nOne of the things that you talk about in your book is a real game and an expectations game. Can you take us through that?
\n<\/em>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).\u00a0 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 \u2013 15 times earnings for the SENSEX over the long term \u2013 most of the value of a given stock is in the expectations of future earnings rather than the reality of the current earnings.
\nWhat can capitalism learn from sport?
\n<\/em>Capitalism can learn a lesson from all of modern sport \u2013 whether American football or Indian cricket for that matter.\u00a0 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.\u00a0 There is an associated expectations game: betting on cricket matches.\u00a0 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.
\nSo what are you trying to suggest?
\n<\/em>The betting odds in a cricket match are identical to the stock price in capitalism \u2013 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 \u2013 i.e. if players in the real game are allowed to participate in the expectations game, they will wreck the real game.\u00a0 Cricket fans know that from the 2010-1 betting scandals in cricket in Pakistan.\u00a0 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.\u00a0 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. \u00a0On this front, capitalism is not as smartly managed as cricket.
\nHow does this entire idea of \u201creal game and expectations game\u201d contribute to the kind of volatility we have seen in the last ten years?<\/em>
\nWhen 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 \u2013 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.\u00a0 This creates wild swings in the capital markets of the sort we have seen in the past decade.
\nCould 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?<\/em>
\nAt Microsoft, its stock dropped dramatically after the dot.com meltdown like many other technology stocks.\u00a0 But thereafter, Microsoft spent the next decade doubling its sales and tripling its profits for an entire decade.\u00a0 Despite that spectacular performance, Microsoft stock price stayed flat over the entire decade.\u00a0 That is because expectations were already high at the start of the decade and even with impressive growth and profit increase, Microsoft couldn\u2019t increase expectations. Similarly, Google recently reported a large increase in sales and profits yet experienced a drop in its stock price because it didn\u2019t meet its expectations.\u00a0 Both demonstrate how the real and expectations markets often diverge.
\nWhat about a company like Procter and Gamble?
\n<\/em>Like all companies, P&G faces similar schisms between expectations and reality.\u00a0 At times, expectations get too high and then fall too low.\u00a0 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.
\nSo how do we separate expectations and reality in business<\/em>?
\nIt is impossible to completely separate expectations from reality.\u00a0 Humans cannot help but form expectations; even animals do.\u00a0 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. \u00a0The best way to avoid exposing your company to the expectations market is to be a private company \u2013 like Cargill or Koch Industries.\u00a0 Facebook prospered for a number of years as a private company, then went public and felt the wrath of the expectations market.\u00a0 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.
\nOne 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\u2019s only a matter of time before another crisis hits us. Why do you say that?<\/em>
\nI 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.\u00a0 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\u2019t be because of an Internet-bubble or sub-prime residential mortgages.\u00a0 Any other cause is as likely to precipitate a bubble\/crash as it was before the various regulatory changes.
\nThis 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?
\n<\/em>I believe that it was lapped up because it was incredibly simple and compellingly logical.\u00a0 The alignment theory sounds so lovely \u2013 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.\u00a0 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 \u2013 and indeed they have kept on gaming!
\nHow was it responsible for the current state of things?<\/em>
\nThe central thrust of the Jensen argument was that the real market needed to be wedded directly to the expectations market through stock-based compensation.\u00a0 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.
\nWhat went wrong with that idea?
\n<\/em>The tool was wrong.\u00a0 Attempting to increase shareholder value over the long term is not a bad idea.\u00a0 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.
\nSo is banning stock options a way out? Has any company done it?
\n<\/em>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.\u00a0 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.\u00a0 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.\u00a0 But no public company of which I am aware has banned stock-based compensation entirely.
\nSo 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?
\n<\/em>Real outcomes are things like market share, return on invested capital, customer satisfaction, etc.\u00a0 The most important real outcomes vary by company and depend on the company\u2019s context. Most companies use these measures as part of their compensation structures.\u00a0 What needs to happen is for companies to raise these measures from part of their incentive compensation packages to 100% of them.
\n<\/em>
\nThe interview was originally published in the Daily News and\u00a0Analysis\u00a0on October 8,2012.
\n(Interviewer Kaul is a writer. He can be reached at vivek.kaul@gmail.com<\/a>)
\n 
\n 
\n <\/p>\n","protected":false},"excerpt":{"rendered":"

Roger Martin is the Dean of the Rotman School of Management at the University of Toronto, in Canada. In 2011, Roger Martin was named\u00a0by 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 … <\/p>\n

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