Assessing the Best Way to Manage a Company

Professional management ostensibly is supposed to act in the best interests of shareholders but it can pose a problem if executives make decisions in their own self-interest.

For shareholders of McDonald’s, the CEO and the rest of the management team are expected to work to maximize the value of the company rather than to enrich themselves. If the arrangement works well, the reward for shareholders is increased profitability and sales, as well as capital appreciation from the rising price of the stock and any dividend payments.

The challenge for virtually any public company is to choose a management team that will fulfill its responsibility to enhance shareholder value. The key is to have an effective board of directors of five to 15 people to represent the shareholders in hiring and monitoring the performance of the corporate leaders.

Even agreeing on who to hire for a management team would be a nearly impossible coordination and knowledge problem for the hundreds of thousands of McDonald’s shareholders to solve without the board of directors. Since board members are bound by what is called a fiduciary duty to shareholders, they are legally obligated to look out for the best interests of shareholders.

In reality, of course, the coordination and knowledge problems of having multiple owners are not easily solved.

Disgruntled shareholders do have some options for trying to “take back” a company from a management team they feel is holding it hostage or taking too much of its value for themselves. Companies are required to have an annual shareholder meeting during which shareholders can vote on different measures and express their general grievances.

One way that shareholders can protest is by submitting proposals for the company’s annual meeting that oppose certain policies of the directors and even the management. In extreme cases, disgruntled shareholders who have significant financial resources and ownership stakes may opt to wage a “proxy fight” to try to elect their own slate of directors to oust the incumbents.

To really take control of a company, shareholders would need to get their own candidates onto the board of directors and doing so in the face of a company’s own financial resources is a huge and expensive challenge. While companies are required to hold some kind of election for the board members, in most cases this is just a “Soviet-style” up/down vote with only one person running for each seat on the panel!

Even when very large shareholders are able to nominate candidates to run against the management’s choices, winning such proxy fights can be quite difficult and expensive. Dissident shareholders attempting to win a hostile proxy fight must contact all the other shareholders of the company and convince them to vote against the management’s choices and for their own choices. Most shareholders find this too difficult and expensive to manage. Instead, they prefer to just sell their shares to someone else if they are unhappy with a company’s direction.

The oversight role of the directors never really goes away. Indeed, even agreeing on a board of directors to oversee the management team is problematic.

Technically, shareholders appoint board members by a majority vote. But shareholders come from all across the country and the world, and there is no way they could agree on a common set of people they trust to represent their interests.

The result is that board members are often appointed to their roles by the management team — the same team they are supposed to supervise independently. In some cases, the directors may even be the CEO’s golfing buddies! The conflict of interest here should be obvious — in many cases, the CEO gets to hire his or her own bosses.

Most decision-making still happens through the board of directors, despite the flaws in how such representatives are chosen. The potential conflict of interest between management and shareholders is actually a pretty serious and fundamental issue with modern capitalism. Before the days of the contemporary stock market, most companies were owned and operated by the same person or family. This resulted in very clear incentives for the manager, since it was his or her money that could be lost. While the fractional share ownership system has many advantages in terms of capital allocation, it also has very real costs. One of these is the cost for investors to monitor the management team. This is one of the primary functions that active investment managers serve in the economy.

What good is being an owner if I can’t tell anyone what to do?

The reason to own stocks for the long term is to collect dividend payments in the future. When a company makes a profit, it usually will distribute a portion of the money to its shareholders in what is called a dividend. These payments can occur on a quarterly or annual basis. If you own a stock for a long time and the company does well, the value you get in dividends over your lifetime may dramatically exceed the price you originally paid for the stock.

In the short-term, of course, you also may be able to make a profit by selling your shares to someone else for a higher price than you paid. It is the price that these secondary exchanges of shares take place at that is reported in the newspaper every day. But if the buyers in these transactions are rational, they will not be willing to pay more money than they think the dividends will be worth in the future. We will talk more about the process of buying and selling shares of a stock on a secondary exchange like the New York Stock Exchange in the next article.

Billy Williams is a 25-year veteran trader and author. For a free strategy guide, “Fundamentals for the Aspiring Trader”, and to learn more about profitable trading, go to www.stockoptionsystem.com.