Stop blaming CEOs! It’s the way we invest that’s killing us.

Day by day, the leading corporations of the United States are growing more and more disconnected from the U.S. economy. Their interests are less and less attached to those of our workers and our consumers. Worse: they are becoming indifferent to our own nation’s economic future.

A decade ago, only 32 percent of income for firms listed in Standard & Poor’s index of the 500 largest publicly-traded U.S. firms came from sources outside the United States. However, by 2008 that figure had grown to nearly half—48 percent.

A 2008 survey conducted by Duke University’s Fuqua School of Business in conjunction with the Conference Board uncovered the fact that 53 percent of the 1,600 companies surveyed had an “offshoring strategy”—compared to only 22 percent three years earlier. The survey drew the conclusion that “very few” of the companies had any “plan to relocate activities back to the United States.”

Many of the companies that have tried—usually driven by unions—to maintain a significant production presence in the U.S. (such as the automobile industry) have been “hollowed-out” by year-on-year losses. Many of these losses can be traced to bad decisions for profit-taking in earlier years or unwise concessions to unions that management must have known could not be sustained in the long run.

What’s driving this trend?

Of course, we all know the answer to this question: It’s “profits,” stupid!

But there is more than that. The whole of the blame cannot be laid on the shoulders of the CEOs and the corporate boards.

Here’s why:

 

A little history on investment

Prior to the year 1924, most people who invested in a corporation did so for one of two reasons:

1. Because they—or their advisor—believed the firm had opportunity for making profits. Not necessarily profits in the coming quarter, but in the long term.
   
2. Because they had a sincere “investment” in the firm itself. They had a heartfelt interest in what the firm produced or did for people or the economy as a whole.

So, what happened in 1924?

The first modern mutual fund was created in 1924 in Boston, Massachusetts. This began a dramatic shift in the way investors were connected—or, rather, disconnected—from the firms in which they made investments.

Mutual funds removed any sense of heart-felt investment in the long-term good of the firms in which the monetary investments reside. In fact, it removed the investor by one full step from his or her investments. Mutual funds are a dispassionate “yield” instrument only.

 

Paper entrepreneurs

Here’s how the picture has changed. In the pre-mutual fund days, most investors had a relatively direct connection with their investments and the companies in which they were invested.

Investor –> Corporation

In those days, larger investors took a personal interest in their investments and not infrequently attended stockholder meetings. They, more often than not, had a longer view of their investments and were looking out for the long-term profitability of the businesses in which they invested their funds.

However, as open-ended mutual funds grew from 19 in 1929 to more than 100 by 1954, Wall Street investment bankers began to see that the middle class could become a great source for new capital investment (and profits for the investment bankers, of course).

By the end of the 1960s, there were about 270 mutual funds supplying $48 billion in capital. The introduction of bank “money market” funds in the late 1970s boost growth even more. Then the real explosion came when Congress introduced tax-favored treatment for such investments through IRAs, 401(k)s and other defined-contribution plans.

Today, while a great number of middle class Americans are invested in the stock market, the vast, vast majority of them would be unable to name any single corporation in which they hold investments. They are entirely disconnected and interested in one and only one factor: the yield on their investments.

Today the picture looks like this:

Investor –> Fund Manager –> Mutual Fund –> Corporation

As I said, the investor has one and only one interest in his investment: yield—especially short-term yield. (Since this is the “McDonald’s generation,” everything is expected to happen fast or impatience sets in.) Between the investor and his money sits the fund manager. The fund manager also has only one interest: the short-term yield on the fund. His or her interest is driven by a couple of concerns:

• Short-term yield will attract new assets to the fund, likely contributing to the fund manager’s bonus
• Short-term yield will keep assets from leaving the fund, also contributing to higher bonuses in all likelihood
• Short-term yield will increase the earnings of the fund, which is also likely a metric by which the fund manager is measured and compensated

I think you get the picture. The fund manager will measure every investment in corporations by short-term returns on investment (ROI) and the likelihood of future short-term returns. This is why I inserted the “mutual fund” as an entity between the fund manager and the corporation in which the fund is invested. It is likely that the fund manager views the fund as a entity in and of itself and its individual corporate investments as only vehicles for yield on the fund. He has no real interest—beyond short-term yield estimates—in any of the corporations in which the fund is invested.

 

The tail wags the dog

Formerly, CEOs at corporations were wise enough to not sacrifice a firm’s future for short-term profits. They were careful not to consume the company’s long-term future in pursuit of profits in the coming quarter.

But that was back in the days when the investors were invested in the firm with both their money and their hearts (and, sometimes, their souls). That was back in the days when an investor might show up in the CEOs office or at a board meeting and upbraid management for not taking a longer view toward the success of the firm.

Those days are gone for almost all publicly-held companies.

Mutual fund managers can make or break a company today by moving hundreds of millions of dollars from one company to another based solely on the prospect of short-term returns on investment. The fund managers care not one iota about the long-term success of the firms, and the investors in the mutual funds care even less.

So, what do CEOs do?

CEOs of publicly-held corporations seek only one thing: short-term profits. Boards of directors hire and compensate CEOs for this one objective because they know the dramatic loss of market capital that might be incurred if major fund managers decide to disinvest in their firms.

 

Local interests cannot play a part

It is America’s investment strategy that has driven this. It is because American investors are disconnected from their investments that CEOs are driven to this end.

It is America’s investment methods that have driven CEOs to lose interest in the American economy. The investors do not care whether the profits that bring yields to their 401(k) or IRA come from off-shoring or from selling products in South America or on the African continent.

Unlike prior American recessions—including the so-called “Great Depression—this recession is the first in American history from which corporate profits can rebound without rehiring of large numbers of American workers.

 

Politicians blame the “greedy” capitalists and the capitalist system

The politicians ought to look at their own policies. It is the preferential tax treatment given by Congress to instruments like IRAs and similar investment vehicles that have made the mutual fund market explode. Politicians ought to consider revamping every market intervention that makes “paper entrepreneurs”—instead of old-fashioned “investors”—a primary source for capital in the markets.

Actually, corporations that are not publicly-held are more likely to have a local and regional interest in our American economy and the American worker.

In the past, downwardly-mobile American consumers would have created problems for U.S. corporations. Today, since more and more profits come to these corporations from markets in other nations, this is far less a concern to them. And, it should be noted, that the U.S. market emerging from the present recession is very much downwardly mobile. (I, personally, have taken a 29 percent pay-cut in the last two years.)

 

The German model

U.S. politicians could learn a lot by looking at the German model for business financing. In Germany, city-owned savings banks provide funds to enable enterprises, especially family-owned (read: passionately invested) mid-sized businesses, to grow and prosper. The same locally-based financing gives these businesses what they need to grow and become involved in exporting their products. Nearly two out of three of Germany’s small-to-mid-sized businesses get their funding from these local banks.

The funding links and limits these enterprises to doing business in the local markets, thus building both their local economies and the larger economy of Germany as a nation.
Sadly, no similar localism can be found in America’s investment model. Our brand of capitalism and dispassionate investment drives our corporations to move more and more of their part of economic growth and hiring away from the U.S.

The answer is not more regulation of corporations. The answer is a radical restructuring of our investment and financing model for corporations.