Share ownership should be an effective way to invest your money. Unfortunately, there are many pitfalls, only some of which can be mitigated. Things seem to go wrong when ownership becomes widely dispersed. All of the problems below affect, to varying degrees, widely-held publicly-traded companies. As a side note, they also affect state-owned enterprises.
The first problem is that of “principal-agent”. Take as an example a national bank. The business is owned by millions of people who each have a tiny fraction of ownership. Since these people can’t realistically manage their company through consultation, they hire managers to run the company and manage day-to-day affairs. The managers, working on behalf of the owners, should maximise profits and look out for the best interests of owners in every way. But it is not realistic to believe that the owners have any control over management. The owners can only rely on information that management provides, which could be used to mislead. Owners could try to fashion an incentive plan to align management’s interests with that of the owners, but in practice, this has rarely succeeded.
They “free-rider” syndrome takes effect as ownership becomes widely dispersed. If many people own the company, why would one person invest their time and energy in reviewing all available information to ensure it is properly managed? When one person owns shares in dozens (or hundreds) of companies, it becomes impossible to review the effectiveness of management in each company. Either the shareholder will rely on others to review available information, or will leave management entirely alone.
Businesses that are “too big to fail” may experience “soft budget constraints”. When a company provides a good or service that is seen as essential to the nation, management may feel little need to ensure the long-term viability of the company, expecting that the government will bail them out of any crisis. Returning to the example of a national bank, citizens may come to see a network of deposits, payments and withdrawals as a right. Should the bank appear on the verge of failure, the government may feel it necessary to ensure the integrity of the system, requiring a bailout.
So, we have seen that owners are not necessarily well served by the managers that run the company, on their behalf. Worse, there are conflicts between the interests of management and the interests of the owners. For example, any salary and bonus that is paid to management, must necessarily reduce the profit paid to the owners. Further, because of the nature of salary and bonuses, management is likely to adopt a short-term view, where the owners should have a long-term view.
Some of these problems should be addressed by having a board of directors to supervise management, on behalf of owners. In practice, because of the large number of small shareholders, management generally nominates directors. These directors, who may be paid for their services, in turn determine the compensation of management. If directors are not, themselves, shareholders, it is unlikely that they will fairly represent the interests of owners. It is possible to make directors, and even management, shareholders by giving them shares. It is even possible to require that they buy shares. But if the return from their ownership continues to be dwarfed or even matched by salary, bonuses and perks, the incentives are still inadequate. And that assumes it’s possible to use money as an effective incentive.
The above-mentioned problems are so common that they are rarely discussed. I believe that there are two simple ways to address these problems. The problems are mostly caused by widely-dispersed ownership, whether it’s management’s lack of accountability to owners or owners’ lack of interest in management.
Owners would be more involved in the management of their companies, if they could have more communication and interaction with management. Owning a small number of companies seems to be the obvious first step. If you own 30 or more companies, there’s little chance of having a deep understanding of each business, short of making it a full-time job. If you invested, as an example, in only five companies, you would not only have less work in developing an understanding of each business, but it would be more important, since each would represent, on average, 20% of your investments. Choosing to own small businesses would make it more likely that management is available and willing to be open to discussion. Combining these two ideas, you may eventually take a large stake in each of a small number of companies. You would understand your companies, and management should recognise and respect large shareholders. If not, you may be able to develop the sway to nominate directors or put forward a motion to replace management.
Not everyone has the resource, or desire, to develop influential ownership. A similar situation can be found in cases where the company already has large shareholders. One example is institutional ownership, where a mutual fund or pension fund has taken a substantial stake in the company. Another possibility is a controlling shareholder, such as in the case of a family-owned business. In these cases, your free-riding doesn’t mean management is unsupervised. The large shareholder could use their influence, on behalf of all owners, to ensure that the business is run in their best interest.
Publicly-traded companies with widely-held ownership suffer many problems similar to state-owned enterprises. That is not to say they can’t be profitable. However, many of these concerns can be addressed by either finding a company with a large or controlling shareholder or to take significant stakes in the companies you choose to own.