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Alex Edmans
Alex Edmans
Professor of Finance @ London Business School
Corporate finance, behavioural finance & responsible business

Alex Edmans is Professor of Finance at London Business School. Alex graduated from Oxford University and then worked for Morgan Stanley in investment banking (London) and fixed income sales and trading (New York). After a PhD in Finance from MIT Sloan as a Fulbright Scholar, he joined Wharton in 2007 and was tenured in 2013 shortly before moving to LBS. Alex’s research interests are in corporate finance, responsible business and behavioural finance. He is a Director of the American Finance Association, Vice President-Elect of the Western Finance Association, a Fellow of the Financial Management Association, and a Fellow of the Academy of Social Sciences. From 2017-2022 he was Managing Editor of the Review of Finance, the leading academic finance journal in Europe. Alex serves as a Non-Executive Director of The Investor Forum, on the World Economic Forum’s Global Future Council on the Future of Responsible Investing, and on Royal London Asset Management’s Responsible Investment Advisory Committee. The UK government appointed him (jointly with PwC) to study the alleged misuse of share buybacks and the link between executive pay and investment. Alex previously served as Mercers’ School Memorial Professor of Business at Gresham College, giving a four-year programme of lectures to the public. His series were on The Principles of Finance (2021/2), The Psychology of Finance (2020/1), Business Skills for the 21st Century (2019/20) and How Business Can Better Serve Society (2018/9). Alex’s book, Grow the Pie: How Great Companies Deliver Both Purpose and Profit, was featured in the Financial Times Best Business Books of 2020 and won the Financial Times award for Excellence in Sustainable Finance Education; it has been or is being translated into Arabic, Chinese, French, Italian, Japanese, Korean, Portuguese, Russian, and Turkish. He is a co-author of the 14th edition of Principles of Corporate Finance (with Brealey, Myers, and Allen).

What Stakeholder Capitalism Can Learn From Milton Friedman
What Stakeholder Capitalism Can Learn From Milton Friedman
Instead of ridiculing the Friedman doctrine and proclaiming its death, advocates of stakeholder capitalism and responsible investing, like me, can learn a lot from it. In 1958, Nobel Laureates Franco Modigliani and Merton Miller controversially claimed that, under certain assumptions, the value of a firm is independent of its capital structure.Their article was a landmark at the time. Executives were fretting about how to fine-tune their capital structure, paying fat fees to bankers and consultants to advise them. Modigliani and Miller pointed out that they were wasting their time—CEOs should instead concentrate on the operational side of the business.The key words, of course, are “under certain assumptions.” These assumptions, such as no taxes or bankruptcy costs, clearly don’t hold in the real world. Yet, even in 2020, the Modigliani-Miller theorem is a cornerstone of MBA finance classes around the world. The theorem is valuable not because capital structure is actually irrelevant, but because it highlights the only reasons why it can be relevant. A company should only base its capital structure on violations of the assumptions such as taxes and bankruptcy costs—and not other arguments such as “debt is cheap and equity is expensive.” Modigliani and Miller’s article was a landmark at the time; it remains a landmark today, and has been cited over 26,000 times.In 1970, Nobel Laureate Milton Friedman controversially claimed that, under certain assumptions, a CEO should focus entirely on maximizing profit and not on serving society.His article was a landmark at the time. But, unlike Modigliani-Miller, today it’s an object of scorn and ridicule. It’s been cited over 20,000 times, yet most of these citations are to highlight how broken shareholder capitalism is. 3,000 of those citations have come in the past year, as the stakeholder capitalism movement has gathered momentum. To declare that you reject the Friedman doctrine has become almost a requirement for acceptance into polite society.But advocates of stakeholder capitalism, like me, can learn a lot from Milton Friedman by using his article in a similar way to Modigliani-Miller. Friedman highlighted the assumptions under which “the social responsibility of business is to increase its profits.” If—and only if— those assumptions are violated, is there a case for moving away from shareholder value.The first step to learning from it is to understand what Friedman actually said. While this may seem a truism, Friedman’s article is widely misquoted and misunderstood. Indeed, thousands of people may have cited it without reading past the title. They think they don’t need to, because the title already makes his stance clear: companies should maximize profits by price-gouging customers, underpaying workers, and polluting the environment.By presenting Friedman as a narrow-minded caricature, critics of capitalism can then push their own theory of how it should operate, and it’s not difficult to argue that theirs is superior when the alternative has been presented as a straw man.But Friedman never advocated that companies exploit stakeholders. He argued that it is legitimate for a company to focus on increasing profits because the only way it can do so, at least in the long term, is if it treats stakeholders seriously. He wrote, “It may well be in the long-run interest of a corporation that is a major employer in a small community to devote resources to providing amenities to that community or to improving its government. That may make it easier to attract desirable employees.”Thus, while last year’s Business Roundtable statement was heralded as “the end of Friedmanism,” it’s fully consistent with it. Any company maximizing shareholder value needs to “commit to delivering value to our customers … investing in our employees … dealing fairly and ethically with our suppliers … [and] supporting the communities in which we work.”Indeed, critics of shareholder value attack it for being short-termist, but this makes no sense because shareholder value is an inherently long-term concept. Shareholder value is the present value of all future cash flows that a company generates. That’s not just abstract theory—it holds in practice. Some of the world’s most valuable companies are tech firms whose market valuations are orders of magnitude higher than what their short-term profits imply.But there are at least three important assumptions in the Friedman doctrine. These assumptions don’t always hold in the real world, thus yielding a case for stakeholder capitalism. Yet just like Modigliani-Miller, Friedman is a useful starting point, because only if these assumptions are violated should we move away from explicit profit maximization.“THERE ARE AT LEAST THREE IMPORTANT ASSUMPTIONS IN THE FRIEDMAN DOCTRINE. THESE ASSUMPTIONS DON’T ALWAYS HOLD IN THE REAL WORLD, THUS YIELDING A CASE FOR STAKEHOLDER CAPITALISM.”One key assumption Friedman makes is that a company has no comparative advantage in socially responsible actions. $1 spent on a social initiative creates the same value as $1 spent by anyone else. This assumption holds for many initiatives, such as donating to charity: A company could instead pay higher dividends to investors or wages to employees, or charge lower prices to customers, and they could donate it to the charity of their choice. So Friedman did recognize that individuals have social responsibilities beyond profits. He argued that the social responsibility of business is to increase profits because doing so gives individuals—investors, employees, and customers—maximum flexibility to choose which social responsibilities they wish to fulfill. It’s not the CEOs’ prerogative to take this decision away from them and support their own pet social cause.This has profound implications, because many companies—and even governments—believe that stakeholder capitalism involves corporate philanthropy. India requires large companies to spend 2 percent of their profits on CSR initiatives; many firms around the world make similar pledges voluntarily. But if you’re a drinks company, your expertise is making drinks —not choosing which charitable causes are most worthy.Friedman’s doctrine states that companies should only invest in social causes if they can generate more value than anyone else, and there are many activities that satisfy this “principle of comparative advantage.” Coca-Cola has developed expertise in logistics to distribute its drinks all over the world, including the onerous last mile to a rural village. So its Project Last Mile leverages this expertise to distribute medicines throughout several African countries. It delivers medicines, rather than books, as the former must be kept cool—and, as a drinks company, Coca-Cola has a particular comparative advantage in refrigerated transportation.But others don’t. Companies donating money to Black Lives Matter in the light of George Floyd’s tragic death would have been wise to heed the Friedman doctrine. They should have instead invested their money in recruiting under-represented minorities at all levels, stamping out discrimination in their promotion and evaluation processes, and ensuring that their culture encourages a diversity of thinking—actions that only they can control, which means they have a comparative advantage in doing so.A second key assumption in Friedman’s article is that governments are well-functioning. Friedman states an important caveat to his claim: “there is one and only one social responsibility of business … to increase its profits so long as it stays within the rules of the game.” [emphasis added]The government sets the rules of the game: it has “the responsibility to impose taxes and determine expenditures for such ‘social’ purposes as controlling pollution or training the hard-core unemployed.” Some voters want high minimum wages and carbon taxes; others don’t. Politicians set regulations at the level that best represents the aggregate preferences of the electorate—or else they can be voted out. In contrast, a CEO who pursues social causes “is in effect imposing taxes, on the one hand, and deciding how the tax proceeds shall be spent, on the other.” She may pursue her own preferences, not shareholders’ or society’s.However, regulation is imperfect, and this is another reason why businesses should have a social responsibility. Regulation is most effective at addressing measurable issues such as wages and carbon emissions. However, it’s much harder to regulate qualitative issues such as providing employees with meaningful work and skill development. Thus, a company could go above and beyond in the working conditions it provides. But the Friedman principle remains useful because there are situations in which regulation is generally effective. If a firm wishes to pay above the minimum wage, even though market forces don’t dictate this, it needs to have good arguments for why the government has set it wrongly.The third key assumption is the most important, and is the reason why I am an advocate for stakeholder capitalism. This assumption is often overlooked as it’s only implicit in Friedman’s article.When he argues that profit-focused companies will invest in stakeholders, Friedman is assuming that they can calculate the impact that such investments have on profit. Calculation works for some investments: When contemplating a new factory, a CEO can forecast how many widgets it will produce and how much it can sell them for. Subtracting the cost gives her the Net Present Value (NPV)—the investment’s impact on shareholder value. While the real world is risky, NPV is able to handle risk. The CEO can do a “sensitivity analysis,” where she plugs in different assumptions, and see how the conclusion changes.But the implicit assumption in Friedman is that there’s no uncertainty. A risky problem can be analyzed, if you have a rough idea of its parameters and can do a sensitivity analysis around them. With uncertainty, you have no idea what the parameters are.Consider the deliberately simple decision of whether to provide colleagues with a free gym. The cost is easy to estimate but the benefits are not. Will the gym attract and retain workers, and what’s their value to the firm? How many lost days due to sickness will the gym prevent, and how much would they have cost the company? How many interactions between colleagues in different departments will the gym foster? These questions are almost impossible to answer. There’s not even a baseline around which to conduct a sensitivity analysis. So you can’t calculate the NPV of the gym, and without it, you can’t justify the gym under shareholder capitalism.Arguing that “increasing profits” will lead a company to invest in stakeholders is only true if profits can be forecast with some degree of accuracy. For particularly uncertain investments, they can’t. Thus, NPV would lead a company to forsake many investments in its employees, and also other stakeholders, ultimately destroying shareholder value. The mindset of maximizing profits may actually lead to companies failing to do so.That’s where stakeholder capitalism comes in. A company with explicit stakeholder objectives makes investments for intrinsic reasons—to deliver value to such stakeholders— rather than to instrumentally increase profits. This leads it to make many investments that are ultimately profitable, but could not be justified by a financial calculation. A company might build a gym simply because it cares about employee health. By doing so, it will recruit, retain, and motivate great workers, likely increasing profits as a by-product, even if this increase couldn’t be quantified at the outset.Importantly, this argument means that it may be in a company’s own interest to adopt social objectives. Such objectives aren’t simply worthy or fluffy, but good business sense—the guide to decision making in a world of uncertainty. For example, one of my own studies finds that companies that treat their workers well outperformed their peers by 2.3-3.8 percent per year over a 28-year period, or 89-184 percent compounded. However, it’s highly unlikely that CEOs could forecast that stock return uplift when deciding to invest in employee satisfaction.Now, such social objectives can’t be unfettered or a free-for-all. If a company moves away from NPV, it needs alternative criteria to decide whether to take an investment. In a recent book, I propose three. One is the “principle of multiplication,” that $1 invested in a stakeholder must create more than $1 to that stakeholder. The second is the aforementioned “principle of comparative advantage,” that $1 creates more value than someone else could by investing in that stakeholder. The third is the “principle of materiality,” that the stakeholder(s) the activity benefits must be material to the enterprise.My proposed criteria aren’t necessarily the last word. But any advocate of stakeholder capitalism can’t attack Friedman’s rule—of appraising projects based on shareholder value—without proposing an alternative.Overall, just as capital structure is not irrelevant for firm value, I believe that a company’s explicit goal should not be to maximize profit. However, by highlighting the assumptions required for his claim to hold, Friedman shows us that a company should only depart from intentional profit maximization where these assumptions are violated: the company has a comparative advantage, there is regulatory failure, or instrumental decision making is difficult. This is true in some cases, but not others such as charitable donations.Moreover, this framework is relevant not only for business leaders but also investors. Savers are piling into ESG funds, but many such funds are channeling this capital to companies that support social causes in a box-ticking manner, not questioning whether the Friedman assumptions hold. Rather than ridiculing the Friedman doctrine and proclaiming its death, advocates of responsible business and responsible investing can use it to guide us.This article was first published on Promarket (10 Sept 2020). https://www.promarket.org/2020/09/10/what-stakeholder-capitalism-can-learn-from-milton-friedman/
0 Comments   04 September 2023
Is Sustainable Investing Really A Dangerous Placebo?
Is Sustainable Investing Really A Dangerous Placebo?
Tariq Fancy, BlackRock’s former sustainable investing chief, caused a splash last month when he claimed that sustainable investing is “a dangerous placebo that harms the public interest”, “like selling wheatgrass to a cancer patient”. This ruffled the feathers of many ESG advocates, who immediately got on the defensive and started arguing why Fancy must be wrong.I’m also an advocate of sustainable investing, having worked in this area for 15 years and recently released a book on it — so I too wanted to tear apart Fancy’s essay. But the problem with giving a TED talk on listening to different viewpoints is that it obligates me to practice what I preach. One of the lines in that talk is: “Read and listen to people you flagrantly disagree with. 90% of what they say may be wrong, in your view. But what if 10% is right? As Aristotle said, “The mark of an educated man is the ability to entertain a thought without necessarily accepting it.” ” So I gritted my teeth and read Fancy’s article as open-mindedly as possible — and ended up concluding that he’s far more than 10% right.For any academic study, we should base our view on the rigor of its methodology rather than whether we like its conclusions. For an essay, we should similarly start with the logic of its framework before fast-forwarding to its implications. The analogy that Fancy uses throughout his essay compares capitalism to a basketball game. Two teams compete against each other and have strong incentives to win — just as executives have strong incentives to increase profits due to their pay schemes. Good sportsmanship reduces teams’ ability to win (if it didn’t, it would be gamesmanship, not sportsmanship), so — given their incentives — they won’t practice it by themselves; they need a clear set of rules and referees to enforce those rules. Believing that sustainable investing can transform the world is like having a professional basketball league without rules or referees, but clubs writing glossy purpose statements promising to play fair.There’s much to learn from this analogy. First, it highlights the criticality of government intervention. Just as referees punish fouls, so governments should tax carbon emissions rather than relying on investor promises to combat climate change. Indeed, while any card-carrying ESG advocate will fall over themselves to bash Milton Friedman’s claim that “The social responsibility of business is to increase its profits,” Fancy has actually read Friedman’s article beyond the title. Friedman argues that businesses should focus on profits not because he thinks that social issues are unimportant, but because governments are far better placed to deal with them through taxation and regulation. We have no problem with basketball teams trying their hardest to win games while playing by the rules, so — according to Friedman’s view — we should support companies maximising profits while obeying the law.Moreover, governments are democratically elected by citizens, with each having one vote. The problem with leaving social policy to the CEOs of companies and CIOs of asset managers is that they’re the 1%. They may ignore issues that matter to ordinary citizens who don’t hold shares and aren’t represented in capitalism — such as the loss of millions of blue-collar jobs if we fail to achieve a “just transition” to a low-carbon economy.Second, the basketball analogy stresses that sportsmanship often conflicts with success. Similarly, in business, there are trade-offs — creating value for society sometimes erodes profits. But ESG advocates often deny any trade-off, and people lap it up due to confirmation bias. As Fancy writes: “there’s always money to be made from telling people what they want to hear”. A Wall Street Journal op-ed by David Blood and Al Gore claimed that “Voluminous research has shown conclusively that businesses properly integrating ESG factors into their plans are typically more successful and profitable”. They didn’t cite any research, and didn’t need to because ESG supporters will lap up the claim uncritically. But the most rigorous research, published in the elite academic journals, shows that the evidence is decidedly mixed.Third, the analogy highlights the limitations of divestment. If basketball fans each owned shares in athletes, and someone sold her stake in an unsportsmanlike player to another fan, nothing changes — the player would still be on the court, and continue to play dirty. Similarly, an investor can only sell shares if someone else buys, so divestment doesn’t deprive a polluting company of capital.So there’s much to like about the basketball analogy. But it breaks down in two important ways. First, basketball is a zero-sum game. One team can’t win without the other team losing. But business isn’t zero-sum. Fancy argues the analogy of two basketball teams is two rival companies. Yet the concept of “coopetition” has existed for over a century, where industry competitors can not only compete with each other to grab a greater slice of the pie, but also cooperate to grow the pie, for example by improving industry standards and sharing best practice. And the relevant analogy isn’t to a company and its rivals, but to a company and its stakeholders. Unlike in basketball, where sportsmanship to your opponent can cost you points, “sportsmanship” to your stakeholders can grow the pie for the benefit of both. This isn’t just wishful thinking; it’s based on rigorous evidence. One of my studies showed that, over a 28-year period, companies that treat their employees well outperformed their peers in total shareholder returns by 2.3–3.8% per year — that’s 89–184% compounded.Fancy argues that, if indeed there is a link between purpose and profit, there’s no need for ESG — profit-motivated CEOs will invest in purpose. But that’s assuming the “rational economic (wo)man” idea confined to economics textbooks. With perfect information, profit can indeed be maximised instrumentally. You estimate the net present value of an investment — if it’s positive, you take it; if it’s negative, you reject it. But while you can estimate the NPV of investing in a factory, it’s much harder to do so for investments in stakeholders. If you grant employees more parental leave, how much more motivated and productive will they be, and how much more profit will this give you? There’s no way that you can put even a rough number on this, and so a purely profit-maximising company won’t make such an investment. But a purpose-driven company might, and the evidence shows that such investments end up profitable ex post even if you can’t predict the payoffs ex ante. Strikingly, my paper was published 10 years ago, and so “rational economic (wo)man” investors should be jumping on the employee satisfaction alpha, eroding it away. Yet my study was recently replicated for the 10 years that have happened since — and the returns are just as strong. Profit-seeking investors are clearly not capitalizing on the employee satisfaction alpha, but an ESG investor might.Fancy’s fixed-pie framework means that he ignores the key mechanisms through which sustainable investing changes company behavior — engaging with companies to grow the pie. Indeed, careful research shows that engagement by index funds, hedge funds, and investor collective action groups creates shared value for both shareholders and society. In particular, activism on ESG issues creates shareholder value as a by-product, and that engagement on shareholder value ends up improving ESG.The second limitation of the analogy is that regulation is easy in basketball — referees can spot fouls, perhaps aided by video replays. In business, regulation can address measurable issues such as wages and carbon emissions. But many activities are invisible and can’t be regulated, such as providing employees with meaningful work and skills development. Thus, there’s a substantial role for companies to undertake them voluntarily, and for investors to hold companies to account for doing so.Moreover, Fancy’s black-and-white view suggests that it’s either sustainable investing or regulation — that investors are practicing ESG to dupe governments into thinking that no laws are necessary. But such a conclusion is inconsistent with his own analogy. Most basketball teams want rules and umpires, so that the winner is decided by who plays better, not who fouls the most — it’s only the teams that intend to pay dirty who want a free-for-all. Similarly, most responsible investors support regulation — in July 2021, investors representing over $6 trillion in assets called for a global carbon price. And in addition to explicit calls, the mere practice of sustainable investing shifts the Overton window and makes governments more likely to take action. Regulation isn’t decided in a vacuum, but responds to the support of the electorate. In the UK, the plastic bag tax and the sugar tax were introduced with the grain of public opinion.One reason why Fancy’s essay has attracted so much attention is how sweeping and blanket his criticisms are. His USA Today Op-Ed opened with the line “The financial services industry is duping the American public with its pro-environment, sustainable investing practices.” Not “some players in the financial services industry”, but “the financial services industry”.Some criticism is certainly warranted. Many investors, executives, and even finance professors, who poo-pooed ESG in the past, have suddenly jumped on the bandwagon. Fancy is right that they make similarly sweeping and blanket claims that aren’t backed up by evidence. The more extreme the claim, the more column inches they grab, the more fund flows they attract and the more books they sell. But the more extreme the claim, the less expertise behind it — not only because black-and-white statements aren’t supported by either research or practice, but also because extreme claims make it seem like the point is so obvious that no substantiation is needed. No evidence is asked for, and so the lack of expertise is never uncovered.But the charge that “the financial services industry” is guilty just isn’t true. Fancy praises the excellent Ben Yeoh as one of the few ESG investors he agrees with, but Ben (my colleague for 6 years at Royal London Asset Management) is not an outlier. True sustainable investors — who’ve been in the field long before it became a bandwagon — are the silent majority, not the vocal minority. They recognize that some ESG factors pay off and others don’t, the promise but also perils of relying on ESG data, the role of government, and the power but also limitations of engagement and divestment. They are more interested in researching and practicing sustainable investing rather than crowing about it through grandiose statements. They rely on their expertise and reputation to attract clients and don’t need to resort to bluster.Fancy quotes Ben as modestly referring to ESG as “another data set” rather than a strategy to change the world. But this is how many sustainable investors and researchers view it. The title of my employee satisfaction paper was “Does the stock market fully value intangibles?”, highlighting that ESG information is intangible and thus not priced in by the market, making it relevant for investors. It did not claim that investing in high-satisfaction companies would have impact or provide them with capital, since you can only buy if someone else sells. Similarly, Fancy quotes former assistant professor of finance Inessa Liskovich who correctly notes that the evidence for ESG is mixed. But all academic experts on ESG — not just Inessa — know this is the case.In summary, Fancy’s article tears down a straw man. It’s a straw man that needed to be torn down, and so his essay has great value. But it doesn’t mean that the whole sustainable investment industry is a ruse. For the ESG advocates piqued by it, the best way to avoid such teardowns in the future is to avoid making sweeping and blanket claims ourselves. And for neutral observers, we should be very careful of any statement, essay, or book that takes one-sided positions — ESG is either elixir or snake oil — and avoid sharing them and adding to the polarisation and misinformation. Neither ESG cheerleaders nor Fancy would have grabbed anything close to the same attention if they more accurately represented reality.But shades of grey get lost in the shadows if we only look for black and white.This article was first published on Medium (30 sept 2021). https://medium.com/@alex.edmans/is-sustainable-investing-really-a-dangerous-placebo-70d4767864db
0 Comments   01 September 2023
The purpose of a finance professor
The purpose of a finance professor
ABSTRACTThe academic finance profession has the potential to be uniquely purposeful due to four characteristics – the freedom to take risks and work on what we're passionate about, the loyalty to our profession rather than just our institution, the collaborative nature of the creation and dissemination of knowledge, and the magnitude of our potential impact. However, what the profession currently values, and its current social norms, are significant barriers to the fulfilment of this potential. This article highlights the special features of our profession that we often take for granted and ignore, and proposes ideas to make it not only more impactful and relevant but also more collegial and fun.1 INTRODUCTIONI'm grateful to you for even starting to read an article with such a title. Titles like this jar with many readers, and for good reason. The author typically writes as if he's made it – found the elusive meaning of life that no-one else has, and knows the one best way to pursue a vocation that he'll now dictate to the uneducated masses.That's not my reason for writing. So why this topic? I was honored to be invited to give the keynote address at the 2021 Financial Management Association Annual Meeting. A keynote is a great opportunity to publicize your research, but I realized that many audience members might just not be interested in my research – they may work in other areas. And, as I looked at the highly intimidating list of past keynote speakers, I realized my research is, quite frankly, not as good as my predecessors’. Some have won Nobel Prizes; most have been Presidents of the American Finance Association (‘AFA’).And that's perhaps my only advantage. Giving a talk about purpose preaches well from the pulpit when you've made it to the very top and can afford to invest in citizenship, but seems unrealistic when you're still climbing the ladder. It's easy to wax lyrical about taking risks with your research if you've never had a paper rejected in your career, as is the case for at least one past speaker. I've been in this profession for fewer than 15 years and been a full professor for under 10. So, many things I said in that keynote were issues I often struggle with myself, wrestling with the purpose of this profession when I've had another paper rejected or am dealing with an apparent injustice (where the other party is always wrong, of course). I was saying them to myself as much as to the audience.I'm very grateful to Financial Management for inviting me to write up that talk. Doing so has allowed me to go above and beyond that speech, by incorporating the comments from many colleagues in the profession who saw the talk or read an early draft of this article. I thank all of them for their input – but none of them should be blamed for the output.There are many generic talks on purposeful careers that aim to apply across all professions; I've given such a talk myself as a Gresham College public lecture (Edmans, 2019). This article will thus focus on four dimensions specific to our profession. Some features may apply to other academic disciplines beyond finance, and a few even to non-academic professions. However, the focus of this article is the purpose of a finance professor.1The first unique dimension is the freedom to work on whatever topic we're passionate about. Ours is a profession of hard knocks, with multiple rejections and harsh discussions, but if we're working on what truly excites us, we're willing to pick ourselves up and persevere. It also means that the years invested in a paper were well spent, even if we're disappointed by the eventual publication outcome. We also have the freedom to work on open, unexplored questions, even combining insights and methodologies from outside of finance.But many researchers don't leverage that freedom. Common advice is to research what's hot, even though this may lead to marginal contributions in a crowded area. Moreover, the paper-counting nature way in which we're evaluated encourages us to work on popular fields, to maximize the probability of a top publication, rather than taking risks and trying something new.The second dimension is the significant amount of luck in our profession. A publication may depend more on the referee draw rather than the paper's inherent quality; a chance encounter leads to a productive co-authorship; bad luck means that someone else is working on the same idea. Of course, skill, creativity, and hard work matter, but we underplay the importance of luck and overplay the signal contained in a single publication, leading to path dependency. A lucky publication as a PhD student significantly improves your job market outcome; quickly publishing your job market paper can lead to a move up. We draw substantial inferences from a person's institution – indeed, we may decide not to talk to someone at a conference because of the school on their nametag – so it affects future outcomes.Path dependency now extends to our PhD students. To get into a good program, you're advised to have a masters, undergrad experience as a research assistant (RA), and even a predoc. As with the publication process, we're excessively conservative and go for safety rather than innovation. Someone with non-academic experience, or who only discovered their passion for research later in life, may have diverse skills useful for innovative work.The third dimension is the non-rivalrous nature of our profession. In an M&A deal, only one acquirer can win the auction; one investor's trading profit is another's loss. In contrast, journal space is not finite, particularly given the move to online journals, and our loyalty is to our profession not our institution – we trust the recommendations of ‘rival’ schools when deciding who to tenure at ours. We can thus view other academics as our colleagues in the creation and dissemination of knowledge – providing feedback on their papers and sharing their work.However, some faculty have the ‘pie-splitting mentality’ that the profession is a fixed pie, so the only way to increase their slice is to reduce others’ – by trashing them on anonymous message boards or failing to acknowledge their research. But reducing our colleagues’ slice doesn't mean more for us – instead, the pie will be taken by companies and consultancies, who are increasingly releasing sloppy research that claims what people want to hear and thus boosts their image. The general public, which includes donors, are increasingly sceptical about the value of academic research, believing we can't agree on anything. While there are legitimate disagreements (e.g. different methodologies reaching different results), we focus too much on them rather than highlighting the substantial areas of academic consensus, leaving a big open goal for consultancies to shoot into.The final dimension is the potential impact of our work. Professors of all subjects create and disseminate knowledge, but we do so in finance – which affects how companies invest and fund themselves, how citizens save for the future, how agents share risks, and how resources are allocated to their best use. Yet the profession places very little weight on either teaching or impacts outside academia in tenure or hiring decisions. And most teaching ratings reward entertainment and popularity rather than challenging and stretching students.I'll use a number of examples from my own career to illustrate my points. This is not to suggest that my career is the right way of doing things, nor that we can extrapolate from it to form general principles, but instead to make certain points more concrete. Some are instances when I've stumbled upon purposeful behavior, but this is not to imply that I always do things the right way. Many things I do, I get wrong, but there's greater pedagogical and aspirational value in giving examples of what works than what doesn't.2 WHAT IS PURPOSE?A big chunk of my current work is about corporate purpose. In Edmans (2020), I explain how a company's purpose has two unique features. First, a purpose is about serving wider society, not just maximizing profits. Second, even though a purpose is genuinely altruistic, purposeful behavior may unexpectedly lead to a company becoming more profitable in the long term – employees may become more motivated, customers more loyal, and governments less likely to pass restrictive regulation.The same two principles apply to a professor's purpose. A ‘strategic professor’ will focus exclusively on advancing her own academic standing. This might involve creating some public goods, but only for instrumental reasons – where she can, at least roughly, forecast an ultimate benefit to herself. A ‘purposeful professor’ is primarily inspired by serving society, and will create public goods for intrinsic reasons. She's comfortable that not every single decision she takes will improve her career, even in the long term. But adopting a purposeful approach across all her decisions may, in aggregate, lead to even more career success than a strategic one, because altruistic actions may lead to unexpected benefits. (I'll give a few examples in this essay).So what exactly is a professor's purpose? I'll use definitions coined by two professors who I've learned a lot from on this topic. One is Andrew Metrick, who I was lucky to overlap with for a year at Wharton. Andrew was a legendary teacher (as well as a top researcher), winning best teacher awards not only at Wharton but across the whole of UPenn. The student body was crestfallen when he announced his departure to Yale, and invited him to give a ‘last lecture’. Andrew spoke on ‘How to Have a Successful and Meaningful Career’ (Metrick, 2008). Most of the talk was on careers in industry, given his audience, but he touched on a professor's purpose, defining it as ‘the creation and dissemination of knowledge’. He explained that one of his early passions was chess, a pastime I also enjoy and respect. But chess doesn't really contribute to something greater than yourself, so he chose to become a finance professor instead.The second is Laurie Hodrick who, similar to Andrew, won best teacher awards not only at Columbia Business School but also across the whole of Columbia University. Word-for-word, her ‘Ten Questions’ interview in the Financial Times (Hodrick, 2011) is the single most transformative article I've read. The first question was ‘What does it mean to be a professor?’ Laurie replied ‘I have come to realize that, rather than being a title or job description, for me being a professor is a way of life. Being a professor is not something I do, it is who I am. It is being driven by intellectual curiosity to create, translate, and disseminate ideas. I am equally a professor when working at Columbia or when working as an investment banker.2 I am still honored and thrilled when I step into an elevator and someone says “Good morning, professor”’.Andrew's and Laurie's descriptions span very similar ground. The intersection contains the words ‘create’ and ‘disseminate’, so for this article I'll – following Andrew – define a professor's purpose as ‘the creation and dissemination of knowledge’.3 FREEDOMPassionI attended the 2006 FMA Doctoral Tutorial in Salt Lake City as a third-year PhD student. This kicked off with a panel of distinguished scholars either presenting a field of research, or giving their advice on how to succeed in the profession. One, whom I'll call Joe, spoke about how to choose a research topic. He suggested we focus on one area, so we can be known for it when up for tenure. Even post-tenure, we should continue the same agenda as there are economies of scale, allowing us to rack up more publications. We'll then be seen as a world expert on the topic – perhaps invited to write a Handbook chapter.And how to choose that topic? You should base it on two factors. One is what your skills are. If you're a master of math, perhaps go into behavioral theory. With non-standard utility functions, the typical concavity requirements to show a global optimum aren't always satisfied, so you need more sophisticated techniques. The second is what's hot at the moment. Look at what's getting published and cited; see what subjects journals are running Special Issues on; take the most recent crop of job market stars and study what they were writing about.The next person got up and said ‘I completely disagree with Joe. You need to work on what you're passionate about’. He stressed that academia is a tough gig, a profession of many hard knocks. The top journals accept fewer than 10% of papers – and before even submitting to a journal, your paper might be savaged at a seminar or destroyed by a discussant. And the more innovative your paper, the less likely it is to be appreciated, at least initially.3 So you'll need to pick yourself up from multiple rejections and criticisms, and only if you're passionate about the topic will you persevere – continue to present and submit your paper, and do that extra analysis (having already worked on the paper for many years) to address people's concerns.But even though passion helps you succeed by encouraging perseverance, that wasn't the main reason he advised us to research what we were passionate about. He said we should do so because it's fun. (As I'll stress in Section 3.2, fun does not mean self-indulgence or working on trivialities). What we work on is our life, or at least the working part of it. Many of us could earn far more money in industry, so a key reason for selecting academia is freedom. But many people are too afraid to enjoy this freedom, which defeats the point of our career choice. And pursuing your passion might lead you to switch direction, perhaps quite drastically, as your research interests change over time. Why be constrained once-and-for-all by what you wrote your job market paper on?That person was Jonathan Berk – someone who's written seminal papers across a number of areas as well as a leading textbook. I recognize correlation isn't causation, but this is a researcher whose pursuit of passion doesn't seem to have been at the expense of success.Jonathan's words have stuck with me ever since. And, as I spent more time in the profession, I saw the typical advice you hear doesn't always work, at least if your objective is to create knowledge rather than just crank out publications. The idea of researching a booming area doesn't make sense if markets are efficient – if a topic is hot, everyone else knows it's hot, making it a crowded field. You might still get your paper published, but it's unlikely to be innovative. Now, many people (including me) don't believe markets are fully efficient, but then you have a worse problem – you might end up working in a bubble. We over-extrapolate from past successes, not realizing the ‘time-to-build’ in writing a paper is long, and by the time you're written your paper, the bubble may have already burst. During my first year as a PhD student at MIT, almost every seminar flew above my head. In the second year (2004–2005), I could understand at least a little bit of each talk. That year, most of the job market stars were working in behavioral finance, as that was the really hot topic. The Odean dataset was now widely available; Smith-Breeden Prizes had been handed out to behavioral asset pricing papers every year since 1999 (starting from Daniel et al., 1998), and behavioral corporate was starting to emerge with papers such as Malmendier and Tate (2005). But by the time I was on the market in 2007, the interest in behavioral finance had declined and there were few job market papers on the topic – before it later enjoyed a resurgence as researchers discovered new questions and new data. Beyond this one anecdote, Dai et al. (2021) show that novel topics quickly become saturated and thus reshuffle.After my job market was over, I had a few months left at MIT. My job market paper and two others in my packet were on corporate theory, so it would have been rational to focus on this field, but I had an idea for an empirical paper on corporate social responsibility (CSR). Remembering Jonathan's advice, I pursued it – I cared about whether employee-friendly companies perform better. At the time, CSR was a non-existent field and so it was a very difficult paper to publish; the first journal said it was a ‘clear reject … there is simply nothing novel, creative, or important in this paper’, and the second that it belonged in a practitioner journal. Edmans (2011a) is now my most-cited paper, through sheer luck because the field ended up booming in a way I could never have predicted.Being skilled at a topic is far from a sufficient condition either, because skills are in abundant supply in our profession. I was strong at math during my economics undergrad – but as I started my PhD I realized how distinctly average my ability was. Some of my classmates already had PhDs in math or physics, or were undergrad majors in more quantitative subjects like engineering. I then thought I might have unique institutional knowledge as I'd worked as an investment banker in Morgan Stanley's Financial Institutions Group, so hoped to specialize in empirical banking. But anyone in a PhD program can quickly learn institutional detail. Except in rare cases, your technical skills or institutional knowledge are unlikely to be unique.I don't mean to portray the standard advice as a straw man. No one says you should choose a topic by simply looking at the intersection of your skills and what's in demand, paying no attention to what you care about. But when people ask what you care about, they'll ask ‘what are you interested in?’ An academic's CV lists her research interests. When someone tells you about their latest research during a seminar office visit, you'll say it ‘sounds interesting’ – even if you don't care for it. But Jonathan's advice wasn't to work on what you're interested in – he said ‘passionate’. There's a big difference between being interested in something and being passionate about it. If you're merely interested in a topic, you'll spend a couple of years writing your initial draft, but might not stick with it after a few rejections. And the time you spend researching it will be pleasant, but it won't be fun.In Section 4, I'll discuss how there's significant randomness in the profession. Whether you get your paper published depends on which referee happens to be chosen, not just its inherent quality. There's no objective standard of the quality of finance research; when two leading scholars read the same paper, one might love it and the other hates it. As a result, we have less control over where our paper ends up published than we think, but we can control whether we had fun writing it. In some sense, the most important referee is you – whether you thought it was worth you spending three, five, perhaps ten years of your life on a paper.In July 2012, I had to submit my tenure packet at Wharton – a great school where I was lucky to spend six years. Back then, we not only had to submit it electronically, but also print out every paper we'd ever written and give them to the department chair's assistant. As I walked to her office, I ran into my colleague John Zhu who asked me what I was carrying, and I told him. He quipped that this must be the first time I'd held my life's work in two hands. I never realized that before, because I was so focused on the admin elements of submitting my packet that I was blind to the big picture, but John was right. After John wished me luck, I took a moment before resuming my walk. I looked through all the papers I was holding, arranged chronologically as was the requirement. They started with the paper on soccer and the stock market I wrote during my PhD, then my job market paper on blockholders, then my CEO compensation theories with Xavier Gabaix, then my CSR research, and finally my studies on the real effects of financial markets. I realized I didn't write these papers to get tenure – to get approval from some committee containing many people I barely knew, based on anonymous letters – but because I was passionate about these topics. I cared about how companies are governed, whether socially responsible firms perform better, whether financial market trading is a sideshow or affects the real economy – and I loved soccer. By then, I'd received many negative signals about my tenure chances and might have to uproot to a different city, perhaps a different country. But I was able to hand in that packet and be fully relaxed about it, even though I'd spend the next four months mired in uncertainty – because I was proud of what I'd discovered during my five years at Wharton and four years at MIT.As will be a common theme throughout this essay, I'm not advocating going from one extreme to the other. The decision does matter, and I was truly grateful when it came back positive. But the uncertainty of that external assessment was attenuated by my internal satisfaction with what I'd worked on.SignificancePursuing passion and fun does not mean self-indulgence – devoting our life to trivialities that have little significance on the world. Instead, what's typically most fun, and inspires the most passion, is work that connects with something greater than yourself. That's why Andrew Metrick turned down a career in chess, even though he found it inherently interesting.The creation of knowledge involves working on important, unexplored questions. Doing so has great overlap with passion – you're driven to continue exploring a question, despite numerous setbacks, if the answer really matters. Discovering something that's novel, rather than a minor extension, is exciting. While there's some overlap with what the profession rewards, the overlap is less than it should be. The safe route to publishing is to make a minor contribution to a popular literature. For such a literature, you can see the formula that published papers have followed and copy it. Moreover, there are many potential referees working in the area so they'll view the topic as important. One of my co-authors refers to this publication strategy as ‘read a paper, write a paper’; another as ‘move from A to A prime’.Journals have strong incentives to publish papers in popular fields, given the attention to impact factors. Even if the contribution is minor, new research in that field (Paper 2) will still cite the paper (Paper 1) in their literature review, as part of a long list of papers. This is true even if the Paper 1 had no influence on Paper 2 – Paper 2 would have still been written even if Paper 1 didn't exist. If, in contrast, Paper 1 developed a new methodology that inspired Paper 2, that still counts as only one citation. Impact factors measure relatedness more than contribution.This is particularly the case since journals are primarily assessed on their two-year impact factor. Two years! This fails to reward research with long-term impact. Some innovative papers may be before their time. The first FinTech paper I'm aware of is Yermack (2017); only citations to it by papers published in 2018 and 2019 count to its journal's impact factor. But aside from the Review of Financial Studies’ special issue in July 2019, most FinTech papers weren't published until 2020 and beyond. Dai et al. (2021) find that more conventional papers are significantly more likely to be published in a top-three finance journal, yet garner fewer long-term citations. They conclude that ‘a paper's measured differentiation from previous work is not as prized by our profession's top outlets despite the academic community's stated goal of pursuing original research’. They also show that novelty, in terms of deviating from standard finance subfields, significantly reduces publication prospects even though it's associated with higher citations.If the purpose of a professor is to create knowledge, not just publish papers, this requires bravery in choosing research topics and going after novel questions, even if the field is nascent or non-existent today. Doing so means that what we devote our lives to, spend five years working on, stay up past midnight perfecting, has significance.Some have caveated that this approach is too idealistic. Given the bang-bang nature of tenure outcomes, people need to be pragmatic and optimize their tenure chances. They do so by choosing research topics that maximize the probability of publication in journals in their institution's A list, even if at the expense of knowledge creation. But that's only the optimal strategy because of how we decide tenure. Many schools and letter writers simply count the number of top publications, placing much less weight on a paper's significance or the researcher's contribution. Being a glorified research assistant on a multiple-authored paper in a top-three journal counts as 1; having a sole-authored paper on an innovative topic in a journal just below counts as near-0 in some schools.Journal quality certainly matters – higher-ranked journals typically publish better papers. But while reasonable people can disagree whether journals just below should count for 0.6, 0.3, or something else (for those taking a ‘counting’ approach), the optimal weight is almost certainly not zero. The binary way in which we treat different journals has several negative consequences. If we're out after three strikes, authors go for safety over innovation, either in choosing a conservative research topic or co-authoring with a senior professor on her agenda. It increases the role of luck, since if you don't get a favourable referee draw at an A-journal, your paper counts for almost nothing. It also means that schools effectively outsource the tenure decision to anonymous referees whom they never chose, rather than reading the paper for themselves.There's an active literature in corporate finance on how a focus on short-term signals, such as quarterly earnings, leads companies to take myopic actions. In myopia models, one solution is to gather qualitative information about the firm's fundamental value rather than just relying on freely available quantitative measures (e.g. Edmans, 2009, 2011b). Such information acquisition is costly, but worth it for important decisions such as whether to fire a CEO. Applied to academia, for a decision as important as whether to show an assistant professor the door, we should gather qualitative information on ‘input’ factors scholars can control (e.g. innovativeness and significance) rather than relying exclusively on ‘output’ factors significantly affected by randomness (e.g. journal publication). In short, we should read papers more.Again, we shouldn't go too far to the other extreme. Completely ignoring quantitative measures such as publications and citations, with the justification ‘we read the papers’, opens the door to decision being based on cronyism or taste – personal like or dislike for the candidate or type of research. An objectively weak candidate may be tenured based on claims that the papers are of high quality; a process that involves purely subjective criteria may be significantly influenced by bias. Just like evaluating companies, the optimal approach involves a combination of hard and soft information. Similarly, the significance of a topic is a matter of opinion, particularly for a nascent subject. Many elder statesmen initially dismissed behavioral finance as studying trivial curiosa that aren't important enough to affect asset prices or corporate decisions. However, the innovativeness of a topic might be less subjective – people might agree that that a paper takes a new direction even if they disagree on how important that new direction is.Note that the reliance on short-term quantitative signals pervades throughout the profession, not just in evaluating tenure. Rankings of finance departments count the number of publications in certain journals, paying no attention to the importance or impact of those publications. This in turn may explain why schools are so risk-averse in their tenure, hiring, and even PhD admission decisions (see Section 4.4).Co-authorshipsAnother freedom we often take for granted is that we can co-author with whoever we like, without being limited by our institution – in a company, you're forced to work with your colleagues. It might be tempting to choose a big name to increase the impact of your paper (Brogaard et al. [2020] find that author fame has a positive causal effect on citations), even if they do little work or are unpleasant to work with. Sometimes there's pressure to co-author with a senior colleague in our department for political reasons. But we have the freedom to choose co-authors who challenge us as iron sharpens iron, possess complementary skills that we can learn while simultaneously passing on our own expertise, and have fun working and celebrating success with.4 LUCK AND PATH DEPENDENCYThe importance of luckWhen I started my PhD, the upperclassmen told me how fewer than 10% of submissions to a top journal are accepted. I was shocked at the low odds, but they reassured me the tenure process takes this into account – at good schools, four to five top publications might be enough.With successes being so lumpy, there's a significant amount of luck in the profession. If you get a favourable referee draw, you could already be a quarter of a way towards tenure. Welch (2012) found that, for conference reviews, the referee-specific component of a paper's score is twice as large as a paper's common component. Loosely speaking, which referee is chosen is twice as important as its actual quality.The effect of luck is compounded by path dependency. If you get a paper accepted early on, further successes likely follow. If an assistant professor at a top school gets her job market paper published quickly, the profession thinks she deserved her placement and sees her as a star. She'll receive seminars and conference invitations, and editors and referees will look upon her work favourably. But if she strikes out in the first couple of years, people write her off as having been overrated by her letter writers. And successes can make future publications not only more likely but also more impactful, given the effect of author fame documented by Brogaard et al. (2020).What this all means is those who are in privileged positions are there at least partly due to luck – and one of these people is me. Because luck affects not only whether your paper gets published, but whether you even write it in the first place. At the start of the second year at MIT, you take an empirical asset pricing course. The regular professor was on sabbatical, so it was taught by Tim Johnson, visiting from LBS. Normally the course is focused on neoclassical asset pricing, but Tim included Hirshleifer and Shumway's (2003) paper on weather and stock returns in the first week's reading list. During the lecture, Tim discussed the broader literature on sentiment and asset prices and explained how the most convincing papers had a strong a priori hypothesis – they used variables with a powerful effect on sentiment that's correlated across a country. Soccer results immediately came to mind.After the class, I emailed Tim to ask if this might be a potential research idea. Tim wrote back approving of the topic, with the caveat that he's not on top of the behavioral finance literature so didn't know if someone was already working on it. So he reached out to Nick Barberis, whom he knew from his time as a Chicago PhD student. Nick also said the idea was new, so I pursued it, found positive results, and posted a draft on SSRN.When you work on a paper, what's the worst thing that can happen? That someone else is doing so. Diego Garcia and Oyvind Norli, then at Dartmouth, were independently working on the same idea. During Nick's seminar at Dartmouth, Diego told him about their paper and so Nick informed them of mine. Diego and Oyvind would have clearly won any ‘fight’ – I hadn't even passed my qualifying exams and had limited time to work on it, and had no experience of the publication process. But instead they reached out and graciously invited me to combine our papers. And the worst thing that could have happened turned out to be the best thing, as I learned a ton from Diego and Oyvind – how thorough you need to be with empirical research (particularly on a controversial topic like ours), how to write a paper, and how to respond to a referee.4The paper was published by the Journal of Finance as Edmans et al. (2007). Yes, I benefited from the alphabetical ordering studied by Brogaard et al. (2020) – something that's been an undeserved windfall to me throughout my career. I don't want to belabour the point, but it's worth putting in one place all the luck I had with that paper. I was lucky Tim was teaching the PhD class and knew Nick; lucky two professors were working on the same paper (even though it would normally be a death-knell to a PhD student); lucky Nick gave a seminar at Dartmouth and found out about both papers; lucky Diego and Oyvind invited me to join forces; lucky to have a supportive Editor, Associate Editor, and referee for a potentially controversial paper; and lucky my name was first so that I got equal credit despite being a PhD student.I had luck on the next paper as well. Shortly after the soccer paper was conditionally accepted, the AFA annual meeting took place. I was lucky it happened to be in Boston, so I could go along. I saw Cliff Holderness present his paper, later published as Holderness (2009), which showed how prevalent blockholders are in the United States – but also how small their stakes were. I recalled the blockholder theory papers I'd learned in Stew Myers’ PhD corporate finance class. These papers were about governance through ‘voice’/intervention, but the small stakes Cliff found would likely make intervention difficult. This gave me the idea to write a theory of how blockholders can govern even if they can't intervene, that is only engage in ‘exit’, which became my job market paper (Edmans, 2009).These stories aren't meant to be a self-indulgent autobiography, but to stress how I'm here largely due to luck. If I played that same game 100 times starting with those same initial conditions, 99 of those times I wouldn't have the honor of giving the FMA keynote. Other scholars with strong records may also have benefited at least in part from good fortune. Again I don't want to go to the other extreme and suggest it's all due to luck. Skill, creativity, hard work, and resilience to setbacks all play significant roles – and even if you get lucky, you have to make something of it. But luck plays far more of a role than we think. In the words of Taleb (2001), we're ‘fooled by randomness’. Our profession has so few tangible measures of success that we overweight the signal contained in a single publication or someone's institution. Your job market outcome may be thanks to a lucky publication as a PhD student, or your job market paper happening to be close to the research interests of someone on the hiring committee for that year. This overweighting leads to path dependency and means the effects of luck are long-lasting, as evidenced by the rarity of upward mobility in our profession.The implications of the importance of luckWhat this means is those fortunate enough to be in privileged positions are indeed there – at least partly – because we've been fortunate. We thus have the responsibility to share this fortune with the profession through creating public goods. For the most elite group of scholars, the best public good they can create is their own research, and they should focus on that. But for others, tenure frees us from having to focus exclusively on our own papers and allows us to create other public goods. This may involve mentoring PhD students or assistant professors,5 serving on boards of journals or professional organizations, running conferences or summer schools, or providing comments on others’ papers. Now for most types of public goods, there's an instrumental benefit. Being a journal editor or President of a professional association is prestigious; running a summer school on your research field will help that field grow. Thus, even a strategic professor will create these public goods because she estimates the benefit exceeds the cost. But a purposeful professor will do so for intrinsic reasons – to contribute to the profession – and any boost to her own reputation will be a by-product.The importance of luck and path dependency also means that those with thinner CVs, or at institutions written off as lower-tier, may be just as capable as those at top schools. They may have suffered bad luck, or chosen a department due to dual-career issues or other geographic preferences. But our profession puts so much weight on someone's institution. Why is it that every conference name tag contains not only your name but also your institution? At an industry conference, that makes sense. People do different jobs, and so knowing a stranger's employer helps you decide whether to strike up a conversation. If someone has Houlihan Lokey on their badge, then someone interested in restructuring will approach him. Fidelity signals you're in public markets investing, and KKR you're in private equity.But in our profession, everyone does the same thing – we're all finance professors. Now we don't exactly do the same thing – some of us work in macro-finance, others corporate governance theory, others still behavioral asset pricing. But then, why don't conference name tags say our research field? That would lead to far more interesting conversations at conferences, where people strike up dialogs based on their shared interests – sorry, their shared passions – rather than whether we judge another person as worthy of our time based on their school.It's even worse at arguably the two most prestigious conferences in our profession. At the National Bureau of Economic Research (NBER), you start every meeting with everyone introducing themselves by their name and institution. Knowing someone's name is useful as you may have never met them before. Perhaps you've read their papers and now you can put a face to them, and initiate a conversation later. But why is their institution relevant? Will you go up to someone during the coffee break and say ‘Hi, professor at University X, I'm a professor at University Y’? The main effect is that others start judging whether you deserve to be in an NBER meeting, or are a gatecrasher. At the AFA, students are branded with ‘STUDENT’ on their badge, as if to say ‘don't waste your time talking to me; you're better off sniffing out a big shot’.6The school clearly contains some information about a person's quality, and conversations with more knowledgeable folks are more stimulating. I'm sure we could write a model of limited attention in which it's rational to talk to someone at a conference based on their institution, but as a profession we've taken it to the extreme. In legal parlance, the prejudicial value of the school outweighs its probative value. If we write-off another scholar – a colleague in the same profession – based on their institution, we're judging on a variable that's significantly affected by noise. This in turn starts a vicious cycle – being repeatedly treated like a second-class citizen can discourage researchers from attending conferences, which reduces their exposure and further perpetuates the path dependency.7And it goes beyond the name tag. Why do conference programs list the institutions of the authors and discussants – why aren't the titles of the session and papers sufficient? For conferences with multiple parallel sessions, this practice may cause us to attend sessions based on the presenters’ schools rather than whether we're passionate about the research being discussed. Now the quality of the talks, not just the topics, affects how stimulating the session will be. But the relevant factor is the person, not their institution. Some discussants outside the elite schools consistently give excellent comments; others in the magic circle always twist a discussion into an informercial for their own papers. But this reputation formation is hindered if we overweight the institution.8How much deadweight loss is created in our profession through judging others based on their institution? How many research conversations between people with the same passions have been lost, and how many great papers would these conversations have led to? How many interesting articles have we never read, despite being published in top journals, or never seen, despite being accepted to great conferences, because of the authors’ school? We'll never know about the past – but we can fix this for the future.Organizations are responding. At least two schools have used blind recruiting processes where faculty read job market papers that omit the author's name. Of course, there's significant information contained in reference letters and CVs, but these are read after the job market paper to avoid first impression bias. Such experimentation is to be encouraged. Some experiments may fail, as there turn out to be costs of removing the institution that I've failed to anticipate. But we won't know until we try, and if any profession should be open to innovation, it's ours. I'd encourage future conferences to think about removing institutions from name tags and conference programs, and replace the former with either research interests or nothing at all.9As with everything in this article, I'm saying this to myself as much as I'm saying it to everyone else, as I'm also prone to prejudice. On my office wall is a quote from the book ‘The One Minute Manager’, which reads ‘Everyone is a potential winner. Some people are disguised as losers. Don't let their appearances deceive you’. This quote is quite blunt, and I absolutely don't mean to suggest that faculty at different institutions, MBA students who struggle with the material I'm teaching, or journalists from less famous newspapers who want an interview are ‘losers’. Instead, this quote is to remind me that if I write someone off through my own prejudice, then the biggest loser – the person who loses out the most – is me.The importance and irrelevance of luck on the job marketWhen I went on the job market, I was neurotic about where I'd end up. This was when your ‘type’ is revealed, and you'd learn whether all those years slogging away in the PhD program, while your college friends were bringing home the bacon in industry, were worth it.But Dimitris Papanikolaou, also on the market from MIT Finance in the same year, pointed out that our eventual placement didn't really matter, at least from a purpose standpoint. All it affected was pride. We write the same papers, go to the same conferences, and teach the same material, regardless of what school we're at. And he was right. If the real reason I'd chosen academia over industry was because I loved research and teaching – because I wanted my purpose to be the creation and dissemination of knowledge – rather than to introduce myself at cocktail parties as a Harvard Business School professor, the outcome would make little difference. So, paradoxically, luck is both important (our job market outcome depends far more on luck than we think) and irrelevant (our job market outcome has far less effect on life satisfaction than we think).Yet again, I'm not advocating the opposite extreme. Your institution does matter somewhat. You might have smarter colleagues, a bigger research budget, superior PhD students, a smaller teaching load, and a stronger seminar series. But it matters far less than we think. In investment banking, if you're not at the bulge bracket banks, you're not in the room when the biggest deals are being negotiated. In our profession, we all have a seat at a table. Anyone can go to any conference,10 sit in any session – even by a Nobel Laureate – and ask questions in the Q&A. We can collaborate with co-authors from any institution, particularly in the days of Zoom. In Spring 2020, Murray Frank, Vojislav Maksimovic, and Gordon Phillips launched a Virtual Corporate Finance seminar series that anyone can attend, and for others there are similar series around other themes. Anyone can submit to any journal, while novelists can't send a manuscript to a publisher – editors only accept submissions from agents, who play a screening role. The main reason the school matters is if, as a profession, we've decided it does – if we judge others by their institution or if I, as a journal editor, am prejudiced against authors because of it. This not only leads to wrong decisions ex post, but also adds a huge amount of ex ante stress to job market and tenure outcomes which are already significantly driven by luck.The barriers to entry in PhD programsJudging happens not only once we're assistant professors, but also when we're PhD students – our institution affects whether we get job market interviews or are invited to doctoral conferences. It occurs even before that – applicants to a PhD program are evaluated on where they studied before and who they've worked with. Nowadays, the barriers to entry are huge. Most PhD applicants already have a Masters; many have undergrad or predoc RA experience where the fame of the professor matters much more than the tasks undertaken. PhD students now take six years to graduate, since we now expect a large pipeline and even a publication, making the pathway to a finance professor even more financially costly. Both the premium placed on RA experience with a famous professor and the financial resources needed for a PhD may alienate students from developing countries or less affluent backgrounds. It's becoming an arms race.Of course, some of this prior training is useful. And, institutions do carry some informational value, particularly when sifting through lots of applications. But if a precondition for getting into a PhD is years of research experience plus a Masters, we're going to exclude many people who didn't find their passion until later in life – they didn't know to get RA positions during their undergrad. We make the path dependency even worse.I never wanted to be a finance professor. I loved my job at Morgan Stanley's Investment Banking Division, but had never lived outside the United Kingdom and wanted to travel. I had a Fulbright Scholarship to the United States but it wouldn't fund an MBA. There were no Masters in Finance back then, so my only option was to do a PhD in finance and drop out after two years with a Masters. I took a Summer Associate position at the end of my first year, hoping to get a full-time offer for after my Masters. I moved into Fixed Income Sales and Trading to give me experience of another side of industry, and I enjoyed it much more. During the weekends, I wrote my first paper – a theory of inside debt I later completed at Wharton with a PhD student and published as Edmans and Liu (2011). Morgan Stanley gave me an offer, but since I had the inside debt and soccer papers, I thought the PhD might only take one year more than the Maters, so I decided to complete it before returning to Wall Street.Knowing it would be my last chance to travel, I spent my second summer as a volunteer teacher of English in Saraburi, Thailand. I chose rural Thailand because the absence of tourists meant that barely anyone could speak English, making volunteers particularly important. My surroundings meant there was no internet where I stayed, nor anything for a non-local to do. So, once the school day was over, I wrote a theory paper of capital structure which ended up being Edmans (2011b).I returned to MIT for my third year and went straight on the (industry) job market. I'd chosen Morgan Stanley for my fixed income internship since I'd previously worked with them in investment banking. But I learned that, in fixed income, Lehman was the market leader so I signed with them. I defended my dissertation and told my advisors I was graduating. One advisor, Dirk Jenter, caveated that I was leaving academia before learning what my outcome would have been. He advised me to stay for a fourth year, write a job market paper, and see how I fared. If I didn't get the placement I wanted, ‘Lehman will always be around’. Famous last words.Lehman graciously deferred the offer, and I started my job market paper after seeing Cliff Holderness's presentation at the 2006 AFA. But the more important effect of that extra year was that it made me realize how much I enjoyed academia. I gave my first conference presentations in Spring 2006 and really enjoyed this part of the profession.11 I'd started delivering lectures as a Teaching Assistant and felt in the zone doing them. I loved writing my job market paper, getting lost for long hours with just pencil and paper, and exploring something deeply. So I decided I was going ‘all in’ to academia – there was no cut-off school below which I'd join Lehman. Research and teaching had become my passion.I'd have never gotten into a top PhD program if I applied today. Even if I sneaked through, I'd have been nudged out for doing an internship in my first summer, and booted out for doing volunteer work in my second. Many leading scholars have similarly told me how they decided on academia much later in life. If the profession is going to be truly serious about diversity, this extends beyond the important aspects of diversity in gender and ethnicity to diversity in background. As with evaluating researchers by counting publications, our approach to recruiting PhD students is extremely risk-averse. Applicants who've been finance or economics RAs from when they've been undergrads might be the safest bet. But some right-tail outcomes might arise from researchers with a broad set of skills. Behavioral finance was catalysed by insights from psychology; nowadays, promising topics such as machine learning and corporate culture similarly bring in ideas from outside finance. Our current preference for career RAs recruits candidates who are used to working on other people's ideas, rather than their first experience of research being to take the risk of exploring their own.5 NON-RIVALRYAt Morgan Stanley, many interactions with other investment banks were zero-sum. Most mandates are awarded to only one bank, so if you win a pitch, no one else can. On the trading floor, if you make a profit on a transaction, your counterparty loses.12But in academia, many things aren't zero-sum – the pie is not fixed. Journal space is not finite, so someone else publishing doesn't reduce the space for you. The Review of Financial Studies was created in 1988 because there were more top papers than top journal slots, and expanded from bimonthly to monthly in 2009 as the supply of great research grew. At the Review of Finance, we've recently increased our issue size by over 50%. The move towards online journals removes any constraints associated with limits on the size of a physical issue. At a conference, there are limited presentation slots, but supply adjusts to accommodate increasing demand; many professors believe there are now too many conferences. Collaborating on a paper is similarly not zero-sum – if a paper has three authors, each one gets more than a third of the credit (indeed, there are some schools that simply count the number of publications without adjusting for co-authorship; Google Scholar and other citation databases similarly make no adjustment). And unlike in other disciplines, we don't need to argue with our co-authors over who contributed the most and thus should be the first author.Certainly, there are rivalries in some elements of our profession. Only one person can win the Fischer Black Prize or be the AFA President in a given year. But, for most of us, these honors are out of reach – and of little consequence if our purpose is the creation and dissemination of knowledge (there are many influential scholars with neither honor). There are also rivalries between authors working on the same topic, but they can often be overcome if approached with a non-rivalrous mindset. In Section 4, I discussed how Edmans et al. (2007) came about through a merger of two similar papers. Sometimes mergers are impossible – it's difficult to go on the market with a paper co-authored by senior faculty. When I presented the first draft of my job market paper (Edmans, 2009) at the MIT PhD student lunch, I was despondent to see the MIT external seminar that afternoon was another model of governance through exit by two leading theorists (Admati & Pfleiderer, 2009). But we kept abreast of each other's papers, ensured we maintained our different focuses rather than steal each other's turf, and cited each other fairly – and both ended up getting published. In contrast, copying someone else's idea or failing to give others credit leads to win–lose outcomes.Ours is a unique vocation in that our main loyalty is to our profession, not the institution. People at other universities are our colleagues, not our competitors. We decide on who to give tenure to based on what our competitors say about the candidate. How crazy is that? Would a law firm decide which associates to promote to partner based on their rivals’ assessment of them? This process is so standard that we follow it without stopping to think how nonsensical it would be in the private sector. Yet it's not crazy in our field, since our main affiliation is to the profession.At a conference, we ask someone at a ‘competing’ institution to discuss a paper. How crazy is that? Would an asset management conference have one company present its responsible investment strategy and a rival then comment on that strategy's effectiveness? Journal editors decide which papers to accept by scholars at competitor universities based on advice by referees also at different institutions. Would an M&A acquirer outsource its decision of which investment bank to hire to another advisor which, for some reason, was not pitching for the deal?That the profession's pie is not fixed provides us with tremendous opportunities to grow it by contributing to the creation and dissemination of knowledge across our profession as a whole – by viewing other members as our colleagues in the advancement of knowledge.Collaborating to create knowledgeSo how do we do that? Starting with the creation of knowledge, perhaps the biggest thing is to provide comments on each other's papers. I was lucky to have had PhD classmates who I did that with. Because the soccer paper allowed me to go to conferences, I met many faculty who later sent me their papers for feedback. I was flattered that they were reaching out to a PhD student for comments and tried my best to help.When Diego, Oyvind, and I merged our papers, I wrote to Nick thanking him for his role in it. He replied saying it was a pleasure, and kindly inviting me to send him the first version of our joint paper as he'd be happy to provide comments – and he indeed did. I later told Tim Johnson I had a corporate theory paper on inside debt, but there were few corporate theorists in MIT Finance. So, he advised me to send it to his LBS colleague Denis Gromb. That summer, I presented the model in Gerzensee, and Denis came up to me afterwards with a full mark-up of my paper (which he'd read in advance) and spent an hour giving me comments.Having benefited from others’ input on my papers, this was one of my key criteria for choosing which school to join on the job market. During one of my post-offer visits, I asked someone whether the faculty provide comments on each other's papers. He said no one does that – but no one does that at any school because people are too busy with their own research, so it shouldn't factor into my decision. I was surprised, and explained how Nick and Denis had helped me even though I wasn't at their schools. He replied ‘Ah, but Nick and Denis are special. Most people in the profession aren't like them’.I went away from that meeting impressed by his honesty but depressed by his message. But, as a theorist, I understood the concept of multiple equilibria. You can have competitive equilibria and you can have cooperative equilibria. And, unlike models where a sunspot decides which equilibrium is selected, here you might be able to affect the equilibrium. Deviating to ‘cooperate’ when everyone else ‘defects’ may not be a best response if your only objective is your own utility, but if your purpose is the creation of knowledge, it may well be. (And, unexpectedly, others may start cooperating too, so you end up benefiting even though that wasn't your motivation). I tried to provide the best possible comments on every paper people sent me, and soon formed relationships where we'd send each other our papers for feedback. Perhaps I gave more comments than I received myself, but I wasn't keeping track. I genuinely enjoyed reading others’ new findings and providing input into them.These relationships are ones we can proactively form ourselves. Why is it that, until the pandemic, nearly the only way to obtain feedback was to fly around the world, at great financial and environmental cost? Why does our ability to receive suggestions hinge on whether our paper gets accepted at a conference (which Welch (2012) showed largely depends on luck), whether we're invited to give a seminar (which depends on our institution and perhaps luck from knowing a faculty member there), and our research budget and ability to travel (a particular barrier to non-U.S. authors)? Why will we only give feedback in the form of a public discussion or in a seminar, where we get something in return by appearing smart in front of our colleagues?I was lucky to form most of my relationships implicitly. I never sat down with someone and said ‘let's have an arrangement where we send each other our papers for feedback’; I'd just provide comments when people sent me papers and the relationship naturally evolved. But, there's no reason why such a relationship can't form deliberately – and, why limit it to two people? At Wharton, I established a corporate finance discussion group for junior finance, accounting, and economics faculty to present embryonic work. The guidelines were that you had to attend every session, even if you were not presenting, and much bigger organizations like the Finance Theory Group have similar rules. When I moved to LBS, some colleagues and I set up an LBS/LSE corporate finance discussion group with an extra rule – you had to read the paper in advance and prepare your comments. Thus, when the author presented, it wasn't a standard seminar where the goal of each slide was to explain its contents to the audience, but instead to prompt the audience to provide their comments on the aspect of the paper contained on that slide.In today's virtual world, such hubs can be formed across the globe – we're not limited by our institution. We can read each other's papers and then provide comments over a Zoom call, if it's a hassle to write an email; or we can give virtual presentations to each other to save reading effort. The challenge with physical conferences is you need scale for them to run, but the online world shatters the minimum efficient scale. A hub can be established even around a niche area.In addition to informal comments, we contribute to the creation of knowledge through our formal role as referees. I started refereeing as a PhD student, and quickly these requests exceeded 40 per year, in part due to working in different fields. Senior colleagues said this was my fault and I should do a good job rather than aiming for perfection – not only is the time spent directly costly, but being too diligent means that editors will keep coming back to you.But I was grateful that editors trusted me to advise them whether to accept a paper – a decision that would affect not only the journal's reputation but also whether the authors step as much as one quarter of the way to tenure. I enjoyed seeing how papers evolved after incorporating my comments, and was thankful to play a role in the creation of knowledge. I never expected any instrumental benefit. But the Review of Financial Studies unexpectedly introduced a Distinguished Referee award in 2009, at the end of my second year as an assistant professor, and I was an inaugural recipient; two years later I was invited to become an associate editor. And, junior faculty at other schools informed me that editors told their departmental colleagues over lunch that they appreciated my reports, something I never expected to become public. Through the process itself, I learned a ton – how to pick apart a paper, highlight its contribution, and tease out the implications for a general audience – that I could apply to my own papers and, more recently, my editorial work. I could have never predicted these outcomes, but the power of purpose is that actions undertaken for intrinsic reasons can bear unexpected fruit.Another way we can contribute to knowledge is to answer requests for help. As finance professors, we're all familiar with the concept of arbitrage – things of equal value trade at equal prices. But the key to citizenship is to provide gifts of unequal value that are worth far more to the recipient than they cost the gifter. When I was a PhD student, I'd sometimes email professors with questions about their dataset or analysis that weren't covered in the paper, or ask if they knew of follow-up work that had expanded on it in a particular direction. I was grateful for all the responses I received – they may have taken them five minutes to write, but saved me five hours.Morgan Stanley was a company with potentially huge rivalry, yet it was routine for analysts to help each other. When someone needed sample slides on how to deal with flowback in cross-border M&A, they'd email the analyst mailing list in case any of us had done something similar. In our profession, we have Statalist for coding queries, but no list or message board if someone has a question on a dataset, or wants to know if there's a paper that shows a particular result. We have message boards for gossip and slander, as I'll discuss in Section 5.3; why don't we have ones that catalyse the creation and dissemination of knowledge?None of the above is to suggest that we're obligated to respond to every email, nor that we have the right to expect responses to our own messages. It's our responsibility to compose our emails so that the recipient wishes to respond to them – for example explaining that we've already looked at X, Y, and Z but still couldn't find the answer. But it does mean that, if the sender has done his homework, a response may be a gift of unequal value.Similarly, we shouldn't expect everyone to provide comments on papers that we send them, particularly if they're way outside our research field. I hope my earlier suggestion to provide comments on each other's papers doesn't lead to the other extreme, where people send around papers randomly and bear a grudge if they don't get a response. While many two-way relationships can be created, it's the recipient's prerogative to decide whether to enter into a relationship with us. They may have other professional or personal commitments that we're not aware of.Collaborating to disseminate knowledgeThe second way to grow the profession's pie is to share others’ research – mention it to others working in similar fields, invite it to a conference, or posting it on Twitter or LinkedIn so that it's seen by practitioners. Doing so has instrumental benefits – the beneficiary is grateful and may return the favour later.13 Thus, a strategic professor will disseminate others’ research, but only that of big names, hoping for reciprocity – thus perpetuating the path dependency. But a purposeful professor will do so because the research is interesting and, in some cases, because it's a gift of unequal value.How did I end up at Gerzensee to receive Denis Gromb's comments? My advisor Dirk Jenter saw a working paper version of Sundaram and Yermack (2007), an empirical study of inside debt. I sent the authors my theory paper on the same topic and both graciously responded. David Yermack asked if I'd sent the paper to a journal; I replied that it had been rejected by one. He told me not to be discouraged as many of his most innovative papers had to be sent to multiple journals. While most professors know that rejection is part and parcel of the profession, I was quite devastated to have been rejected and so this was a gift of unequal value to a green PhD student. A few months later, David invited me to present my work in a Focus Session he was organizing in Gerzensee that summer. There were so many other people he could have invited to bolster his career, but invited me to help publicize a paper that might not otherwise see the light because I was a PhD student.Another way of disseminating knowledge is to let authors know about relevant papers. I've written a number of survey papers, and my co-authors and I send drafts to people in the literature to ensure we're referencing everyone accurately and haven't missed relevant research. There are some authors who always respond by telling me to cite several of their other papers, even though none are relevant, with no comments beyond that. But others will alert me to papers by other scholars that I've missed, perhaps alongside a suggested correction to how I've cited them.Some researchers have public platforms, for example on Twitter and LinkedIn, and thus the ability to disseminate knowledge to a wider audience. A number will only share their own papers, or newspaper articles. But sharing the writings of others is a great way to increase our profession's impact.Shrinking the pieEven though our profession is characterized by non-rivalry, we sometimes act as if we have huge rivalry – as if making others lose automatically causes us to win. The worst example is the anonymous trashing of our colleagues on internet forums. Such forums are the cancer of our profession. They lambast others’ work, their character, and their personal lives, sometimes involving sexist or racist comments. No other profession to my knowledge has such forums. Our students, our executive education clients, our university administrators, those who donate to our school, and companies who sponsor conferences and best paper prizes would be aghast if they saw this side of our profession.Our profession is enhanced by criticism and challenge, but only within a framework of accountability. A discussion is public, so if a discussant is below the belt, her own reputation is harmed. A referee report is anonymous to the authors, but visible to the Editor. But message forums allow people to post false allegations with zero consequences. Doing so is like urinating in a swimming pool. It can be done without anyone noticing it's you, spreads easily, and can't be easily taken back. The damage only subsides once everything is sufficiently diluted, which takes years.Now one might claim it's OK to read these forums, as long as you don't post on them, but doing so contributes to advertising revenue. Is a platform where our colleagues get vilified something we really want to support? We might instead argue that reading them is a way to obtain information about the profession. But by trying to ‘rationalize’ it this way, we're telling ourselves ‘rational lies’. Ours is a profession characterized by evidence. We can't publish a conclusion without it being based on research, which has been vetted diligently by a review team. These forums allow people to post claims without any substantiation; while we might think we'll apply the appropriate discounting, once you've heard an allegation, it's difficult to unhear it even if false. There are far more reliable channels to keep abreast of what's going on.14 And viewing such forums pollutes the reader with endless negativity or – worse – misinforms our decisions (e.g. we might not submit to a journal if we believe it's biased, or approach a professor if he's been labelled a predator). If you step into a swimming pool in which others have urinated, you get contaminated yourself.A second way in which we practice rivalry is through Schadenfreude. If someone's paper is destroyed in a discussion, overturned, or retracted, we're secretly delighted – particularly if it's a high-profile person. We think reducing their slice leaves more of the pie for us. But the entire pie shrinks if outsiders view academic research as irreplicable. If a paper is indeed irreplicable or flawed, the researchers who point this out are creating a public good. However, we often react positively due to the embarrassment for the original authors, not because the criticism helps science evolve.Third, we can shrink the pie through being territorial about our own agenda. If we work in (say) sustainable finance, we want to position ourselves as the only academic expert in sustainable finance. We refuse to disseminate others’ work; in contrast, we may trash it. But reducing our colleagues’ slice of the pie doesn't mean more for us – instead, the pie will be grabbed by others outside our profession. Companies, consultancies, and think tanks are all putting out their own research. While some practitioner papers are informative, most don't aim to be a scientific analysis of the data but to support the organization's pre-existing position or yield a conclusion that the public likes and thus boosts its image. These organizations may not have the expertise or incentives to produce high-quality research, but they certainly have the resources to market it. If we don't promote the research of our profession as a whole because we're only focused on tooting our own horn, this leaves the rest of the pie up for grabs – and it will be grabbed, by companies and consultancies.A lion can't catch a springbok in a race. So the lion waits for springboks to fight with each other and then attacks. I don't want to be apocalyptic, but our entire profession is under attack. Corporations are now developing their own executive education programs. The move to online education means that whatever teaching requirements we retain can be met by fewer people, so the profession is likely significantly over-capacity. The public – which includes both users and funders of academic research – doesn't recognize the value of research, both because it gets crowded out by practitioner studies that exploit their confirmation bias, and also because the petty fights we get into with each other give the impression that no one agrees and so there's nothing to learn from academia (see also Schoar, 2020). Of course, healthy dissent is to be encouraged if people reach different conclusions – but, each year, our profession pushes out the frontier of knowledge and we agree much more than we disagree. For example, the consensus from a broad stream of research is that share buybacks are much less value destructive than politicians and talking heads claim them to be – but academia is having very little impact on this debate and so unwarranted regulation is a real possibility.If we don't stand up for our own profession or, worse, actively try to destroy it, we ourselves will lose in the long term. The schools of the future may be teaching schools. Indeed, such schools are already starting to crop up, with few research requirements aside from developing case studies. If research is irrelevant, why should students or donors pay for it?Despite these threats, the scenario is far from a doomsday one. We have the power to help our colleagues create knowledge and to disseminate their research. Our time is a scarce resource, and we face our own creation and dissemination pressures. But the beauty of gifts of unequal value is that public goods can be created at little cost to ourselves – seemingly small actions make a big difference. The main barrier isn't so much time, but a mindset shift – from a zero-sum mentality to thinking proactively about how we can advance our profession.One such gift is kindness. This doesn't mean telling white lies – if we're asked to discuss a paper with serious flaws, it's our duty to point them out. Not to do so is unkind to the authors, otherwise they send a flawed paper to a journal, as well as being a disservice to the conference. But even harsh criticisms can be given in a constructive way15 – yet sometimes the discussant thinks he can boost his reputation by slamming the (usually junior) author, like a bully who beats up little kids in the school playground. And like in the playground, it's tempting to weigh in ourselves – to be the thermometer that reflects the temperature around us – but we have the power to be a thermostat and affect the temperature. In the Q&A following discussions that went overboard, I've seen audience members politely, but firmly, explain why the main criticism is invalid – to defend those unable to defend themselves.16Other gifts of unequal value involve small acts of awareness. After a discussion, it's tempting to respond to at least the main criticism, but I've seen authors remark that the session is running late and forgo the opportunity to respond so other papers get their full time. Presenters and discussants have voluntarily shortened their own talks for the same reason. The effect of these actions goes far beyond providing a few extra minutes to the later papers. They change the temperature of a conference from being about marketing your own research to listening to others’. This then inspires the audience to think about how they can be a thermostat themselves.Some acts of awareness involve talking to a conference attendee who's alone at a conference cocktail party. I don't want this to come across as an ‘adopt an introvert’ project, but to highlight how such awareness can have an outsized effect. During the second evening of the Utah Winter Finance conference, there's no scheduled dinner to allow professors to form their own groups. One group noticed I knew virtually no one as I was a PhD student. They kindly invited me to their dinner even though it meant they now had too many people for the car and we had to take a taxi. When the bill came, a professor remarked that I won't have a research budget and should pay less than everyone else.In the third summer of my PhD, I was grateful to be invited to the NBER Summer Institute. I was at the dinner the evening before the conference. A social psychologist studying human behavior would have a field day at NBER dinners. When it's time to move from the drinks to the dinner, no one sits down. They wait for the big shots to seat themselves first and then they rush to sit at the same table. Then, when you're at the table, you hang on their every word and laugh as audibly as you can at their attempted jokes.There was an assistant professor at my table. She should have talked to everyone else at the table instead of a PhD student; she wasn't even sitting next to me so had no obligation to do so. Yet she struck up a lengthy conversation, showed genuine interest in my research, and looked at my website after the conference and dropped me a note saying she found my capital structure paper interesting (at the time, it had ‘limits to arbitrage’ in the title). This was Wei Jiang, and we ended up writing two papers together, one on limits to arbitrage. At the time, she couldn't have calculated that there'd be any instrumental benefit to such a conversation. But, at the risk of repeating myself yet again, actions taken for intrinsic reasons might end up benefiting us unexpectedly.6 IMPACTThe first deal I did at Morgan Stanley was selling the consumer finance division of Abbey National, a U.K. bank, to GE Capital. The sense of accomplishment was fantastic. The next day, the transaction hit the front page of the Financial Times. It praised Abbey National for obtaining a good price and, more broadly, giving credibility to its overall disposal strategy.But the next day, the Financial Times had completely different headlines. I realized I'd spent 7 months of my life working on a single company's problems at a single point in time. Of course, the long-term consequences of that transaction would be far beyond a single day, but the transaction still only affected two companies, Abbey and GE.Even in investment banking, I got exposure to the research done by Morgan Stanley's economists. I read a note on the implications of greater female labour force participation for economic growth, and thought how engaging it would be to have a job studying companies or economies as a whole, not just one client. And when I got to MIT, and started reading academic research, I realized that not only was the perspective broader than a single company, but also timeless. It wasn't about forecasting economic growth for that year but uncovering relationships that might hold in general – not only at the time the researchers wrote their paper but also in the future.We're lucky to work in a profession with incredible impact. Our research can be read by thousands of people, and we teach hundreds of students each year who then practice it and pass it onto their colleagues. The knowledge we create and disseminate affects how citizens save and invest for the future, how managers run companies, and how policymakers set regulations. Our research and teaching really matter.But I need to rephrase that last sentence. Our research and teaching ‘have the potential’ to really matter. At the moment, they don't, due to what our profession rewards and values. Two aspects are particularly underweighted: teaching and engagement.TeachingTeaching has very little effect on professional success, as long as it doesn't fall below a rather low bar. When I joined Wharton, there was a half-day orientation for new assistant professors. I asked the Deputy Dean how much weight is put on teaching in tenure decisions. He replied ‘Zero’. If I was initially surprised, I was shocked a few moments later when he clarified ‘Zero or negative’. He explained that, if you did too well in teaching, faculty would assume you're not serious about research – as if one is inevitably at the expense of each other.This is sad. Our salaries are primarily paid by current students through their tuition fees and alumni via their donations. Yet our evaluation system ignores our impact on our students. It would be crazy for a professional services firm to put zero weight on what clients think of a consultant when making promotion decisions. The Journal of Finance is the most-cited finance journal, with a 2-year impact factor of 7.5. If we get a paper into our profession's most elite outlet, on average it will be cited by four other papers published each year. Yet how many students do we teach each year? 200, 300, maybe more? This isn't to say that research isn't important, and I recognize I'm comparing apples and oranges because one student isn't equivalent to one citation – but it's to say that teaching is very important. Our profession is about the creation and dissemination of knowledge, yet we pay no attention to how we disseminate information to a key stakeholder group. Just as path dependency exists for us, it also exists for our students17 – a little more investment in the classroom can help them get a great job, which then sets them on a quite different trajectory.Moreover, there are significant synergies between teaching and research. Adding new material to courses can spark research ideas that take many years to publish (potentially after a tenure decision) given the time-to-build; many pioneers in FinTech started teaching it before writing papers. Condensing complex ideas into simple language for students forces you to understand them deeply. Such a skill is transferable to writing papers and giving seminars that are of interest to a general academic audience rather than just those in your niche.The problem is serious. It can't be solved by simply increasing the weight we put on teaching ratings for tenure or hiring. Most schools’ teaching ratings don't actually measure teaching, but customer satisfaction. Scores of ‘the quality of the professor’ gauge popularity and entertainment; ‘how did the course meet its stated objectives?’ or ‘how clearly did the faculty explain the course concepts?' reward easy courses with non-ambitious objectives and easy-to-explain material, and ‘how respectfully did the professor treat students?’ penalizes instructors who tell students they've given a wrong answer, or hold them to account for consistent lateness or smartphone usage. In contrast, there are few ratings or awards that capture how much we challenge and stretch students.18The problem has become markedly worse over my 15 years in the profession. Business schools, which should focus on education and view students as the product,19 are becoming business schools, focused on customer service and viewing students as the client. One reason might be schools’ growing concern with MBA program rankings, which are significantly influenced by student satisfaction. A second could be the increasing staff-to-faculty ratio,20 which in turn raises administrators’ influence on evaluation processes. Staff may have different objectives than faculty, such as maximizing response rates for course evaluations rather than their accuracy. As a result, some schools ask students to fill in evaluations at the end of the final class. Given recency bias, there are a huge number of ways to game the system – make the final class particularly entertaining, or turn it into a revision lecture and say ‘this will be on the exam’ so students think the course was useful (of course, defining ‘usefulness’ in relation to the exam rather than real life). At other schools, the ratings are after the final exam, punishing instructors who give a challenging exam.A strategic professor shouldn't want to change the system, particularly since it's easy to game. But a purposeful professor will be deeply concerned with the system. Our profession has developed many optimal contracting models where agent actions have long-lasting effects. None of those theories predict rewarding only the most short-term measure of performance available – an evaluation immediately at the end of the final class. Alternative, or at least complementary, approaches might involve students evaluating core professors at the end of their degree (to gauge whether the core class helped with electives), or all courses several years after graduation to assess whether they had long-lasting impact. The criteria themselves could be supplemented – ratings of the academic research content of an elective will encourage dissemination of our profession's primary output. However, no matter how much we improve the evaluation questions, quantitative scores will remain an incomplete measure. Just as how our evaluation of research should go beyond paper and cite counting to reading papers, those assessing teaching should read students’ qualitative comments rather than just the scores.EngagementStudents aren't the only constituency we share knowledge with. But our coverage in the media, our impact on policy and practice, writing practitioner summaries of our papers, responding to SEC consultations, or contributing to public debates on the most important finance issues of the day similarly has almost no effect on professional success. This is crazy – not only does doing so directly influence the specific topic we're contributing to, but also elevates the impact of our profession more generally. In fact, such activities can reduce our academic standing if others think that, if research can be covered by a newspaper it can't be highbrow, just as an indie musician might turn his nose up at an artist who's gone mainstream.Writing textbooks might be met with mild nods of approval, particularly if they're for PhD students. But anything for a general audience is sometimes seen as selling out, even though the economics of writing books are unattractive (unless you write something fluffy to be sold in airport bookstores). Yet trade books are an excellent way of disseminating academic research to the public. In other business fields, such as organizational behavior and strategy, books are highly respected and seen as a natural next step after becoming an expert in a field. But for finance, the sign that you're an authority is that you write a survey paper for a Handbook or the Journal of Economic Literature. We see the pinnacle of dissemination as writing solely for other academics; other fields view it as influencing the practice of business.Similarly, the relevance of the topics we're writing academic papers about has little or negative effect on success. One of my former senior colleagues told me that a ‘proper’ theorist shouldn't do empirical work as he should be pure, and that citations and media coverage are a negative measure because pure theory should be unintelligible to the unwashed proletariat.Expanding the information setWith all these things, I'm again not recommending a complete 180. Rigorous research must be front and centre of what we teach our students, what we communicate to the media, and what we advise practitioners. There's a high personal payoff to telling practitioners what they want to hear even if not based on evidence, as they might invite you to keynote at conferences and give you lucrative consulting projects; to exaggerating your findings to the media, as they're more likely to share it; or to writing a one-sided book that quotes research selectively as it's more likely to be a bestseller. And I fully understand the importance of basic research that doesn't have any immediate applications – this is the research that can only get done in academia. Thus, reasonable people can disagree on whether the optimal weight we put on teaching and external impact is 10%, 20%, or something else. But I'm pretty sure it isn't zero.The weighting scheme matters beyond tenure. When candidates are up for election to director of a professional association, their biography (sent out with the slate of candidates and the basis on which association members are expected to vote) focuses on their research contributions. Who we choose as our association representatives bears little relation to their teaching or engagement, suggesting we ourselves don't care about them. This is surprising since the actual duties of a director don't involve conducting or even evaluating research but producing public goods – which is arguably more correlated with teaching and external impact.Those in senior positions, who evaluate junior colleagues and decide on tenure, have the power to change the system. Do we really want to be in a profession that put negligible weight on how we educate our students, how we inform practitioners, and how we contribute to the most pressing debates of our time? This is our profession, and we can decide what we value. Can those on the boards of our professional associations (including me) do more to improve our profession's external impact, rather than focusing exclusively on internal issues such as our conferences and journals, important as they are?And those not yet tenured have the power to choose how much time we spend on teaching and engagement, even if our seniors put negligible weight on them. If we view our purpose as the creation and dissemination of knowledge, then these things really, really matter, regardless of whether they're extrinsically rewarded. We put effort into teaching because it's a privilege every year to meet hundreds of smart young people who will run companies, start businesses, and allocate capital. We speak to the media because we want topical issues such as executive pay, dividends, and share buybacks to be portrayed fairly to the public rather than being subjected to one-sided bashing. We engage with policymakers because we care about the laws they pass and wish them to be based on evidence. None of these things are valued by the profession, nor are they financially compensated, but they may be some of the most rewarding activities we undertake. And, centring our worth in part on teaching and engagement rather than exclusively on publication or tenure reduces the anxiety resulting from the latter's significant dependence on luck.My fourth year review at Wharton was very negative. I had nine so-called A publications, but was told that my probability of tenure was so low that it was pointless even coming up; instead, I should focus on looking for another job. An hour later, an MBA student walked into my office because he had some finance questions. He saw I was upset and I told him what happened. He started consoling me and, mid-sentence, remarked offhand ‘wow, look at all your teaching awards’, nodding to my shelf. I lamented that they're all irrelevant because I was going to be fired. He rebutted that each award represents 200 students, so the awards collectively corresponded to over 1000 students who I'd had an impact on.The next day, I was teaching at the Faculty Showcase during Wharton Welcome Weekend. This is where hundreds of MBA admits check us out to decide whether to accept Wharton or another school. Even though I clearly wasn't going to be unprofessional, I feared I wouldn't be able to give my class wholeheartedly. How could I with full sincerity pump up a school that was treating me so badly? Of course, given my behavioral biases, I believed the negative signal I'd received was completely unjustified; I ignored the fact that tenure is a lifetime contract and a very high bar ‘should’ be imposed. In my eyes, I was right and the collective opinion of over 20 senior faculty was wrong.But I remembered I wasn't a member so much of my institution, but the profession – a profession whose purpose is, in part, to educate, challenge, and inspire MBA students. And, even as far as my own school, I realized what a privilege it was to represent it at this event. I tried to delude myself that I could get my own back by not putting heart and soul into the class, and then some admits would go to other schools, but I'd have only been hurting myself. I recalled something my advisor Xavier Gabaix said when I told him I was leaving MIT for Lehman, giving a trivial slight I'd received at MIT as one of the justifications. He told me ‘never make any decision out of spite’ – something that had applied to many situations since, and now applied to my present one. I had little power to affect my tenure decision, but I did have the power to live unoffended.I delivered that lecture with the same passion and enthusiasm as I'd done every year. And it was I who benefited the most, not my employer or even the admits. The black cloud cleared from my head as the lecture reminded me why I chose this profession in the first place.7 CONCLUSIONThis is a fantastic profession to be part of. We have the freedom to research bold, important questions we're passionate about – but we're sometimes afraid to leverage that freedom as we feel pressured to work on what's currently popular or where our expertise lies. We have tremendous power to be citizens to this profession, and our loyalty is indeed to the profession, not our institution – but some things we do are motivated by rivalry. The school we work at may not be that relevant – yet we judge members of our profession by it, contributing to our own stress when on the job market or coming up for tenure. We have the potential to make profound contributions to wider society – but the way we evaluate each other ignores such impact.We have the power to change that. This article has proposed a number of suggestions for how the profession can be improved, which I'll summarize here.Decision-makers (e.g. tenure committees and hiring committees)Be less risk-averse in hiring decisions; hire those with the potential to create knowledge, not just publish papers.Place less weight on quantitative measures and treat journal publications as less binary. Place more weight on qualitative measures, such as innovation, independence, impact, and importance. However, recognize that the optimal assessment involves a balance of hard and soft information, to avoid decisions being based predominantly on cronyism or taste.Evaluate the dissemination of knowledge, through both teaching and engagement. Ensure that teaching assessments reward education, rather than entertainment or popularity.Consider ‘blind’ recruiting processes where faculty read papers that omit the author's name and institution, and only see the CV and reference letters after submitting their comments on the paper.Conferences and professional bodiesConsider removing institutions from conference name tags, and replace them with research interests or nothing at all. Consider removing institutions from conference programs.Explore ways to improve the creation and dissemination of knowledge, such as hubs, forums, or mailing lists around a research area, or coordinating the profession's response to a policy consultation.Members of the professionBe bold in your choice of research topic. Pursue the questions you're passionate about and view as important, rather than feeling pressure to work on a currently popular area.Recognize the significant amount of luck in this profession. Focus on inputs (what you choose to work on) rather than outputs (publications); celebrate what you can control (paper submissions) rather than what you can't (paper acceptances).See yourselves as members of a profession, rather than an institution. While the ‘rank’ of your school makes some difference, the effect is much less than commonly thought. A disappointing job market or tenure outcome has limited impact on your ability to create and disseminate knowledge.View colleagues in the profession as partners in the creation and dissemination of knowledge. Provide feedback on others’ papers and share others’ research, both to other academics and to the real world. Stand up for the value of academic research (over and above practitioner studies) for real-world questions.View dissemination of research to be an integral part of the purpose of a professor, through teaching or engagement with practitioners, media, or policymakers.Be comfortable with the fact that a purpose-driven approach to the profession may not maximize short-term success. However, it may lead to more success in the long term, as well as greater life fulfilment.Never forget what caused you to join this profession to begin with – the freedom to work on what you want, with whom you want, and when you want; the ability to discuss the latest research discoveries with world experts at conferences or seminars; the privilege of meeting hundreds of smart young students each year and teaching them skills they'll use to manage companies or allocate capital; and the power to influence public opinion on the leading issues of the day. Keep this at the forefront of your mind through uncertainty or disappointment.My ideas for making the profession more purposeful are only the musings of one person. Others may have quite different ideas. I hope this essay will not necessarily advance my suggestions, but encourage a discussion more generally about how our profession can become more impactful, relevant, collegial, and fun. ACKNOWLEDGEMENTSThis article is based on my keynote speech at the 2021 Financial Management Association Annual Meeting. I am grateful to the FMA and, in particular, the VP-Program Michelle Lowry, for inviting me to give the talk, and to Utpal Bhattacharya, the Executive Editor of Financial Management, for his interest in publishing a written version. For helpful comments, I thank an anonymous referee, Kenneth Ahern, Jack Bao, Nick Barberis, Taylor Begley, Jonathan Berk, James Choi, John Cochrane, Vivian Fang, John Graham, Jill Grennan, John Griffin, Moqi Groen-Xu, Laurie Hodrick, Cliff Holderness, Wei Jiang, Tim Johnson, Marcin Kacperczyk, Ralph Koijen, Cami Kuhnen, Doron Levit, Michelle Lowry, Dimitris Papanikolaou, Luke Taylor, Ed Van Wesep, Ivo Welch, Toni Whited, and David Yermack.
0 Comments   29 August 2023
The Social Responsibility of Business Includes Profits
The Social Responsibility of Business Includes Profits
Illustration by erhui1979, via Getty ImagesProfits these days are often seen as a dirty word, but it is wrong to demonize profits. A company’s responsibility is not to sacrifice profits by donating them to charity, but to create profits only through creating value for society.Responsible business is the order of the day. Policymakers, investors, and executives themselves correctly believe that companies must stop focusing exclusively on shareholder value, instead turning their attention to social issues such as climate change, biodiversity loss, and inequality.These problems are very serious, and businesses can and should use the vast resources they’ve been entrusted with to solve them. But one responsibility is often ignored—generating profits for their investors.Profits are often seen as a dirty word—as something that shareholders extract, that could have otherwise gone to society in the form of wages to workers, taxes to the government, or fairer prices to customers. But the demonization of profits is flawed for two main reasons. First, profits play a crucial role in society. Without profits, companies can’t fund the innovation needed to address society’s challenges. As Merck CEO Kenneth Frazier points out, to explain why drug companies sell life-saving medicines for a profit: “The price of [a] successful drug is paying for the 90%-plus projects that fail. We can’t have winners if we can’t pay for losers.” In addition to being reinvested within a company, profits can also be paid out to shareholders, which is perhaps the most controversial use of profits. Shareholders are seen as nameless, faceless capitalists—they are “them,” while society is “us.” But shareholders are part of society—they are “us.” They include parents saving for their children’s education, pension schemes investing for their retirees, and insurance companies funding future claims. Any responsible business must take shareholders seriously. And investors are needed to finance companies in the first place, which they’ll only do if there’s the prospect of a return. Second, rather than being the deliberate outcome of value extraction, profits can be the by-product of value creation. The traditional view of profits is based on the pie-splitting mentality. This sees the value created by a company as being a fixed pie, which can be given either to shareholders in the form of profits, or society in the form of “stakeholder value” such as taxes, wages, and fair prices. Under this view, the only way that a company can increase profits is by lowering the slice given to society—and so high profits are something to name and shame. It’s “them” vs. “us,” either shareholders or stakeholders, and the only way that you can be with “us” if you’re against “them.” To repurpose capitalism, and take back the pie, we must weaken shareholder rights—redefine directors’ duties away from shareholders, allow non-shareholders to appoint their representatives to the board, and hinder shareholders from proposing resolutions. But the pie-growing mentality stresses that the pie is not fixed. The only way that a company can make profits—at least in the long-term—is if it grows the pie by actively creating value for society. A company may improve working conditions out of genuine concern for its employees, yet these employees become more motivated and productive. A company may develop a new drug to alleviate a pandemic, without considering whether those affected are able to pay for it, yet end up successfully commercializing it. A company may reduce its emissions far beyond the level that would lead to a fine, due to its sense of responsibility to the environment, yet benefit because customers, employees, and investors are attracted to a firm with such values.All of the above actions are likely to be driven by the desire to create social value. It’s difficult to justify them with the traditional net present value (NPV) approach used to maximize profits. If a company adopts a generous parental leave policy, there’s no way to calculate—even roughly— how much more motivated employees will be and how much this will boost future profits. But even though the higher profits couldn’t have been predicted at the outset, they often manifest anyway. The fact that a company ultimately profits from serving society does not detract from the value it creates by doing so. Sustainable profits are the sign of a responsible company. “RATHER THAN BEING THE DELIBERATE OUTCOME OF VALUE EXTRACTION, PROFITS CAN BE THE BY-PRODUCT OF VALUE CREATION.”In my book Grow the Pie: How Great Companies Deliver Both Purpose and Profit, recently updated for the pandemic, I highlight the shift in thinking that arises from adopting the pie-growing mentality—a practice I call Pieconomics. The implications are profound. A company’s responsibility is not to sacrifice profits by donating them to charity, but to create profits only through creating value for society. The “only” highlights how its primary duty is to solve social problems, not to create profits—but if it succeeds in the former, it will be profitable. Delivering high profits need not be shameful; failing to create profits by creating social value is. While Milton Friedman is wrong that profits are “the one and only social responsibility of business,” the social responsibility of business does include profits, alongside social value. The idea that we can have “win-win” outcomes, where both shareholders and society can simultaneously benefit, sounds too good to be true. So the book backs this up with rigorous evidence. One study investigates the list of the “100 Best Companies to Work For in America,” which assesses how well a company treats its employees—covering dimensions such as credibility, respect, fairness, pride, and camaraderie. After comparing the Best Companies to other stocks in the same industry, or with similar characteristics (e.g. size, value, and recent performance), and controlling for other factors, I found that they beat their peers by 2.3-3.8 percent per year over 1984-2011, or 89-184 percent compounded.  Moreover, their future profits systematically beat analyst expectations, attenuating concerns of reverse causality or omitted variables. Simply put, investing in your employees isn’t at the expense of profits—it grows the pie, ultimately generating profits. Yet, it’s critical to stress that the evidence isn’t all one-way. While win-win outcomes are indeed possible, there remain important trade-offs. It’s popular to claim that doing good always leads to companies doing well, and such claims are often accepted uncritically due to confirmation bias. However, they’re not supported by the data. One inconvenient truth is that companies that release more carbon emissions (regardless of whether they’re Scope 1, Scope 2, or Scope 3), generate higher shareholder returns. A second is that companies with high ESG ratings don’t beat their peers. Instead, outperformers are ones that do well on only the stakeholder issues most material to their business model, and scale back on the immaterial ones. The existence of these trade-offs means that any responsible business requires a framework to help evaluate them.  A company can’t cheerfully abandon NPV calculations and just try to “do the right thing.” Since doing good is costly, a company needs to know when to do good, and critically when not to. If “anything goes,” then a company might be so focused on social value that it forgets about profits and fails, as James O’Toole explained in his book The Enlightened Capitalists: Cautionary Tales of Business Pioneers Who Tried to Do Well By Doing Good. In Grow the Pie, I propose three principles to help executives decide whether to take an investment that can’t be justified on pure NPV grounds. One is the “principle of multiplication,” which says that $1 invested in a stakeholder must create more than $1 for that stakeholder. Providing employees with a free on-site gym isn’t responsible if there are adequate local gyms. It would be better for the company to pay higher wages and allow its employees to spend them on gym memberships.  The second is the “principle of comparative advantage,” which states that $1 must create more value than someone else could by investing in that stakeholder. Donating to charity doesn’t satisfy this principle, since employees could donate the same money themselves if corporate philanthropy was reallocated to wages. But investing to reduce plastic packaging does, as it has a much greater impact on the environment than if the company instead paid higher wages, which employees then donated to Greenpeace to lobby for a tax on plastic bags. The third is the “principle of materiality,” according to which the benefits from a stakeholder’s activity must be material to the enterprise.  This is supported by the research showing that addressing only material stakeholder issues ultimately boosts returns. Taken together, these principles mean that a company’s responsibility is not to solve all of the world’s problems or box-tick all 17 of the United Nations Sustainable Development Goals. Instead, it’s to focus on the issues that it has a multiplicative impact on and enjoys a comparative advantage in addressing, and that affect its most material stakeholders. Advocates of responsible business argue that companies should have a purpose, and “purposeful” is often seen as a synonym for “altruistic.” But that’s not what the word “purposeful” actually means—it’s about being focused and targeted. A purposeful meeting is one with a clear agenda; if you do something on purpose, you do it deliberately. Purpose is as much about knowing what not to do as what to do, and resisting the urge to jump onto whatever social issue happens to be the order of the day. Pieconomics as a Middle GroundThus far, we’ve explored how the pie-growing mentality shifts our thinking on the role of profits. There are two quite separate, but equally important implications. The first is the role of government. While free-market capitalists argue for minimal intervention, and stakeholder capitalists lobby for heavy regulation, Pieconomics argues for a middle ground. It stresses how responsible behavior varies wildly across companies depending on the three principles, while regulation takes a one-size-fits-all approach. But it also acknowledges that many effects a company has on society don’t feed through to profits, and it’s a government’s responsibility to address these externalities through either taxes (so that the firm internalizes them) or outright bans. The more profits and social value are aligned, the more it will be in companies’ own interest to create social value. The second implication is that responsible business is feasible even in difficult times, such as a pandemic.  Traditionally, responsibility is seen as splitting the pie more fairly, by donating to charity or pay higher wages than you need to. But doing so is impossible in a pandemic, when you don’t have pie to give. Thus, it seems that responsibility is a luxury only for good times. But if a company’s primary responsibility is to grow the pie, this is possible even in difficult times. The main investment required is not money, but rather thinking innovatively about how a company can repurpose itself to solve social problems. A responsible leader asks herself “What’s in my hand? What resources and expertise does my company have, and how can I deploy them innovatively to serve society?”Such a mindset can inspire some great ideas. Chelsea Football Club in London doesn’t have anything obviously relevant in a pandemic. Soccer tickets and replica merchandise aren’t going to save lives. But what’s in its hand is its hotel, where it allowed doctors and nurses to stay for free, saving them a long commute after a day of fighting on the front line. LVMH’s luxury perfumes are indeed a luxury during a pandemic—but what’s in its hand is a production facility that uses alcohol, which it redeployed to manufacture hand sanitizer. Many of JetBlue’s planes were grounded as passenger numbers plummeted, so it partnered with charities such as the Red Cross and Médecins Sans Frontières to use these planes to transport medical professionals, devices, and supplies to where they’re most needed. And thinking of responsibility as growing the pie is relevant not only in bad times as well as good, but also for small companies as well as large. Entrepreneurs often think that their primary goal is to start turning a profit—only once they’re consistently in the black can they afford to think about responsibility. But if responsibility involves leveraging resources, not spending money, this unlocks the potential for small businesses to play their part. Take Barry’s, the boutique fitness studio. What’s in its hand is fitness expertise, which it used to offer free livestreamed workouts—particularly valuable when citizens are locked down at home. Now, it might seem not particularly innovative for a fitness studio to provide fitness classes, albeit online. The real creativity was in how it redeployed its office and desk workers. Some of them also had jobs as actors; since acting can be volatile, they also worked for Barry’s to provide a stable income. If you’re an actor, what’s in your hand is that you’re entertaining. How does that help in a crisis? Barry’s launched a “Barry’s Cares” program, which included their staff reading stories and providing entertainment to children over Zoom—taking the load off working parents whose kids were at home due to school closures.These inspiring examples give us hope, even in bleak times. If there’s any silver lining to the crisis, it’s that it will permanently lead to a shift in thinking about what responsible business entails—from splitting the pie by spending money to growing the pie by innovatively using what’s in our hand. Doing so need not always require the investment of profits, and in the long-term may enhance profits—allowing a company to fulfill its social responsibility.    This article was first published on ProMarket (19 Oct 2021). https://www.promarket.org/2021/10/19/social-responsibility-business-profits-pieconomics/
0 Comments   23 August 2023
Is There Really A Business Case For Diversity?
Is There Really A Business Case For Diversity?
Am I seriously asking this question?The evidence on the business case for diversity appears to be overwhelming. A famous 2020 McKinsey report, entitled “Diversity Wins” concludes that “the business case for gender and ethnic diversity in top teams is stronger than ever”. A 2021 study commissioned (but not conducted) by the Financial Reporting Council, a UK regulator, finds that “Higher levels of gender diversity of FTSE 350 boards positively correlate with better future financial performance.”Given these results, many people think asking the question is a waste of time. One Chair, interviewed in the FRC study, raged that “There have been enough reports … statistics and … evidence-based research to stop talking about it and get on with it.” Another viewed the evidence as so overwhelming that he tells executive search firms “I don’t want to see any men. I don’t care if they’re Jesus Christ. I don’t want to see them.”But a new study has uncovered an inconvenient truth. It’s documented a strong negative relationship between gender diversity and shareholder value. The authors found that, over the last 20 years, the proportion of women on FTSE 100 boards improved by 26 percentage points, compared to 15 for the S&P 500. But total shareholder return for the FTSE 100 has been only +136% over the same period, versus 221% for the S&P 500. Commenting on the findings, the lead researcher said: “This is the clearest evidence yet that having more women on boards destroys shareholder value. Every additional 10 percentage points of female representation costs 77% in cumulative shareholder returns. Attaining gender parity on boards would reduce the value of UK companies by a cumulative £2.3 trillion.”How do we react to that new study?We immediately want to tear it apart, because we don’t like the findings. And, it’s not hard to invalidate it. There are dozens of other potential reasons for why the S&P 500 might have outperformed the FTSE 100, which have nothing to do with gender diversity — known as omitted variables. Yet for a report whose findings we like, we accept it uncritically, share it widely, and quote it enthusiastically. If it claims that diverse companies perform better, we conclude that diversity must be the reason for the superior performance, and forget about those pesky omitted variables.This is an example of confirmation bias. We lap up any study confirming what we’d like to be true, and reject anything that contradicts it. Indeed, confirmation bias is deeply rooted within us. Three University of Southern California neuroscientists hooked up students to an MRI scanner, and found that when they heard evidence that contradicted their political beliefs, their amygdala was triggered. That’s the same part of the brain that’s activated when a tiger attacks you and induces a “fight-or-flight” response. People respond to opposition — ironically, to diverse viewpoints — as if they’ve been attacked by a tiger.The new study is indeed garbage, and fortunately it’s a fictional one (I thank Tom Gosling for coming up with the parody). But we should apply the same discernment to all studies, including those whose conclusions we like. We often use the phrase “Research shows that …” to imply that something is gospel. But that research claims something is meaningless, because there’s huge variation in the quality of research. As a result, it’s nearly always possible to hand-pick a paper to show anything you’d like to show.The McKinsey and FRC studies have been widely quoted despite being deeply flawed. For example, the McKinsey study has been shown to be irreplicable even with their chosen performance measure (EBIT) and preferred methodology. Moreover, there is no link between diversity and other performance measures — gross margin, return on assets, return on equity, sales growth, or total shareholder return — or when using more established methodologies (e.g. considering all the data, rather only the top and bottom quarter of diversity). Note that this study is on ethnic diversity, so I have a strong personal interest in its results being true, but they are not.The FRC study, conducted by the London Business School Leadership Institute and the consultancy SQW, is even more problematic. Not only does it make basic methodological errors — for example, ignoring dividends when calculating shareholder returns — but the reporting of their results is disingenuous. The Executive Summary claims that “Higher levels of gender diversity of FTSE 350 boards positively correlate with better future financial performance (as measured by EBITDA margin).” But when you look at the actual results, they run 90 regressions relating diversity to EBITDA margin, of which not a single one is significant. The claim is strongly contradicted by the authors’ own analysis.The main body claims that “These results suggest that gender-diverse boards are more effective than those without women” (emphasis in original). This claim comes just after the EBITDA margin and stock return results. There are 90 EBITDA tests of which 0 are significant, and 90 stock return tests of which 7 are significantly positive and 2 are significantly negative. Combining “these results” together, they find 7 positive and 2 negative results out of 180.Not only do the authors claim a correlation when there is none, but they argue their study goes beyond correlation to document causation — that greater diversity causes better firm performance. They use the phrase “effect(s)/impact(s) of (gender) diversity” 38 times, and contrast their report with previous research that could not document causality. The foreword by the CEO of the FRC states “There has been a good deal of research about the business case for diversity. Often a correlation is found, but not necessarily full causality … I am pleased to see the analysis from this research builds the case for diversity across the board.” The Executive Summary claims “These results are significant because, for decades, researchers have largely failed to confirm any causal link.”But despite the results being non-existent, many articles about the report (by organisations I greatly respect) believed the authors’ claim and popularised it. Examples follow below:· “Diverse boards lead to better corporate culture and performance” (title of FRC’s press release announcing its report)· “Boardroom diversity improves financial performance” (title of Minerva Analytics article)· “The effort to diversify boards pays benefits in terms of boardroom culture and performance” (Linklaters)· “The case for diverse boards was given further clout after new research published by the FRC supported the thesis that it leads to better corporate culture and performance” (opening sentence of ICAEW article)The Delusion of Rigorous ResearchWhy have so many people taken the study’s claims at face value when they are clearly contradicted by the results? One reason could indeed be confirmation bias. A second could be the “delusion of rigorous research”. This is a phrase coined by Professor Phil Rosenzweig, in his excellent book The Halo Effect, to describe how authors over-exaggerate the sophistication of their methodology to brow-beat the reader into thinking that the study must be correct. Indeed, an unusual amount of space is devoted to describing what should be standard regressions, including going beyond the Hausman (1978) specification test (which is unnecessary in a standard regression to begin with) to using the Mundlak (1978) test. But, it doesn’t matter what specification test you use if you don’t include dividends in your measure of stock returns, or you misreport your results.The authors also emphasise the rigour of their research. The foreword by the LBS Leadership Institute promises “The Leadership Institute at London Business School treated this opportunity accordingly, with the rigour and care of our best scholarly research.” The foreword by SQW argues: “The research design and analysis used in this report is both innovative and rigorous.” The foreword by the Dean of LBS claims “The academic rigour with which data was collected and analysed yields new insights on the impact of diversity and how to make diversity work. We all stand to learn from the authors’ methodology and findings.”But we do not learn from a methodology that involves misreporting one’s results. With such strong claims of rigour, made so prominently by a reputed research institution, it is not surprising that people have accepted the conclusions uncritically.To the authors’ credit, they do include caveats in the paper that not all their findings are statistically significant, and that some results are correlations rather than causation. However, buying gifts for your spouse on some days does not make up for mistreatment on other days. All claims quoted in this article are made in prominent places, such as the Foreword and Executive Summary, or in bold. Not every reader will have time to read the entire 132-page report and see the caveats, which is why articles by serious institutions took the claim at face value.The Broader LiteratureI have analysed one particular paper to highlight how easy it is to completely misrepresent findings on a topic that people feel strongly about. It is to my chagrin that the report was co-authored by an institute at my own employer, but the scientific process is about being equally discerning about all research, regardless of who wrote it. Just as diverse views by Eugene Fama and Richard Thaler at the University of Chicago have significantly illuminated the debate on whether markets are efficient or irrational, I hope that diverse views from LBS help shed light on the important topic of diversity.But what does the broader literature find? The diversity movement should not be hamstrung by one flawed paper. The best way to find scientific consensus on any issue is to survey the literature, taking into account the quality of each paper rather than simply counting the number of papers that find a result. This is why it is particularly valuable for leading academics to conduct such surveys. Professor Katherine Klein of Wharton summarises the academic consensus in a non-technical article, concluding:Research conducted by consulting firms and financial institutions is not as rigorous as peer-reviewed academic research. Here, I dig into the findings of rigorous, peer-reviewed studies of the relationship between board gender diversity and company performance. Spoiler alert: Rigorous, peer-reviewed studies suggest that companies do not perform better when they have women on the board. Nor do they perform worse. Depending on which meta-analysis you read, board gender diversity either has a very weak relationship with board performance or no relationship at all.A newer survey by Professor Jesse Fried of Harvard, on Nasdaq’s recent diversity rules, concludes:While Nasdaq claims these rules will benefit investors, the empirical evidence provides little support for the claim that gender or ethnic diversity in the boardroom increases shareholder value. In fact, rigorous scholarship — much of it by leading female economists — suggests that increasing board diversity can actually lead to lower share prices. Adoption of Nasdaq’s proposed rules would thus generate substantial risks for investors.If the evidence is so weak, why might it be that claims of a “business case for diversity” are so widespread? As Professor Alice Eagly of Northwestern explained in her Presidential Address to the Society for the Psychological Study of Social Issues, entitled “When Passionate Advocates Meet Research on Diversity, Does the Honest Broker Stand a Chance?”:From advocacy and policy perspectives, there is an obvious appeal in simple, straightforward claims that diversity in groups and organizations produces performance gains. Given this appeal, simplistic renditions of scientific findings on diversity continue to find favor among diversity’s advocates and the legions of practitioners and consultants engaged in helping organizations meet their diversity goals. Presented as if they were evidence-based findings, broad claims about the advantages of diversity for group and organizational performance appear regularly in promotional materials of consultants and advocates.Is There A Business Case For Diversity and Inclusion?So do the consistent scientific findings of no positive link between diversity and firm performance mean that we should stop trying to pursue diversity?Absolutely not. The crux is that many of these studies don’t actually measure diversity. Most arguments for diversity argue that what matters is diversity of thought rather than demographic characteristics, since it’s the former that creates a breadth of perspectives and guards against groupthink. Indeed, a recent discussion paper by the Financial Conduct Authority (another UK regulator) and the Bank of England writes:“With respect to diversity, we focus on ‘diversity of thought’, also called ‘cognitive diversity’. … We propose to define diversity of thought as bringing together a range of different styles of thinking among members of a group. Factors that could lead to diverse thinking could include, but not limited, to different perspectives, abilities, knowledge, attitudes, information styles, and demographic characteristics, or any combination of these.”Thus, there may well be a business case for diversity, but existing studies haven’t found one due to blunt classifications based on only gender and ethnicity. This is a very narrow measure of true cognitive diversity, so these results have no implications for the value of diversity of thought.Moreover, what matters isn’t just to recruit people with a broad set of characteristics (be they gender, ethnicity, or socioeconomic, regional, or experiential background) but making them feel valued and encouraging to contribute their diverse perspectives. This is why most initiatives stress the importance of diversity and inclusion. Not only do crude measures such as ethnicity statistics ignore the myriad of other components of diversity, but they completely fail to capture inclusion.While I am unaware of any study that directly measures D&I and links it to firm performance, there is suggestive evidence that such a link may exist. One of my own studies shows that the 100 Best Companies to Work For in America delivered total shareholder returns that beat their peers by 2.3–3.8%/year over 1984–2011 (89–184% cumulative). While the Best Companies List measures employee satisfaction in general, rather than D&I in particular, several of the five dimensions it captures (credibility, fairness, respect, pride, and camaraderie) are linked to D&I.Interestingly, this study was recently independently replicated by other researchers. They found that the results continue to hold for the original 1984–2011 period, even after controlling for new risk factors and firm characteristics discovered after my study. More importantly, they showed that the results also hold in the decade following its publication. This is surprising, because the returns to a trading strategy typically fall significantly after appearing in a scientific journal, because investors start exploiting the strategy. Given the emphasis on D&I (and ESG more broadly), it seems strange that the returns to the Best Companies remain strong. This may be because investors are focusing on blunt diversity metrics, given the claims of many studies, rather than true D&I.Is There A Case For Diversity?The misrepresentation of the business case for diversity is particularly disappointing since it may be that no business case is needed at all. Even without a business case for diversity, there are strong moral and ethical cases. Some people argue that you should choose the best person for the job, regardless of characteristics. However, others believe that, due to systemic and chronic discrimination against minorities, companies have a role to play in levelling up by actively recruiting under-represented groups. Perhaps doing so might not maximise profits, but many shareholders and stakeholders are willing to accept that trade-off — just as consumers buy organic food, despite its greater cost, due to non-financial considerations.Moreover, study-based arguments for diversity are problematic because they relegate dimensions of diversity for which no study exists. I know of no rigorous evidence on the business case for hiring people with disabilities, but again there is a strong moral and ethical case. Making more money is not the only reason to pursue an initiative.The Bigger PictureBeyond the specific issue of whether there’s a business case for diversity, we can learn broader lessons on how to evaluate research from this example. Here are a few; for a more detailed discussion, please see my cut-out-and-keep guide on Evaluating Research.1. Check whether a study has been published in a top peer-reviewed journal. The peer review process involves the world’s experts on a topic scrutinising a paper. This prevents methodological errors, such as omitting dividends when calculating stock returns, and claims not backed up by the results. (Neither the McKinsey nor LBS/SQW study were published in a peer-reviewed journal). There is a vast range in the stringency of reviewing standards, so journal quality is an important issue. The Financial Times has a list of the top 50 journals in business.2. Look beyond headlines to the actual results. This involves not only checking that the results are what the headlines claim, but also how the authors measured the variables of interest. If the study concludes that X improves Y, verify how they measured X and Y. This is particularly important for papers on ESG topics — they’re hard to measure, so the value of a study hinges on how it measured the key variables. For example, claims to have found that corporate culture boosts firm performance should not be believed without first looking at how the study measured corporate culture.3. Beware of “A study by X university”. Academic studies are often referenced as “A study by Oxford University” or similar wording. However, universities don’t release studies; people do. A company only publishes a study after substantial internal review, so it indeed makes sense to refer to a “McKinsey study” (however, it still won’t have been externally peer reviewed). In contrast, anyone at a university can release a study themselves without any internal approval. Sometimes the authors may not be scientific researchers (e.g. professors or associate/assistant professors) but adjunct lecturers whose main role is teaching. This doesn’t mean the research is definitely wrong, but does mean that “A study by X university” shouldn’t be automatically afforded the mantle of academic rigour. Several people who believed the headlines of the LBS/SQW study told me that, since it was an “LBS study”, they thought they could trust it. What’s more relevant is whether the study has been published in a top peer-reviewed journal.4. Beware confirmation bias. While doing the above checks should not be laborious, they still take some time. It’s not feasible to do them for every study we read. It’s more important to be sceptical when we’d like the results to be true (as our own confirmation bias might be kicking in) or the conclusions go with public opinion (as the authors may have been tempted to draw these conclusions to make their study popular).5. Beware researcher bias. Although it may not seem like it, researchers are humans too. They are subject to the same biases as the rest of us. They have strong incentives to claim results that people want to be true so that their study will be widely cited and shared. Such a bias is particularly problematic when the research is used as a guide to policy. The Financial Reporting Council should be lauded for commissioning academics to conduct a study on the very important topic of diversity (rather than, say, relying exclusively on internal analysis). However, giving the LBS Leadership Institute, SQW, and the Dean of LBS each an opportunity to write three separate forewords increased the incentive to claim eye-catching conclusions. In contrast, when the Department of Business, Energy, and Industrial Strategy commissioned PwC and me to conduct studies into the alleged misuse of share buybacks, and the potential distortive effect of executive pay on investment, we were only included in the acknowledgements each time. This reduced any incentive to misrepresent the results, and is good practice that should be followed for a study commissioned by policymakers. On the other hand, last year’s study conducted by EY for the European Commission on Sustainable Corporate Governance had EY’s logo on the front cover, and has been widely criticised for containing fundamental flaws.This article was first published on Medium (30 Oct 2021). https://medium.com/@alex.edmans/is-there-really-a-business-case-for-diversity-c58ef67ebffa
0 Comments   22 August 2023
Does sustainability reduce the cost of capital?
Does sustainability reduce the cost of capital?
It is often claimed that sustainability reduces a company’s cost of capital – i.e. the return it needs to offer its investors to raise funds. The logic seems straightforward. Sustainable companies are less risky, so investors require a lower return. And this logic seems to hold true in the real world – many practitioners point out how unsustainable companies have trouble raising financing. Cash flows versus the cost of capitalBut it is not actually that simple. Such arguments often confuse the effect of risk on a company’s cost of capital with its effect on a company’s expected cash flows. Let’s illustrate this distinction with an example. Airline A runs on hydrogen, and its expected cash flows are £1 million per year, forever. Its cost of capital is 10%, so its value is £10 million. Assume that airlines can raise debt of up to half their value, so Airline A can raise £5 million of debt. Airline B runs on conventional fuel. Its expected cash flows are also £1 million per year. However, there’s a 10% chance that the government implements a carbon tax which reduces its cash flows to zero (for simplicity). Thus, its expected cash flows are £900,000 per year. Assume that its cost of capital stays at 10%, so its value is £9 million and it can raise only £4.5 million of debt. Thus, Airline B does have ‘trouble raising financing’. But this is nothing to do with its cost of capital being higher – it is exactly the same as Airline A’s. Instead, the difficulty comes purely from a cash flow channel. Airline B has trouble raising financing because risk reduces its cash flows, not because risk increases its cost of capital. What determines the cost of capital?Of course, sustainability might affect the cost of capital, not just cash flows. Finance 101 tells us that risk only affects the cost of capital if it is systemic (shared by the rest of the market) and not if it is idiosyncratic (specific to that firm in question). It is not a foregone conclusion that sustainability affects systemic risk. For example, whether the government implements a carbon tax might be due to action from a pressure group, or new evidence on the seriousness of climate change, and these events have nothing to do with the economy. The same is true for other aspects of sustainability. It is often argued that sustainable companies have a purpose beyond profit, and so are less likely to suffer scandals caused by excessive focus on profit – such as banks opening fake customer accounts or mis-selling payment protection insurance. But whether banks get caught for such actions depends on the effectiveness of the regulator, not the state of the economy. Indeed, there are plausible reasons why unsustainability might decrease systemic risk – unsustainable companies might suffer cash flow shocks, but they occur in economic upswings where investors do not need the cash so much.In an excellent survey paper on climate risk, Giglio et al. (2020) show that if the main risk is about the path of the economy, then unsustainable companies might have a lower cost of capital. It’s more likely the government implements a carbon tax when the economy is booming, since economic activity leads to high emissions and thus the need for a tax. Since Airline B is now countercyclical – it does poorly in good times – its cost of capital falls to 9.5%. Its value is £9.5 million – still less than Airline A because of its cash flow risk – but the value erosion is less due to the countercyclicality. Moving beyond climate, it might be more likely that banks will open fake accounts or mis-sell payment protection insurance in good times – there’s an even stronger incentive to grab that extra piece of the market when it’s large. The above examples view sustainability as risk mitigation – providing downside protection. Another approach is to view it as providing upside value creation, like any intangible asset. For example, ‘purposeful’ companies may have more motivated employees and loyal customers. However, intangible assets are risky since, in a downturn, they have less value than physical assets. While companies can sell their buildings and factories, they can’t sell their corporate culture or customer loyalty. If so, then sustainable companies have a higher cost of capital.Why sustainability might reduce the cost of capitalOn the other hand, there are valid arguments for why sustainability might reduce the cost of capital. The point of this column is not to argue that sustainable companies definitely have a higher cost of capital, but to point out that it’s not automatic which direction any effect will be. Let’s consider some of these arguments:Starting again with climate, Giglio et al. (2020) show that, if the main uncertainty is not about the path of the economy but the path of climate change (the likelihood of a climate disaster), Airline B suffers in a climate crisis where most other companies are also suffering. Then, if its cost of capital is 10.5%, its value is £8.6 million – even less than if there were no cost of capital impact.The risk of scandals might be higher in bad times, if companies are desperate for cash and tempted to engage in immoral behaviour. Likewise, public trust in business as a whole is low during bad times, but sustainable companies retain such trust, as Lins et al. (2017) document. One explanation unrelated to risk is the supply of capital. Some investors may boycott unsustainable companies, such as fossil fuel stocks. However, it’s not clear that this will have a meaningful impact on the cost of capital since, to sell, another investor has to buy. Indeed, energy funds are natural buyers. More generally, there are many types of companies that are not held by certain investors, but they are not deprived of capital as other investors step in. Dividend-paying stocks are underweighted by growth funds but bought by income funds. However, there will be supply effects that impact the cost of capital if there’s a large preference for sustainable companies across the investment industry. Why this mattersOverall, it is not so clear-cut whether sustainability increases or reduces the cost of capital. But it may seem that this doesn’t matter. Airline B is worth less than Airline A in every case (£9.5 million if its cost of capital is lower, £9 million if it’s the same, and £8.6 million if it’s higher – compared to £10 million for Airline A). If the punchline stays the same – sustainability is valuable – does it really matter whether it’s because of ‘higher expected cash flows’ or a ‘lower cost of capital’? Is there really any harm in statements such as “sustainable companies have lower cost of capital”? It may be academically imprecise, but practically it has the same outcome.In fact, this confusion has important practical implications:It is very hard to estimate the cost of capital (at least for equity capital). The expected returns that shareholders expect when they buy a stock are unknown. We observe the realised returns that they receive ex post, but high realised returns could either result from high expected returns (the cost of capital channel) or high unexpected returns (the cash flow channel). In Edmans (2020), I explain how several measures of sustainability are correlated with high realised returns and these seem to be at least partially unexpected, consistent with the cash flow channel. This research complements Edmans (2011), where I find that companies with high employee satisfaction generated earnings that systematically beat analyst expectations. In short, the channel is important for the evidential underpinning. There is no consensus that sustainable companies have a lower cost of equity. The evidence for the cost of debt is also mixed, as shown by Halling et al. (2021).If sustainability did reduce the cost of capital, then sustainable companies should produce lower returns going forward. Indeed, Pastor et al. (2020) model the ‘supply of capital’ channel and show that sustainable companies will attract demand from sustainable funds, pushing up their stock prices and lowering their future returns – inconsistent with the common claim that sustainable investing leads to higher returns. Conversely, unsustainable companies will enjoy higher expected returns. Indeed, Hong and Kacperczyk (2009) indeed found outperformance of sin stocks over a 42-year period.If sustainability reduces the cost of capital, then sustainable companies are counter-cyclical. This suggests that sustainability is not as important in good times. Under the cash flow channel, sustainability is always important. A major determinant of the cost of capital is risk aversion – this is why investors charge a higher cost of capital to risky companies. Evidence supports the idea of ‘decreasing risk aversion’ – wealthier investors are less risk-averse. Thus, the largest investors (such as sovereign wealth funds), with the greatest potential to hold companies to account for embedding sustainability, may be the least concerned with systemic risk. In contrast, all investors – regardless of their risk aversion – are concerned with cash flows. Of course, large investors may be more concerned with sustainability than small investors for different reasons – for example, they are ‘universal owners’ whose portfolios will be more affected by the externalities from climate change. However, this is an externality channel, not a cost of capital channel.So, do sustainable companies enjoy a lower cost of capital? The jury is still out – and, if they do, it might mean lower investor returns, less attention from risk-tolerant investors, and less attention in good times. As a result, it’s important to be careful of making such claims without rigorous evidence. ReferencesEdmans, A (2011), “Does the stock market fully value intangibles? Employee satisfaction and equity prices”, Journal of Financial Economics 101: 621–40.Edmans, A (2020), Grow the pie: How great companies deliver both purpose and profit, Cambridge University Press.Giglio, S, B Kelly and J Stroebel (2020), “Climate finance”, Annual Review of Financial Economics, forthcoming. Halling, M, J Yu and J Zechner (2021), “Primary corporate bond markets and social responsibility”, SSRN Working Paper.Hong, H and M Kacperczyk (2009), “The price of sin: The effects of social norms on markets”, Journal of Financial Economics 93: 15–36.Lins, K, H Servaes and A Tamayo (2017), “Social capital, trust, and firm performance: The value of corporate social responsibility during the financial crisis”, Journal of Finance 72: 1785-1824. Pastor, L, R F Stambaugh and L A Taylor (2020), “Sustainable investing in equilibrium”, Journal of Financial Economics, forthcoming.This article was first published on Centre for Economic Policy Research (17 Mar 2021). https://cepr.org/voxeu/columns/does-sustainability-reduce-cost-capital
0 Comments   16 August 2023
Company purpose and profit need not be in conflict if we ‘grow the pie’
Company purpose and profit need not be in conflict if we ‘grow the pie’
1 A CRISIS OF CONFIDENCE IN CAPITALISMAn apparent consensus exists amongst politicians, citizens, and even executives themselves – at both ends of the political spectrum and in many countries – that capitalism isn't working for ordinary people (see e.g. Frank, 2019; Ignatius, 2019; Kassam & Mathieu-Léger, 2016; Steverman, Merrill, & Lin, 2018).The financial crisis of 2008 is said to have cost nine million Americans their jobs and ten million their homes (Puzzanghera, 2018; Shalby, 2018). Even though the US economy has recovered, the gains seem largely to have gone to bosses and shareholders, while ordinary incomes have stagnated. In a wider context, it is salutary to reflect that, in 2018, just 26 tycoons owned the same wealth as the 3.8 billion poorest citizens in the world (Oxfam, 2019, 2020).Corporations affect not only people but also the planet. The environmental costs created by business are estimated at $4.7trn per year (Trucost, 2013, p. 9). Notable examples are the Deepwater Horizon disaster of 2010 which spilt five million barrels of oil into the sea, and Volkswagen's dodging of emissions tests which may have contributed to an estimated 1,200 deaths in Europe alone (Chu, 2017).People, and politicians representing them, are fighting back. The reaction varies – Occupy movements, Brexit, electing populist leaders, restricting trade and immigration, and revolting against CEO pay. But the sentiment is the same everywhere: ‘they’ are benefiting at the expense of ‘us’.Radical calls to reform capitalism drum up significant support but risk throwing the baby out with the bathwater and ignore the positive role that profit-making businesses can play in society. A host of successful companies design products that transform customers' lives for the better, provide employees with a healthy and enriching workplace, and help preserve the environment for future generations. Merck's drug ivermectin has substantially reduced river blindness worldwide (Turner, Walker, Churcher, & Basanez, 2014); Vodafone's mobile money service M-Pesa has lifted 200,000 Kenyans out of poverty (Suri & Jack, 2016); and Google's maps, search engines, and shared documents make millions of lives easier each day. Moreover, successful businesses generate profits. Profits aren't evil ‘value extraction’ but serve a crucial role in society – providing returns to parents saving for their children's education, pension schemes investing for their retirees, or insurance companies funding future claims.Viewing business as ‘them’ and society as ‘us’ is an example of what can be termed the ‘pie-splitting’ mentality. Its adherents see the value that a company creates as a fixed pie. It follows that any slice of the pie taken by the firm and its shareholders reduces the slice enjoyed by society. In this view, the best way to increase society's take is to straitjacket business so that it doesn't make too much profit. Sadly, rather too many CEOs also display pie-splitting thinking – but the other way round. They think that the best way to increase profit is to reduce society's slice, by price-gouging customers or exploiting workers (Figure 1).Figure 1In the pie-splitting mentality, business and society are enemies. And the battle they've been fighting has been around for centuries. In the mid-nineteenth century, Karl Marx wrote about the struggle between capital and labour. Since then, we've seen a pendulum swing back and forth between business and society. Think of the late nineteenth-century American robber barons who created giant monopolies such as Standard Oil; policymakers responded by breaking some up. Or recall the peak of labour unionism in the 1970s, which was followed by legislation that helped to cause unionism's sharp decline. Or the rise of big banks in the early twentieth century which culminated in the 1929 financial crisis and their regulation by the Glass–Steagall Act of 1933 – itself partially repealed since the 1980s, contributing to another crisis in 2007. Unless we can come up with another way, this movie will keep on being replayed indefinitely.2 A NEW APPROACHBut another way does exist. By applying a radically different approach to business, companies can create both profit for investors and value for society.This new approach is the ‘pie-growing’ mindset, which stresses that the pie is not fixed (Figure 2). By investing in stakeholders, a company doesn't have to reduce the investors' slice, as some CEOs assume, but grows the pie, ultimately benefiting investors. A company may improve working conditions out of genuine concern for its employees, yet these employees become more motivated and productive. A company may develop a new drug to solve a public health crisis, without considering whether those affected are able to pay for it, yet ends up successfully commercialising it. A company may reduce its emissions far beyond the level that would lead to a fine, due to its sense of responsibility to the environment, yet benefit because customers, employees, and investors are attracted to a firm with such values. The pie can grow, to everyone's benefit. Conversely, a company that concentrates exclusively on short-run profit at the expense of stakeholders may end up shrinking the pie.Figure 2Under the pie-growing mentality, a company's primary goal is to serve society rather than generate profits. At first glance, this approach seems completely heretical to the gospel preached in Milton Friedman's (1970) famous article titled ‘The Social Responsibility of Business is to Increase its Profits’. However, that article has been frequently misportrayed and misquoted. Critics of capitalism like to cite it as it seems to advocate a particularly narrow-minded view of capitalism – one that disregards stakeholders and seeks only to feed investors' greed. By caricaturing the current model of capitalism, critics can then push their own ideas of how capitalism should be reformed, and it's not difficult to argue that their philosophy of business is superior when the alternative has been presented as a straw man.To have a serious conversation about how businesses should be run, it's essential to recognise that the Friedman view is far more nuanced than it's commonly taken to be. It argues that a company should focus exclusively on profits because the only way it can deliver profits – at least in the long term – is by serving society. Thus, profit maximisation is socially desirable as it leads companies to invest in their stakeholders. Friedman (1970, p. 5) wrote: “… it may well be in the long-run interest of a corporation that is a major employer in a small community to devote resources to providing amenities to that community or to improving its government. That may make it easier to attract desirable employees.”Even though the Friedman value of shareholder value maximisation is much more enlightened than commonly believed, the pie-growing mentality remains fundamentally different. A shareholder-focused company will indeed still invest in stakeholders – but only if it calculates that such an investment will increase profits by more than the cost of the investment. Indeed, comparing costs and benefits is how finance textbooks argue companies should decide whether or not to undertake investment.However, real life isn't a finance textbook. In practice, it's very difficult to calculate the future pay-off of any investment. In the past, this was easier when investments were in tangible assets – if you build a new factory, you can estimate how many new widgets the factory will produce and how much you can sell them for. But most of the value of a twenty-first-century firm comes from intangible assets, such as brand and corporate culture. If a company improves working conditions, it's impossible to estimate how much more productive workers will be, and how much more profit this greater productivity will translate into. The same is true for the reputational benefits of a superior environmental record. A company that's free from the shackles of having to justify every investment by a calculation will invest more and may ultimately become more profitable.This new approach to business is the subject of my new book, Grow the Pie: How Great Companies Deliver both Purpose and Profit (Edmans, 2020), published 50 years after Friedman's famous article. I wrote this book out of concern for the growing polarisation between business and society. In the face of this conflict, it is a fundamentally optimistic book. Yet this optimism is not based on blind hope, but on rigorous evidence that this approach to business works – across industries and for all stakeholders – and on an actionable framework to turn it into reality.Let's indeed turn to the evidence. The idea that business and society can benefit simultaneously might seem to be too good to be true. However, rigorous evidence suggests that purposeful companies that treat their stakeholders well deliver superior long-term returns to investors. For example, one of my own studies (Edmans, 2012) shows that companies with high employee satisfaction outperformed their peers by 2.3–3.8 per cent per year over a 28-year period. That's 89–184 per cent compounded. I did further tests suggesting that it's employee satisfaction that leads to good performance rather than the reverse. Other studies find that customer satisfaction, environmental stewardship, and sustainability policies are also associated with higher stock returns.So creating value for stakeholders isn't just a worthy ideal – it is often good business sense. When I speak to practitioners on the importance of purpose, I'm introduced as a professor of finance, and the audience often thinks they've misheard. Finance departments are frequently the enemy of purposeful business, which believes that it's simply a distraction from creating profits. This might be true in the short term, but the long-term evidence shows that any finance department with this mindset is failing at its job. The positive relationship with long-term returns also means that it's in companies' own interest to transform the way they do business and take very seriously their impact on society. It's urgent that they do. Otherwise, anti-business regulations will be enacted, and customers and workers will switch to competitors whose values they share. Serving society isn't an optional extra to be confined to a Corporate Social Responsibility department offering ‘community events’ and supporting a few charities, but should be fundamental to how a business is run.3 A TRANSFORMATIVE SHIFT IN THINKINGThe pie-growing mentality shifts our thinking on some of the most controversial aspects of business. First, it transforms what leaders' and enterprises' responsibilities are, and what society should hold them accountable for. We often name and shame companies which engage in errors of commission – actions seen as pie-splitting, such as making what we see as too much profit. But high profits may be a by-product of serving society. Instead, we should hold businesses accountable for errors of omission – spurning opportunities to grow the pie through inaction. For example, Kodak failed to invest in digital cameras and ultimately went bankrupt. Yet it's rarely seen as a corporate governance failure because investors didn't profit – but that's of no consolation to the 150,000 workers who were made redundant. In this new way of thinking, an irresponsible company is one that shrinks the pie or fails to grow it, harming everyone.Second, the pie-growing mentality changes our view on how to reform executive pay (Edmans, 2019). The level of CEO pay is perhaps the single most-cited piece of evidence that business is out of touch with society. In the US, the average S&P 500 CEO earned $14m in 2017, 361 times what the average employee earned. The idea is that, if the CEO wasn't so greedy, his or her pay could be redistributed to colleagues or invested. But that's the pie-splitting mentality. The amount that can be reallocated through redistributing the pie is tiny. The median equity value in the S&P 500 is $22bn. $14m is only 0.06 per cent of the pie – far smaller than the 2.3–3.8 per cent that can be created by growing the pie through improving employee satisfaction.Moreover, just like high profits, high pay can be a by-product of creating value. It's fair for CEOs to be paid like owners – to own a long-term share in the business, so that they're on the hook if it underperforms. But the flip side is that, if they grow the long-term stock price, they'll automatically be rewarded as their shares will be worth more. For example, Disney's Bob Iger was criticised for earning $66m in fiscal 2018, but the market value of Disney had risen by 578 per cent in his four years at the helm, and 70,000 jobs had been created (Sonnenfeld, 2020). So we shouldn't criticise high CEO pay without first asking whether it results from pie-growing or pie-splitting.And that's where there is indeed major room for reform. Some CEOs aren't paid like long-term owners. They're instead given bonuses based on short-term targets – and so it's indeed possible for them to earn millions by exploiting workers and customers. So the solution isn't so much to change the level of pay, even though this might win the most headlines, but its structure – to move away from short-term targets and pay CEOs with shares that they can't sell for (say) five to seven years. Giving CEOs long-term incentives rewards them for pie-growing and discourages pie-splitting. Importantly, bosses should continue to hold shares after retirement, to ensure that their horizon extends beyond their tenure. Moreover, shares should be awarded to all employees, to ensure that everyone benefits from pie-growth. If the company does well, it's not just due to the CEO.Third, the pie-growing mentality shifts our thinking on investors. Investors are often viewed as nameless, faceless capitalists who extract profits at the expense of society. One author (Georgescu, 2017) has claimed that they are “like terrorists who manage through fear and strip the company of its underlying crucial assets, … extracting cash out of everything that would otherwise generate long-term value”. This is the sort of thinking that has led politicians in both the UK and the US to propose restrictions on investor rights. But such views aren't backed up by the evidence. Rigorous studies show that, while shareholder activism does indeed increase profits, this doesn't arise from pie-splitting but from pie-growing – improved productivity and innovation, which in turn benefits society.Investors are not ‘them’; they are ‘us’. As mentioned earlier, they include ordinary citizens saving for retirement, or mutual funds or pension funds investing on their behalf. Policies that suppress investors will not only make companies less purposeful and less productive, but also harm citizens. Investors aren't the enemy, but allies in growing the pie. Any serious proposal to reform business should place investor engagement front and centre.4 PUTTING IT INTO PRACTICESo how does a company actually grow the pie? The starting point is to define its purpose – why it exists, its reason for being, and the role that it plays in the world. A purpose might be to develop medicines that transform citizens' health; to provide an efficient rail network that connects people with their jobs, family, and friends; or to manufacture toys that entertain and educate children.Importantly, in this view a company's purpose cannot be to earn profits – instead, profits are a by-product of serving a purpose. This is similar to the way in which an individual's vocation is not to earn a salary; instead, he or she aims to earn a salary by choosing an enjoyable and stimulating career. Equally importantly, a purpose should be focused. Many companies have broad purpose statements, such as ‘to serve customers, colleagues, suppliers, the environment, and communities while generating returns to investors’, because they sound aspirational. But a purpose that tries to be all things to all people offers little practical guidance because it sweeps the harsh reality of trade-offs under the carpet. Leaders need to make tough decisions that benefit some stakeholders at the expense of others. For example, closing a polluting plant helps the environment but hurts employees. A focused purpose statement highlights which stakeholders are first among equals to guide such a trade-off.And evidence highlights the criticality of focus. Companies that do well on environmental, social, and governance dimensions across the board don't beat the market. But those that do well on only dimensions material to their business – and scale back on others – do significantly outperform. My book introduces three principles (the principle of multiplication, the principle of comparative advantage, and the principle of materiality) to provide practical guidance on which investments in stakeholders a company should make, and when it should show restraint. This balance is critical. Some leaders misinterpret the call to ‘serve society’ as an imperative to invest as much as possible, and many politicians advocate such behaviour. But there are many cautionary tales of companies imploding through overinvestment, Daewoo being a particularly prominent one. In 1998, while other Korean conglomerates were cutting back after the financial crisis, Daewoo bought 14 new businesses, despite losing US$458m that year. The following year, with debts of $50bn, Daewoo was about to go bankrupt and had to be broken up.Of course, purpose must go beyond a mere statement and must be put into practice. The book discusses five tools with which a company can do so – aligning its strategy, operating model, culture, reporting, and governance. It also stresses the role of investors in stewarding a company's purpose – holding CEOs to account for embedding it throughout the organisation, and providing an independent sounding board on long-term issues. I provide a practical guide for how investors can undertake stewardship effectively, and how the relationships between different players in the investment industry – asset managers, asset owners, investment consultants, and proxy advisors – can be reformed from the transactional to the trusted, in turn providing the long-term context necessary for stewardship to thrive.And ordinary citizens have a major part to play too. The popular narrative is that corporations are so large that citizens are powerless to shape them. But I stress how citizens – in their roles as employees, customers, and investors – enjoy agency: their capacity to act independently and influence their environment, rather than being acted upon. One source of agency is the power to put their time and money into companies that reflect what they would like to see in the world, and walk away from others. Customer boycotts for allegedly non-purposeful behaviour are arguably more powerful than ever before due to social media, as shown by the #boycottvolkswagen and #DeleteUber campaigns. In the modern firm, human (rather than physical) capital is more important than ever before, and departures of key employees severely damage a company's competitiveness.5 CONCLUSION: A COLLABORATIVE EFFORTSo it's not business or society – it's business and society. This observation gives us great hope, but also great responsibility. Not only can all stakeholders benefit from a growing pie, but it's also their duty to work together to grow the pie. When they do so, bound by a common purpose and focused on the long term, they create shared value in a way that enlarges the slices of everyone – shareholders, workers, customers, suppliers, the environment, communities, and taxpayers. Evidence presented in the book suggests that visionary leaders can transform a company, growing the pie for the benefit of all. Engaged shareholders can intervene in a failing firm, growing the pie for the benefit of all. A motivated workforce can innovate from the bottom up, growing the pie for the benefit of all.Importantly, an approach to business driven by purpose is likely to end up more profitable in the long term than by attempting to maximise shareholder value. So it is one that leaders should voluntarily embrace, even in the absence of public mistrust or threats of regulation. Creating social value is neither defensive nor simply ‘worthy’ – it is good business. The evidence, not wishful thinking, leads to this conclusion: to reach the land of profit, follow the road of purpose.This article was first published on wiley Online Library (29 June 2020). https://onlinelibrary.wiley.com/doi/full/10.1111/ecaf.12395
0 Comments   10 August 2023
How great companies deliver both purpose and profit
How great companies deliver both purpose and profit
Capitalism is in crisis. The consensus among politicians, citizens and even executives themselves – on both sides of the political spectrum and throughout the world – is that business just isn’t working for ordinary people.The 2007 financial crisis cost nine million Americans their jobs and 10 million their homes. The economy has recovered since then, but the gains have largely gone to bosses and shareholders, while ordinary incomes have stagnated. In 2018, just 26 tycoons owned the same wealth as the 3.8 billion poorest citizens in the world.Corporations affect not only people, but also the planet. The environmental costs created by business are estimated at $4.7 trillion per year. Notable examples are the Deepwater Horizon disaster, which spilled five million barrels of oil into the sea, and Volkswagen’s dodging of emissions tests, which caused an estimated 1,200 deaths in Europe alone.Citizens, and the politicians who represent them, are fighting back. The precise reaction varies – occupy movements, Brexit, electing populist leaders, restricting trade and immigration, and revolting against CEO pay. But the sentiment’s the same. “They” are benefiting at the expense of “us”.While radical calls to reform business drum up significant support, they risk throwing out the baby with the bathwater and ignore the positive role that businesses can play in society. Successful businesses design products that transform customers’ lives for the better, provide employees with a healthy and enriching workplace and preserve the environment for future generations. Merck’s drug Mectizan has substantially reduced river blindness worldwide; Vodafone’s mobile money service M-Pesa has lifted 200,000 Kenyans out of poverty; and Google’s maps, search engines and shared documents make millions of lives easier each day. Moreover, successful businesses generate profits. Profits aren’t evil value extraction, but serve a crucial role in society, providing returns to parents saving for their children’s education, pension schemes investing for their retirees and insurance companies funding future claims.Viewing business as “them” and society as “us” is an example of the pie-splitting mentality (see Figure 1). It sees the value that a company creates as a fixed pie. Thus, any slice of the pie that goes to business reduces the slice enjoyed by society. In this view, the best way to increase society’s take is to straitjacket business so that it doesn’t make too much profit. Sadly, the pie-splitting mentality is practiced by many CEOs, too. They think the best way to increase profit is to reduce society’s slice by price-gouging customers or exploiting workers.Business and society, in this view, are enemies. And the battle they’ve been fighting has been around for centuries. Think of the late 19th century robber barons who created giant monopolies such as Standard Oil; policymakers responded by breaking some of them up. Or trade unions in the 1970s, followed by legislation that caused their decline. Or the rise of big banks in the early 20th century which culminated in the 1929 financial crisis and their regulation by the Glass-Steagall Act – itself partially reversed since the 1980s, contributing to another crisis in 2007. Unless we can come up with another way, this movie will keep on being replayed.But there is another way...By applying a radically different approach to business, companies can create profit for investors and value for society. The pie-growing mentality stresses that the pie is not fixed. By investing in stakeholders, a company doesn’t reduce investors’ slice of the pie, as assumed by some CEOs – it grows the pie, ultimately benefiting investors. A company may improve working conditions out of genuine concern for its employees, yet these employees become more motivated and productive. A company may develop a new drug to solve a public health crisis, without considering whether those affected are able to pay for it, yet end up successfully commercialising it. A company may reduce its emissions far beyond the level that would lead to a fine, due to its sense of responsibility to the environment, yet benefit because customers, employees, and investors are attracted to a firm with such values.In the pie-growing mentality, a company’s primary goal is to serve society rather than generate profits. Surprisingly, this approach typically ends up more profitable than if profits were the end goal. That’s because it enables investments to be made that end up delivering substantial, long-term pay-offs.It’s important to acknowledge that a profit-focused company will still invest in stakeholders – but only if it calculates that such an investment will increase profits by more than the cost of the investment. Indeed, comparing costs and benefits is how finance textbooks argue companies should decide whether or not to take an investment.But real life isn’t a finance textbook. In practice, it’s very difficult to calculate the future payoff of an investment. In the past, this was easier when investments were in tangible assets – if you build a new factory, you can estimate how many new widgets the factory will produce and how much you can sell them for. Most of the value of a 21st-century firm comes from intangible assets, such as brand and corporate culture. If a company improves working conditions, it’s impossible to estimate how much more productive workers will be and how much greater profit this increased productivity will translate into. The same is true for the reputational benefits of a superior environmental record.A company that’s free from the shackles of having to justify every investment by a calculation will invest more and may ultimately become more profitable.“The starting point is to define its purpose – why it exists and the role that it plays in the world.”This new approach to business is the subject of my forthcoming book Grow the Pie: How Great Companies Deliver Both Purpose and Profit. I wrote it out of concern for the polarisation between business and society that the world finds itself in. In the face of this conflict, it’s a fundamentally optimistic book – not based on blind hope, but on rigorous evidence that this approach to business works, across industries and for all stakeholders, and is an actionable framework to turn hope into reality.Let’s look at that evidence. The idea that both business and society can benefit might seem to be too good to be true. However, rigorous evidence suggests that companies that treat their stakeholders well deliver superior long-term returns to investors. For example, one of my own studies (profiled in my TEDx talk, The Social Responsibility of Business), shows that companies with high employee satisfaction outperformed their peers by 2.3%-3.8% per year over a 28-year period. That’s 89%-184% compounded. Further tests suggest that it’s employee satisfaction that leads to good performance, rather than the reverse. Other studies find that customer satisfaction, environmental stewardship, and sustainability policies are also associated with higher stock returns.So, creating value for stakeholders isn’t just a worthy ideal – it’s good business sense. When I speak to practitioners on the importance of purpose, I’m introduced as a professor of finance and the audience often thinks they’ve misheard. The finance department of a company is frequently the enemy of purposeful business, believing that it’s simply a distraction from creating profits. This might be true in the short › term, but the long-term evidence shows that any finance department with this mindset is failing at its job. The positive relationship with long-term returns also means that it’s in companies’ own interest to transform the way they do business and take very seriously their impact on society. In fact, it’s urgent that they do. Otherwise, anti-business regulations will be passed and customers and workers will switch to competitors whose values they share. Serving society isn’t an optional extra to be confined to a CSR department, but should be fundamental to how a business is run.A shift in thinkingThe pie-growing mentality shifts our thinking on some of the most controversial aspects of business. First, it transforms what leaders’ and enterprises’ responsibilities are, and what society should hold them accountable for. We often “name and shame” companies who engage in errors of commission – actions seen as pie-splitting, such as making what we see as too much profit. But high profits may be a by-product of serving society. Instead, we should hold businesses accountable for errors of omission – spurning opportunities to grow the pie through inaction. For example, Kodak failed to invest in digital cameras and ultimately went bankrupt. It’s rarely seen as a corporate-governance failure, because investors didn’t profit – but that’s of no consolation to the 150,000 workers who were made redundant. An irresponsible company is one that shrinks the pie or fails to grow it, harming everyone.Second, the pie-growing mentality changes our view on how to reform executive pay. The level of CEO pay is perhaps the single most-cited piece of evidence that business is out of touch with society. In the US, the average S&P 500 CEO earned $14 million in 2017, 361 times the average employee. The idea is that, if the CEO wasn’t so greedy, their pay could be redistributed to colleagues or invested. But that’s the pie-splitting mentality. The amount that can be reallocated through redistributing the pie is tiny. The median equity value in the S&P 500 is $22 billion. $14 million is only 0.06% of the pie – far smaller than the 2.3%-3.8% that can be created by growing the pie through improving employee satisfaction.Moreover, just like high profits, high pay could be a by-product of creating value. It’s fair for CEOs to be paid like owners – to own a long-term share in the business, so that the CEO is on the hook if they underperform. But the flip side is that, if they grow the long-term stock price, they’ll automatically be rewarded as their shares will be worth more. For example, Disney CEO Bob Iger was criticised for earning $66 million, but the market value of Disney had risen by 578% in his four years at the helm, and 70,000 jobs had been created – so we shouldn’t criticise high CEO pay without first asking whether it results frompie-growing or pie-splitting.And that’s where there is major room for reform. Some CEOs aren’t paid like long-term owners. They’re instead given bonuses based on short-term targets – so it’s possible for them to earn millions by exploiting workers and customers. The solution isn’t so much to change the level of pay, even though this might win the most headlines, but its structure – to move away from short-term targets and pay the CEO with shares that they can’t sell for (say) five years. Giving long-term incentives rewards them for pie-growing and discourages pie-splitting. Importantly, they should continue to hold their shares after retirement, to ensure that their horizon extends beyond their tenure. And shares should be awarded to all employees, to ensure that everyone benefits from pie-growth. If the company does well, it’s not just due to the CEO.Third, the pie-growing mentality shifts our thinking on investors. Investors are often viewed as nameless, faceless capitalists who extract profits at the expense of society. One book claimed that “Shareholder activists … are more like terrorists who manage through fear and strip the company of its underlying crucial assets … extracting cash out of everything that would otherwise generate long-term value” and politicians in both the UK and US have made proposals to restrict investor rights. But such views aren’t backed up by the evidence. Rigorous studies show that, while shareholder activism does indeed increase profits, this doesn’t arise from pie-splitting but pie-growing – improved productivity and innovation, which in turn benefits society.Investors are not “them”; they are “us”. As mentioned earlier, they include ordinary citizens saving for retirement and mutual funds and pension funds investing on their behalf. Policies that suppress investors will not only make companies less purposeful and less productive, but also harm citizens. Investors aren’t the enemy, but allies in growing the pie. Any serious proposal to reform business should place investor engagement front and centre.Putting it into practiceSo, how does a company actually “grow the pie”? The starting point is to define its purpose – why it exists and the role that it plays in the world. A purpose might be to develop medicines that transform citizens’ health; to provide an efficient rail network that connects people with their jobs, family and friends; or to manufacture toys that entertain and educate children.Importantly, a company’s purpose cannot be to earn profits – instead, profits are a by-product of serving a purpose. This is similar to how a citizen’s vocation is not to earn a salary; instead, they earn a salary by choosing a career they enjoy and thus flourish in. Equally importantly, a purpose should be focused. Many companies have broad purpose statements, such as “to serve customers, colleagues, suppliers, the environment and communities, while generating returns to investors,” because they sound aspirational. But a purpose that tries to be all things to all people offers little practical guidance because it sweeps the harsh reality of trade-offs under the carpet.Leaders need to make tough decisions that benefit some stakeholders at the expense of others. For example, closing a polluting plant helps the environment but hurts employees. A focused purpose statement highlights which stakeholders are first among equals to guide such a trade-off.Evidence highlights the criticality of focus. Companies that do well on environmental, social and governance dimensions across the board don’t beat the market. But those that do well on only dimensions material to their business – and scale back on others – do significantly outperform.The book introduces three principles (the principle of multiplication, the principle of comparative advantage and the principle of materiality) to provide practical guidance on which investments in stakeholders a company should make and when it should show restraint. This balance is critical. Some leaders misinterpret the call to “serve society” as an imperative to invest as much as possible and many politicians advocate such behaviour. But there are many cautionary tales of companies imploding through over-investment, Daewoo being a particularly prominent one.Of course, purpose must go beyond a mere statement and must be put into practice. The book discusses five tools through which a company can do so – aligning its strategy, operating model, culture, reporting and governance. It also stresses the role of investors in stewarding a company’s purpose – holding CEOs to account for embedding it throughout the organisation and providing an independent sounding board on long-term issues. I provide a practical guide for how investors can undertake stewardship effectively and how the relationships between different players in the investment industry – asset managers, asset owners, investment consultants and proxy advisors – can be reformed from the transactional to the trusted; in turn providing the long-term context necessary for stewardship to thrive.“Creating social value is neither defensive nor simply “worthy” – it’s good business.”Citizens have a major part to play, too. The popular narrative is that corporations are so large that citizens are powerless to shape them. But I stress how citizens – in their roles as employees, customers and investors – enjoy agency: their capacity to act independently and influence their environment, rather than being acted uponOne source of agency is the power to put their time and money into companies that reflect what they would like to see in the world and walk away from others. Customer boycotts for allegedly non-purposeful behaviour are arguably more powerful than ever before due to social media, as shown by the #BoycottVolksvagen  and #DeleteUber campaigns. In the modern firm, human (rather than physical) capital is more important than ever before and departures of key employees severely damage a company’s competitivenessA second source of agency is the power to shape companies people choose to be members of. Every night, Abdul Durrant worked hard to clean the London offices of HSBC, including that of chair Sir John Bond. But he struggled to support his five children on his low wages. So Abdul attended HSBC’s AGM and addressed Sir John, saying: “I am here on behalf of all the contract staff at HSBC and the families of east London. We receive £5 per hour – a whole £5 per hour! – no pension and a measly sick pay scheme. In our struggles, our children go to school without adequate lunch. We are unable to provide necessary books for their education. School outings in particular they miss out on.” Moved by this plea, Sir John gave HSBC’s cleaners a 28% pay rise. This shows the power of a single employee to change the wage policy of a large multinational.A collaborative effortSo it’s not business or society – it’s business and society. This observation gives us great hope, but also great responsibility. Not only can all stakeholders benefit from a growing pie, but it’s also their duty to work together to grow the pie. When they do so, bound by a common purpose and focused on the long-term, they create shared value in a way that enlarges the slices of everyone – shareholders, workers, customers, suppliers, the environment, communities and taxpayers.Evidence suggests that visionary leaders can transform a company, growing the pie for the benefit of all. Engaged shareholders can intervene in a failing firm, growing the pie for the benefit of all. A motivated workforce can innovate from the bottom up, growing the pie for the benefit of all.Importantly, an approach to business driven by purpose typically ends up more profitable in the long-term than an attempt to maximise shareholder value – so it’s one that leaders should voluntarily embrace, even in the absence of public mistrust or threats of regulation. Creating social value is neither defensive nor simply “worthy” – it’s good business. The highest-quality evidence, not wishful thinking, reaches this conclusion: to reach the land of profit, follow the road of purpose.this article was first published on London Business School (31 Oct 2019). https://www.london.edu/think/how-great-companies-deliver-both-purpose-and-profit
0 Comments   08 August 2023
Sustainable investment: is it worth the hype? Here’s what you need to know
Sustainable investment: is it worth the hype? Here’s what you need to know
Supposedly sustainable investment funds make a staggering list of promises, including higher returns, lower risk, combatting climate change and even supporting diversity. And many believe them: investments in ESG (environmental, social and governance) funds are on track to pass £34 trillion by the end of 2022, nearly double their £18.4 trillion in 2016.But sustainable investing has also attracted strong criticism. Former BlackRock sustainable investing chief Tariq Fancy labelled ESG a “dangerous placebo”, and the Wall Street Journal has published a week-long series of rebuttals to the trend, with their opening piece entitled “Why the Sustainable Investment Craze is Flawed.”Whatever side you’re on, you have incentives to make your claims extreme. Asset managers promising that their ESG funds will save the world see new business flooding in, and are heralded as saviours of capitalism. Critics have similarly become famous by ordaining themselves as whistleblowers who’ve uncovered a financial scandal.If you’re a first-time investor trying to decide where to put your money, it can be hard to know who to believe. So if we strip back the hyperbole and examine the evidence, is sustainable investing worth the hype? To answer that, we’ll consider the three objectives that investors have when buying ESG funds.Does sustainable investment make more money?The first objective is, unsurprisingly, financial. By investing in sustainable companies, you’ll increase your returns, and by shunning unsustainable ones, you’ll reduce risk. Industries like electric cars are the future of transport, while dumping fossil fuel companies means you’re immune to a carbon tax.There’s evidence that certain dimensions of ESG pay off. One of my studies finds that companies with high employee satisfaction, a “social” dimension, deliver shareholder returns that beat their peers by 2.3%-3.8% per year over a 28-year period. Other research finds higher returns for companies with superior governance and those that link CEO pay to performance.But ESG is plagued by confirmation bias. Since we want to believe that ethical companies perform better, we latch onto studies that assert this, even if the evidence isn’t that strong.This highlights how the financial case for sustainability hinges on which ESG dimensions you consider. Every day, attention-grabbing articles insist that “investing in ESG pays off”. But to argue about whether ESG helps or hinders returns is as fruitless as asking whether food is good or bad for you – it depends on the food.Does sustainable investment change company behaviour?The second objective is the fund’s impact on company behaviour. Divestment campaigns aim to encourage shareholders to sell the stock of certain companies and deter new investors from buying it. By divesting (say) fossil fuel companies, the argument goes, we deprive them of capital and stop them creating more pollution.But investor boycotts don’t starve a company of funds, because you can only sell if someone else buys. They’re very different from customer boycotts, which do strip a company of revenue.Perhaps divestment doesn’t pull the plug on a company immediately, but doesn’t it make it harder for it to sell shares in the future? Not necessarily. “Brown” companies like fossil fuels and tobacco aren’t raising much capital to begin with – they’re in yesterday’s industries with few growth opportunities. And evidence suggests that the cost of raising capital has little effect on company expansion. Consumer anger at fossil fuel exploitation is growing. John Englart/Flickr, CC BY-ND The stock price might matter for many other reasons than the cost of capital. Even if a company isn’t raising capital, a low price worsens the CEO’s reputation and demotivates employees. But if so, my research suggests that the best strategy is actually tilting (leaning away from a “brown” sector but still being willing to own companies leading on ESG in that sector), not exclusion (shunning that industry outright).If a fossil fuel company knows it will be divested whatever it does, there’s no incentive for it to develop clean energy. But if its shares will be bought if it’s leading its sector in sustainability, this motivates it to clean up its act by investing more heavily in cutting emissions.Many accuse ESG funds with stakes in brown industries of hypocrisy, and praise those that won’t touch a troubled sector like oil, but the reality is far more nuanced. And owning brown companies is the only way to hold them to account. The investment firm Engine No. 1 famously got three climate-friendly directors appointed to Exxon’s board because it held shares in the company.Claiming you’re a true sustainable investor because you only invest in green companies is arguably like a doctor crowing that all her patients are healthy – when it’s a doctor’s job to treat the sick.Is sustainable investment the right thing to do?The final motive is moral: you believe it’s morally right to invest in certain companies. For example, even if diverse firms don’t perform better, it’s reasonable to invest in them as an expression of your values.Diversity is a dimension of ESG. WOC In Tech Chat/Flickr, CC BY-ND But identifying “moral” companies is difficult, because many key dimensions of morality are difficult to observe. A company could put minorities on its board to check the diversity box, but do nothing to create an inclusive culture.So is sustainable investing worth the hype? It does have the potential to improve performance, but only if you focus on particular dimensions. It can change company behaviour, but through tilting and engagement rather than exclusion. ESG is neither the panacea that advocates allege, nor the scandal that detractors declare. But shades of grey get lost in the shadows if we only look for black and white.This article was first published on The Conversation (10 June 2022). https://theconversation.com/sustainable-investment-is-it-worth-the-hype-heres-what-you-need-to-know-182533
0 Comments   03 August 2023
Are CEOs Really The Problem?
Are CEOs Really The Problem?
A reader (in fact, one that provided invaluable input into “Grow the Pie”) alerted me to the article “CEOs Are The Problem” by renowned MIT economist Daron Acemoglu. The article makes the following arguments:The current model of capitalism (shareholder primacy) is excessively influenced by Milton Friedman’s 1970 article that “The Social Responsibility of Business is to Increase Its Profits”.Capitalism has erroneously followed the recommendations of Michael Jensen – that CEO wealth should be more closely tied to shareholder value, to prevent “agency costs” that arise when CEOs pursue their own objectives rather than shareholders’.“The problem with shareholder primacy … was that it handed a massive amount of power to top managers. Many CEOs now run their companies according to their own personal vision. There is very little social oversight, and executive compensation has soared”.Under shareholder primacy, “there is nothing that prevents [CEOs] from pursuing excesisve automation to reduce labor costs, destroying jobs just to eke out a few more bucks for shareholders”.Shareholder primary allows excessive freedom to CEOs – manifesting in problems such as (3) and (4) above. The article’s final sentence is that “Corporate responsibility is too important to be left to corporate leaders”.There is no doubt that Acemoglu is one of the most brilliant economists of his generation. During my time as an MIT PhD student, he was awarded the John Bates Clark medal for outstanding contributions to economics by a person under 40 (similar to a Fields Medal in mathematics) – a strong predictor of the Nobel Prize in Economics. His work has been cited 177,000 times, with a single paper (“The colonial origins of comparative development”) having 15,000 citations – nearly 4,000 more than all of life’s work put together. His influence extends far beyond academia, with books such as “Why Nations Fail” and “The Narrow Corridor”.However, Acemoglu’s expertise lies in issues such as political economy and macroeconomics, which are a far cry from responsible business. As a result, his article contains basic misunderstandings and contradictions.For example, points (2) and (3) above are inconsistent. Jensen’s work highlights the problems that arise when managers have unlimited discretion, and stressing the importance of accountability. His 1990 paper with Kevin Murphy, which Acemoglu criticises, aims to prevent cases where “executive compensation has soared” by ensuring that CEOs are only well-paid if they create long-term shareholder value. Jensen’s 1976 paper with William Meckling – the most cited academic business article of all time – introduced the idea of agency costs. It’s often misinterpreted as defining agency costs as arising whenever managers don’t maximise short-term profit, and arguing that institutional forces should ensure such maximisation. But, as I explain in “What stakeholder capitalism can learn from Jensen and Meckling“, this article is widely misunderstood. Instead, it acknowledged that shareholders may have non-financial as well as financial objectives. Agency costs arise when a CEO fails to pursue shareholders’ financial objectives (e.g. due to coasting or failing to innovate) or non-financial objectives (e.g. exploiting workers, or prioritising her own non-financial goals such as donating to an opera house when shareholders are more concerned with labor rights).Similarly, points (1) and (5) contain a major contradiction. Friedman’s article is often interpreted as claiming that the goal of society is to maximise short-term profit – that’s why business’s social responsibility is to maximise it. This article is also widely misinterpreted and I clarify it in “What stakeholder capitalism can learn from Milton Friedman.” Friedman agrees that “corporate responsibility is too important to be left to corporate leaders” – he stresses that much of the responsibility lies with governments. The context in which Friedman was writing (often ignored in criticisms of his article) was one in which governments were pressuring companies to take socially responsible actions, to make up for their own failures. But, the government has far more power to achieve social objectives than companies – using income taxes to address inequality, carbon taxes to tackle externalities, and spending to alleviate regional issues (e.g. unemployment in the North of England). Expecting companies to solve all of the world’s problems is placing unrealistic burdens on them. If a CEO has created long-term, sustainable value, it’s fair for the company to pay her handsomely – it shouldn’t be criticised for contributing to inequality.Moreover, the whole article misunderstands the concepts of shareholder primacy and shareholder value, which I clarify in “Why shareholder capitalism benefits wider society“. Acemoglu argues that shareholder capitalism pressures CEOs to exploit society in the pursuit of short-term profit. This makes no sense, because shareholder value is an inherently long-term concept – Finance 101 highlights that it’s the present value of all future cash flows. A CEO pursuing long-term shareholder value will invest in her workers, not exploit them. It’s true that some CEOs who do the latter, but they are not pursuing shareholder value but instead short-term profit (potentially due to a poorly-designed incentive scheme). The solution is to tackle the specific problem (e.g. incentive redesign) rather than throw the baby out with the bathwater and reduce shareholder accountability.The above contradictions are not just academic arguments – they matter for the real-world solutions. Despite my concerns with Acemoglu’s article, I agree with a less extreme version of the title – some CEOs are the problem. What this means is that Jensen’s concept of shareholder accountability is the solution, not the problem, and should be encouraged. Similarly, rather than being ridiculed, supporters of stakeholder capitalism can use Friedman’s article to guide us – by clarifying the different roles that governments and companies should play and not pushing the entire responsibility to repurpose capitalism on CEOs.But isn’t there the concern that shareholder oversight – even if it focuses on long-term shareholder value – will nevertheless ignore stakeholders? Won’t it lead to the destruction of jobs, as per point (4) above? It may do – but the destruction of jobs may actually be good for society. Indeed, many technological advances that destroy jobs in the short-term have had hugely positive social impacts – such as the tractor and the ATM. Not only did this significantly improve productivity, but it also removed the need for humans to work on menial tasks that offer little skills development.Moreover, many of the technological advances that we need to satisfy the world’s most pressing problems will erode jobs – moving to renewable energy will endanger the employment of 5 million employees in the Chinese coal sector. But, the goal of society is not actually to provide jobs. It’s to assign citizens to careers where they can use their talents to serve society and flourish as humans. Employing someone in a role that harms society (e.g. burning coal) or can be easily done by a machine (e.g. cheque deposits) is a massive waste of their time and talents. That doesn’t mean that companies can introduce technology with impunity; instead, they should reallocate employees to more value-adding tasks that cannot be replaced by machines. In his excellent TED talk, Acemoglu’s MIT colleague David Autor explains how the ATM allowed bank tellers’ jobs to move away from simply cashing in cheques to providing customer advice.Indeed, contrary to common concerns that shareholder activism forces companies to focus on short-term profit, rigorous evidence shows that it creates long-term value for both shareholders and stakeholders. In contrast, when managers are insulated from shareholder pressure, managers pursue the quiet life and coast – failing to both close down old, unproductive plants and create new ones.The Bigger PictureOver and above the specific points in Acemoglu’s article, it’s an example of a more general concern. Responsible business is now a hot topic, which encourages everyone to jump on the bandwagon and write about it, regardless of expertise. How does a discerning reader know what to trust? My TED talk, “What to Trust in a Post-Truth World“, and cut-out-and-keep guide to Evaluating Research, provide some potential tips. Here are two:Critically analyse the author’s credentials (e.g. publications in top-tier academic journals) in the relevant field. This avoids the issue of “halo effects”, where someone’s expertise in one field leads to them being seen as an expert in many fields. Indeed, this is why the reader alerted me to this article – concerned that Acemoglu’s influence would mean that many readers would take his article at face value. Beyond this article, a visionary tech entrepreneur is currently see as the leading authority on climate change, even though climate science is a quite different topic.Ask whether the article is balanced. There are almost two sides to every issue in social science. Thus, while a one-sided title may grab headlines, it suggests that the article may not have seriously considered the evidence on both sides. “CEOs are the problem” is a sweeping over-generalisation. Some CEOs are the problem; others are not. Thus, moderate solutions may be warranted, even though extreme remedies might attract more attention.
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