Edition: Dec 2014 - Feb 2015


Keep government out

To address income inequalities, first get education right. International consultant Joel Stern*, who recently completed a series of lectures at the UCT Graduate School of Business, responds to the TT arguments on "radical economic transformation".

There is no question that your idea is terrific for retirement funds actively to participate as shareholders in attempting to build consensus on matters of corporate pay (TT Sept-Nov). But it is only a small piece of the puzzle. The issue of "income inequality" is not isolated in executive compensation.

It is my contention almost all the socioeconomic problems that are discussed worldwide are caused by a failure of markets based on government intervention in the first place.

In SA there is persistently high unemployment and persistently high inflation. What's causing this? The answer is that, since 1994 when "radical economic transformation" (RET) started, there has been almost no serious effort to improve the quality of education.

We have the same problem in the US. Government controls education, offering nothing to ensure competition, and the result is poor-quality education. "Income inequality" is almost entirely caused by government intervention in education.

It reflects the fact that students who complete high school and continue to university, possibly on to graduate school, tend to achieve significantly higher incomes than those who don't. The former will save in the forms of shares and real estate, rapidly growing their wealth. Better incomes arise from better education, often at the higher cost of private schooling.

When it comes to corporate governance and executive remuneration, the solution is similarly to be found in competition. It's to allow an active market for corporate control i.e. an opportunity for shareholder activism in the form of unfriendly takeovers.

Stern . . . free competition, free choice

This happened in the US, beginning in the late- 1970s. Harvard professor of finance Michael Jensen showed that an active market for corporate control through the threat of unfriendly takeover improves corporate governance without actually having the takeover. Merely the threat of takeover would do the trick, and it did. Such threats of takeovers solved the US corporate governance problem in the 1980s. But, of course, Fortune 500 companies were afraid of this. In 1989 they managed to get a judge in the state of Delaware, where most companies are incorporated, to interfere in this activism by just saying no. Bad outcomes were Enron and WorldCom, representing the tip of an iceberg.

Then too, in 1993, President Bill Clinton got legislation passed that prevented management from earning large cash bonuses unless they could prove they were creating shareholder value. This is difficult to do, especially if long-term investments are made that only pay off years later.

Management needs to be rewarded for taking the risks that ultimately reward the shareholders. Thus I suggested to the board of a company on which I served that, instead of paying cash bonuses, stock options be used. Little did I anticipate that, for the next six years, the stock market would increase annually by 23% on average.

So management was granted stock options, but the options needed to be granted at four times the amount that management would have received in the form of a cash bonus (as share options are four times riskier than cash). With the stock market then increasing by 23% a year (2,5 times the norm), management got 10 times what it would have received in a cash bonus (4 x 2,5).

SA executives followed the example of Americans, as did Europeans, using stock options instead of cash. Some worked out brilliantly. Firms such as Bidvest, Tiger Brands and SA Breweries delivered big-time for shareholders. So their levels of executive remuneration should not be held up to scorn, or subjected to government intervention.

Please don't get me wrong. I want all people in SA to do well. But I want them to do well because of hard work and commitment, not because they engage in "takings". Once a country begins to engage in "takings", it will essentially discourage foreign direct investment.

All of us seemed to champion black economic empowerment, but my great fear was that only a handful of people would benefit at the expense of white and black shareholders (directly or through such vehicles as retirement funds) who owned the companies subjected to BEE.

I am in favor of economic empowerment, but economic empowerment for all; not just for black residents of SA. The best remedy for past apartheid abuses is to ensure that in future all people can enjoy opportunity to succeed.

A solution for the US, for Europe, for the Middle East and certainly for SA is what I call "employee capitalism." It means that all employees have an opportunity to earn variable compensation based on sustainable improvements in company performance.

There are no caps on awards, but for senior management their awards should be put into a "bonus bank" that pays out only gradually based on sustainability. The focus is then on long-term and not short-term results. It is a simple free-market solution that will work everywhere. Thus, my response to RET is to permit an active market for corporate control; for government to permit product, labour and financial markets to have true competition.

It is plain stupid to limit immigration into SA of people who are well trained, and are needed in the country, out of fear that they will take jobs away from South Africans. There is no evidence for this anywhere. In fact, by talented people coming to SA, SA will be receiving foreign aid as the education of these people has been paid by the countries from which they emigrate.

They will come to develop business, hire people, train and develop them. What could be better? In addition, as mentioned, an economic value-added (EVA®) transformation would provide incentive for all people to strive to do better.

Finally, government should privatise the education system; for example, to launch an education-voucher system where private firms would provide training and development for people so that they can become productive members of society.

Even if a few executives are getting paid what you and others consider to be excessive compensation, the way around this is not for government to regulate anything. It is to allow for unfriendly takeovers and an activist mentality in the financial markets. The programme envisaged by TT does accomplish some of this.

But what about education? What about foreign direct investment? What about the best ways to overcome the white supremacist attitude that has been so devastating for so long?

I am a champion of individual liberty, choice and competition. They provide the best solution for current and future harmony in SA and elsewhere.

I am a champion of individual liberty, choice and competition. They provide the best solution for current and future harmony in SA and elsewhere.

Since RET has become a discussion point, look at the industrial policy that SA now has. You surely cannot imagine that government politicians are going to tell us where our monies should be invested in order to create sustainable employment. It cannot possibly happen. They will bear none of the risk when mistakes are made, and when losses are generated the spigot will remain indefinite.

We have examples in Transnet and SA Airways (SAA). Both organizations need the type of cleansing I am talking about. I suggested that economic value-added change be implemented in SAA when the chief executive was a former student of mine.

However, the Minister of Public Enterprises turned it down saying bonuses will not be paid until the airline generates profits. Well, if that's it, forget about it. This will never happen.

I have been visiting SA regularly since 1978. For 35 years I have been on the faculty of both UCT and Wits. I love the country and the people, but I fear for the future.

* Prof Joel M Stern, who created the economic value-added (EVA) concept as the primary measure for corporate performance and consults on it for major corporations internationally, is chairman and chief executive of New York-based Stern Value Management. 58 Today's Trustee December 2014/February 2015 I am a champion of individual liberty, choice and competition. They provide the best solution for current and future harmony in SA and elsewhere.