Stakeholder Value & The Dynamic Pie

A recent article by Forbes contributor Steve Denning reviewed Roger Martin’s new book, Fixing the Game. It was a good review and I plan on reading the book.

The gist of the article is that managers of public companies focus too much on the expectations behind their stock price, and in turn “maximizing shareholder value.” [1] According to Martin, the causes stem from misaligned incentives and the business culture that has developed over the past 30 years. This focus on shareholders usually comes at the expense of customers and employees. “If you try to take care of shareholders, customers don’t benefit and, ironically, shareholders don’t get very far either.” When managers are working in the expectations market, they’re much more likely to make short term decisions that benefit only themselves and a (vocal) subset of shareholders—traders. This includes seemingly harmless activities like giving quarterly or annual earnings guidance, or for retailers reporting monthly same-store sales figures.

Martin proposes a few remedies to the problem, like improving board governance and eliminating both safe harbor provisions and stock-based compensation. These would go a long way to nudge corporate behavior in the right direction. But for managers who want to take it upon themselves, here’s my proposal: think of your company as a Dynamic Pie.

If you didn’t notice from the picture above, in this part of the post I’ll be discussing pie—the dessert, not the mathematical constant. The Dynamic Pie represents the value of a company to its customers—or in financial terms, its revenue. The size of the pie grows or shrinks over time depending on the amount of value received from customers. It then gets divided into three groups of stakeholders: Providers, Employees, and Owners.

The job of managers is twofold:

  1. to grow the pie by delighting and growing the current base of customers; and
  2. to divide the pie in a way that’s fair to all three groups.

Of course, the size of each group’s slice isn’t completely determined by managers. Each business is different—in some Providers will take the biggest slice (Wal-Mart), in others it’s Employees (Goldman Sachs) or Owners (Microsoft). The key is not that they are equal, but fair. Or, to be more precise, each group should be satisfied with their share given market circumstances.

Every stakeholder works to increase the size of the pie, because in most cases it’s in their best interest. If one group is being shortchanged in favor of another, they’ll end up focusing only on getting a bigger share, and not on customers. By taking care of customers and being fair to all stakeholders, the pie will grow and shareholder return should take care of itself.

Sears Holdings: Division of a Shrinking Pie

Sears Holdings is the company that owns Sears, Kmart, Land’s End, and other brands like Kenmore and Craftsman. It’s a good example of a business where the size of the pie is shrinking over time, primarily due to customers switching to competitors from under-maintained Sears or Kmart stores.[2] This is a difficult situation, as each group of stakeholders wants to maintain their share. If the pie’s getting smaller overall, it will come only at the cost of other stakeholders.

Although individually they don’t have much of a choice, employees don’t want to be laid off. Sears has 300,000+ associates, and you can’t meaningfully decrease their slice of the pie without consequences. There is value left in the huge amount of real estate that Sears leases, but again, you have to muscle it away from the lessors that provide it.[3]

Because it’s hard to maintain value for all share owners, Chairman Eddie Lampert has been focusing on a subdivision of the Owners slice: that of long-term shareholders. By buying-back a massive amount of shares over the past 6 years, the pie has shrunk further as some investors exit with their fixed slice, leaving remaining owners with a bigger share of a smaller pie.

For dying retailers, the decline is never linear—less customers, less employees, and poorer quality operations are all part of a negative feedback loop that accelerates over time. This is what has been happening to Sears recently. Now, all the investors who exited and “ate” their pie are looking much better off than those who stayed.

Getting it Right

In the article, Denning cites Johnson & Johnson, Proctor & Gamble, and Apple as exemplars. Costco and Starbucks are two more examples of companies that do a fantastic job of dividing and growing their value.

In Starbucks’ case, the Providers take the biggest slice by contributing the coffee beans, milk, paper products, real estate, etc. Though I’m not sure about the rest of their suppliers, I do know that Starbucks treats their coffee suppliers very well. Despite the fact that coffee is a commodity and can be had for the lowest possible price, Starbucks spends a little extra to ensure good working conditions for the farmers and good relationships with the communities involved. Baristas and other Starbucks partners receive full healthcare coverage, including part-time workers. Is this really necessary? Short-term, Starbucks could probably get away with cutting benefits (this was suggested to CEO Howard Shultz during the recession) to increase Owner’s share of the pie. But in the long run giving even the lowliest of partners a fair share will grow the pie for everyone involved.

Costco is a similar example. Despite operating on razor-thin margins (stores aren’t allowed to mark merchandise up more than 14% above cost), Costco pays their employees above-average wages and insures 85% of them compared to less than 50% for other major retailers. “It’s not altruistic,” Costco founder Jim Sinegal said in a recent interview. “This is good business, hiring good people and paying them good wages and providing good jobs for them and opportunities for a career.”

Let’s look back at the Sears example for a moment—what if declining value is the only possibility? Even if Sears plowed money into improving their stores, they would be unlikely to out-compete the Wal-Marts and Targets of the world. An historic example of this can be seen in Berkshire Hathaway.

When Warren Buffett took control of Berkshire in the late 1960s, it was a declining textile mill with no hope for revival. Instead of trying to divide the shrinking pie amongst current stakeholders, Buffett decided to grow the pie by allocating cash to better businesses. Over time, this added new employees and providers to the overall company while the textile mill faded away. Owners were not forced to fight over a smaller and smaller piece, nor were they taking an unfair share from employees or providers.

Some situations are harder than others to fairly split the pie. Companies with competitive advantages have more leeway in how stakeholders are treated. But by making sure everyone “wins” by receiving a fair share, every contributor is more incentivized to grow the pie and delight customers. Now onto finding me some real pie… (My favorites—because I know you’re wondering—are apple, cherry, peach and pumpkin.)

[1] Listening to the comments of current business leaders and reading histories of past leaders, I’ve always been perplexed by the misguided focus on stock price and market expectations. Part of me thinks that they don’t have a fundamental understanding of the way the market and its participants work. With very few exceptions (for companies that require constant short-term financing, or those issuing or buying back stock), businesses and their leaders shouldn’t give a damn about the market price of their company.

As an investor and entrepreneur, my advice to all leaders is this: If the market or analysts “expect” you to grow sales by 20% next year, that’s their business—not yours. If you miss expectations by 2% or by 2 cents a share, they’re the ones to blame for missing estimates. Your job should be to focus on improving the long term value of the business for everyone involved. Most share “owners” these days are short-term holders or mindless algorithms anyway.

[2] Other Sears Holding’s brands and their online division are doing much better, but due to the relative size of the Sears/Kmart retail operations it drags the rest down with it.

[3] Yes, it’s true that lease agreements lock lessors in and give them little options. But this is just another example that shows the only way to extract value in a situation like this: by taking it from the other stakeholders. Real estate Providers aren’t getting their fair share because Sears pays much lower than market rent for their properties.

3 thoughts on “Stakeholder Value & The Dynamic Pie

  1. Hi Max,

    I noticed an article you wrote five years ago on SHLD, where you disclosed an investment position. I was wondering if you still held the same number of shares, if you’re still invested in the company? My reason for asking is, you’re noted as a long time follower of the Buffett/Graham style. As a student of value investing, I’m keen to explore how followers of this style generally perform as investors themselves, ie can normal investors profit in the long term from following the ideas in The Intelligent Investor and Berkshire shareholder letters.




  2. Mark,

    I sold our Sears investment many years ago (probably about a year or so after I wrote the article you mentioned). After further thought and investigation, I came to the conclusion that Sears was in a tougher situation than my optimism warranted, and that the “liquidation” thesis would play out longer and more painfully than the market anticipated.

    To your second point, I won’t go into performance specifics other than to say that I have beaten the market in my personal accounts and (to a much lesser extent) the BHL investment partnership since inception. I think “normal” investors can and do profit from the Buffett/Graham style — but it is certainly difficult. In the long run the most important elements are staying within your competency and possessing an unusual amount of patience.


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