In the last several years, a growing number of global apparel companies have begun having their products manufactured in Ethiopia. For these firms, Ethiopia has become the new low-wage frontier. The East African country now competes with Bangladesh, Vietnam and other South and East Asian nations for a share of the massive volume of global garment production. In this competition, Ethiopia has the dubious distinction of offering the lowest pay anywhere in the worldwide clothing supply chain—and that’s the main reason the big brands are drawn there.
But increasingly it has become clear that these firms need to invest more resources into Ethiopia both to make their make production profitable and sustainable over time, and to ensure that Ethiopians are better off because of their presence. Among the steps they will need to take are to increase wages, enhance training, and help provide housing and other basic necessities to the young women who come from around the country to work in the clothing factories. The challenge these firms face in Ethiopia is to balance the pressures to reduce the costs of production with the realization that to succeed over the longer term, they will need to invest more money. This longer-term view is in tension with what many Wall Street investors and analysts are expecting them to do, driven in part by a mistaken understanding of directors’ legal duties to shareholders.
For the last half-century, most analysts and investors have embraced an antiquated investment model that focuses heavily on maximizing short-term shareholder returns. They have focused on these short-term returns at the expense of longer-term wealth creation for corporations and society at large. This focus took shape in the 1970s, when economist Milton Friedman and then others asserted that corporate CEOs are merely agents of shareholders, responsible for conducting business in accordance with shareholders’ core interest: maximizing stock prices. In an often-quoted 1970 article in The New York Times Magazine, Friedman wrote that corporate executives have a fiduciary duty to conduct business in accordance with the desires of shareholders, which he defined as making “as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom.”
Since Friedman first articulated this rigid view almost 50 years ago, the negative consequences of his perspective have become more apparent. Wall Street’s preoccupation with short-term returns has led too many corporations, like the apparel firms in Ethiopia, to forgo the longer-term investments they need to create maximum societal wealth and to build sustainable business models. Instead, they are doubling down on cost-cutting measures and excessive share buybacks or simply declining to make needed internal investments. What results is a chronic failure to invest in the future and a global financial system that is leaving too many people behind.
One cause of this problem is the mistaken notion that corporate directors “duty of care” to their shareholders necessitates that they deliver maximum quarterly earnings. But, in Delaware, where over 60% of Fortune 500 companies are incorporated, the courts are increasingly clear that corporate directors need to be thinking about and maximizing long-term value for their shareholders. The Chief Justice of Delaware Supreme Court, Leo E. Strine, Jr., has advocated for a broader understanding of business’ role in society than that of the Friedman model, writing: “the generation of durable wealth for its stockholders through fundamentally sound economic activity, such as the sale of useful products and services, is the primary goal for the for-profit corporation.” Strine has highlighted the role investors have to play in encouraging this mindset, saying: “To foster sustainable economic growth, stockholders themselves must act like genuine investors, who are interested in the creation and preservation of long-term wealth, not short-term movements in stock price.”
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And indeed, in the last decade, we have seen greater interest by a rapidly growing number of investors who wish to incorporate both longer-term horizons and a broader range of social considerations into their decision making. Large public funds are at the vanguard of this trend as are a new generation of individual investors led by women and millennials who are looking to invest in businesses that deliver more than just “as much money as possible.” In 2017, Nobel Laureate Oliver Hart of Harvard and Chicago Booth’s Luigi Zingales published an article advancing this broader vision of shareholders’ desires, arguing: “A company’s ultimate shareholders are ordinary people who, in addition to caring about money, are also concerned about a myriad of ethical and social issues: They purchase electric cars to lower their carbon footprint; they buy free-range chicken or fair-trade coffee because they view this as the ethical—albeit more expensive—choice.” They conclude: “If consumers and owners of private companies take social factors into account and internalize externalities in their own behavior, why would they not want the public companies they invest in to do the same?”
This perspective is especially strong in Europe where the legal and economic landscape is much more open and where investors are routinely assessing company performance through a broader, longer-term lens. In recent years, some prominent U.S. business leaders also have begun to embrace this more expansive approach. Last June, two prominent leaders of the financial community, legendary investor Warren Buffett and Jamie Dimon, chairman and CEO of JPMorgan Chase, rejected what they termed “an unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability.” Their admonition echoed the International Business Council of the World Economic Forum, which said in 2017 that “society is best served by corporations that have aligned their goals to serve the long-term goals of society.”
Still too many analysts, money managers and investors continue to focus on short-term growth, as measured by revenue. They pressure companies to shave pennies off production costs without paying sufficient attention to the longer-term costs associated with this model. The governance challenges these companies face, in Ethiopia and elsewhere, are indeed linked to the long-term goals of society. As they look to the future, company leaders will need to adopt a much more comprehensive model that will address the broader needs that workers face in a place like Ethiopia. But it will be difficult, if not impossible for them to take these actions if investors penalize them for incurring these near-term expenses.
Instead, institutional investors and asset managers should support companies that think proactively about their impacts on society and devise business models that will stand the test of time. In his letter to corporate CEOs earlier this year, Lawrence Fink, the CEO of the BlackRock investment management firm, presented a framework that should guide the apparel companies and those who invest in them: “Companies that fulfill their purpose and responsibilities to stakeholders reap rewards over the long-term,” Fink said, “Companies that ignore them stumble and fail. This dynamic is becoming increasingly apparent as the public holds companies to more exacting standards.”
The challenge now for BlackRock and other major corporate investors is to put these salutary words into practice, and to use their financial leverage in ways that persuade companies in the apparel sector, and other industries, to reexamine their business models and make the changes needed to turn their rhetoric into reality.