Methodology

Stocks

Module 5

What is a portfolio?

Shareholder wealth maximisation

When an individual invests in a stock, they aim to increase their own wealth. Regardless of what they are building their wealth for, investors are not just doing it for fun.

When you invest in a stock, you are putting your faith in the management of that company to make decisions that are beneficial to you as a shareholder. 

Generally, the main focus of the management of a company is on maximising the wealth of its shareholders. They will generally try to do this by increasing the company’s share price or dividend.

Shareholder wealth maximisation is different to profit maximisation as it more so about making decisions that will benefit the company in the long term. In contrast, profit maximisation refers to making as much profit as possible in the short term.

Profit maximisation is unlikely to benefit shareholders in the long run, as it has the potential to damage relationships with other key stakeholders (i.e. customers or the government).

For example, a company could maximise profits by reducing the quality of the ingredients used in their  food products. However, if customers don’t like the new taste and decide to stop buying the product, it would have a significant impact on the business in the future.

Instead, to maximise shareholder wealth, the company may decide to invest in a new food item that has the same quality as other products it sells. If it becomes popular, it would create value for shareholders for years to come.

Agency problem

The problem with investing is that you have little influence on what is going on within a company.

As a consequence, it is not necessarily the case that the management of a company will prioritise shareholder wealth maximisation, which is something that investors need to be cautious of.

If the main agenda of the management of the company shifts away from the interests of shareholders, it is a huge problem that may reduce the return that investors achieve. In fact, in the extreme case, it could result in the stock price of the company collapsing.

This is called an agency problem. It occurs when the agent (the management of a company) does not make decisions in the best interests of the principal (shareholders).

The most widely discussed agency problem in investing is when the management of a company focus on building their own wealth, instead of the wealth of the shareholders.

In order to overcome this agency problem, companies try to align the interests of managers and shareholders by offering stocks to the managers for good performance. Regulations have also been established that legally try to prevent such problems from arising.

Agency problem: things to look out for

To determine if a company suffers from an agency problem or not, there are a few things that you can look out for.

Firstly, when a company has a very high level of cash that is unused, they essentially have two main options: to pay this money out as a dividend or to use it on new projects that will grow the value of the company. 

If a company has a lot of cash building up, but isn’t doing anything with it, this is a concern for investors. It is a sign that the company is inefficiently managing money, which may not be benefiting shareholders. 

In addition, another concern is executive compensation. If the management of a company are paying themselves larger and larger bonuses, this is maybe a sign that they are focused on building their own wealth and not that of their shareholders.  

It is especially a bad sign if the management of a company pay themselves excessively high bonuses, without much to show for it.

For instance, in the UK, the CEO of a FTSE 100 company received a 44% pay rise in 2019, despite delivering a loss for shareholders that was in the region of -35% in that business year.

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