Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't by John Jr. (books to read for 12 year olds txt) 📗

making a lot of money from the litigation, but unfortunately the retirement fund didn’t own any stock in the lawyers. Wilson told us that the pension fund had used its influence as a large shareholder in both companies to get them to settle their lawsuit. He also revealed that the pension fund had similarly helped to convince Apple and Microsoft to settle some mutual legal disputes.

While investors care about the value of each stock they own, they care more about the value of their total portfolio. If some corporate decision causes the price of one stock in an investor’s portfolio to rise but depresses the value of another of his stocks by an even greater amount, the investor will not be pleased. As stockholding in general and diversified stockholding in particular has risen over time, corporate decisions have increasingly come to affect other firms and their stockholders.

This phenomenon has been evident in Japan for decades. Japan’s keiretsu are a group of companies that cross-own stock in each other in order to promote cooperation among the constituent firms. The practice represents a kind of halfway point between total independence and a complete merger. In 1989, the Texan tycoon T. Boone Pickens purchased a large stake in Koito, a Japanese automotive lighting and air conditioning company that belongs to the Toyota keiretsu. Toyota works closely with Koito and other suppliers in designing products to fit its cars.

Pickens became upset that Koito was charging Toyota low prices. But the other companies in the Toyota keiretsu did not share his concern. Unlike those companies, Pickens only owned shares in one of the keiretsu’s firms. So he was only interested in maximizing Koito’s share price, while the other shareholders cared about the overall value of all the keiretsu’s companies. If Pickens had also owned Toyota stock, he wouldn’t have had much of an incentive to try to charge Toyota higher prices. In fact, the income he hoped to gain from raising Koito’s prices to Toyota would have been smaller than the loss imposed on Toyota.33

In the U.S., mutual funds and other financial institutions replicate some aspects of the keiretsu system. For example, a study I performed with Tuck Business School professor Bob Hansen found that 33 percent of IBM’s stock and 50 percent of Intel’s stock were owned by institutions that held stock in both companies. Likewise, 29 percent of Apple’s stock and 20 percent of Microsoft’s stock were possessed by institutions that were shareholders of both firms.34 Additionally, some aspects of venture capital funds also resemble the keiretsu system. Typically, such funds specialize in investing in a small number of industries. Like the TIAA-CREF, the funds have an incentive to use their position as stakeholders to encourage cooperation among the companies in which they’re invested and to discourage wasteful internecine disputes.

Hansen and I found that stock diversification also helps to explain other corporate behavior, such as the prices that firms bid in mergers. While merger announcements usually increase the stock price of the firm being acquired, there is substantial evidence that the stock price of the buyer actually falls. Furthermore, the size of this drop has been increasing over time. This can be explained by stock diversification: when shareholders own both the acquired and acquiring firm, they care much more about whether the merger will increase the total value of the two firms than they do about which firm’s value increases and which decreases. If shareholders own both companies, a higher bid simply means more money going from one of their pockets to the other. If there are diversified shareholders and multiple suitors, then shareholders will care not about the size of the bid, but rather that the total value is maximized.35

During a merger, shareholders will only be indifferent to the buyer’s stock price when they also hold shares in the target. When the target is a private, closely-held firm, you usually won’t see this disinterest. In such acquisitions, a firm will only make a bid if the merger would increase its own value. Thus, in mergers involving a publicly-held company taking over a privately-held one, the buyer’s stock price will usually rise upon the bid’s announcement.36

The overall benefits we gain from stock diversification are another example of the market acting effectively when it’s left alone. Sometimes these innovations take some time to evolve, but the inexorable direction of the market tends toward ever greater efficiency.

State Predators and Private Lambs

What kind of company comes to mind when you think of a corporate predator? The textbook example is John D. Rockefeller’s Standard Oil company, which ruthlessly gobbled up and closed down competitors in the late 1800s and early 1900s until the firm was ordered broken up by the Supreme Court.37 More recently, American Airlines was the defendant in a high-profile predation case that was eventually tossed out by the courts. Inevitably, it is large, private companies that are associated with predation in the public mind. This is quite unjust, for it is government-run companies—not private firms—that have the biggest incentives to act like predators.

As noted in Chapter One, predation—the lowering of a company’s prices below cost—usually proves too costly to be successful. After crushing a competitor, the threat of further predation has to be credible enough to keep new firms from entering the market. How is this threat issued? A typical predator has to convince potential competitors that it values something—perhaps overall sales or market share—more than it does profits, which can suffer dramatically while a firm is engaged in predation. This is usually a difficult threat to make convincingly—after all, the overall goal of any private company is to make money.

But government-owned companies are seldom geared primarily toward making profits. Because they are frequently motivated by extraneous factors such as maximizing employment, state-owned firms can make much more credible threats of predation. What’s more, state-owned firms often don’t need to drive their competitors out of business for predation to be successful; predation can work merely by allowing state-owned firms