1. Why write this essay?

Last time in Part 1 we covered the idea of legibility. We standardize things and make them consistent in order to better measure them.

Standardization and consistency from legibility lets us manage large scale processes. But we pay a cost because standardization removes context and nuance.

With this, we can now start to look at one of the major problems people have with modern capitalism: Why do companies care about quarterly profits so much?

(It’s not fiduciary duty. Please never say it’s because of fiduciary duty.)

But first, to answer this question we need to take a slight detour for a quick history lesson…

2. How did we get the modern company structure anyway?

We didn’t get the modern company structure and rules around corporate governance out of nowhere. 

Companies are social constructs. Which means the concepts and theories around them were invented by people to solve real world problems

2a. Problem 1: Collective investment

Let’s say Robin wants to become a shipping merchant. What are the problems here?

Firstly, some business activities are too much for just one person to do by themselves. For example, establishing a factory requires significant capital investment to purchase land and equipment. In this case, Robin needs to pay a large sum of money up-front to buy not only the ship but also hire crew and equipment. A large lump sum of money that Robin might not immediately have available.

Secondly, there’s a ton of risk involved. This is going to be a significant part of Robin’s wealth tied up in that single asset. If a freak storm happens, Robin might lose everything.

It’s a low probability, but it’s like a reverse lottery ticket where you lose everything if you get “lucky”. Owning a lottery ticket of doom sucks.

But if Robin bands together with 19 other ship owners, then they can significantly reduce the risk!

If all ships are equally profitable, then everyone still makes as much money as before on average. But losing a single ship isn’t a cataclysmic event for any of those 20 ship owners. It’s “merely” a large loss that is evenly spread across 20 people, and the remaining 19 ships can help pay for a replacement.¹Of course there’s the tail risk that all 20 ships are destroyed by a singular event. Risk sharing can only take you so far and you cannot permanently eliminate all risk in business. But it’s still better for everyone to share risk this way!

As a society, we consider it beneficial for people to be able to pool together money to invest in large scale economic activity. So, the concept of the corporation is invented to let people either:

• take on larger scale activities than they otherwise would be able to; or
• reduce the risk people are exposed to when conducting business and therefore encourage more business overall.

So we invented the concept of the joint-stock corporation, and fractional ownership through stock ownership. This lets Robin and 19 other people group together to conduct large scale economic activity together in their new shiny Ylisse Shipping Company.

Having laws and regulations around companies means that people have a legal process they can follow rather than relying solely on personal connections. This in turn makes creating a business more accessible to people.²For instance, in low trust societies where the legal process is weak, you see greater reliance on ethnic or religious ties. When you value your place in your social group because of ethnic or religious identity, then you can trust the other person won’t betray you out of shame. Good examples of this are the Chinese diaspora in South East Asia (Chung, 2005, Western Corporate Forms and the Social Origin of Chinese Diaspora Entrepreneurial Networks) or the Jewish diaspora in Europe (Aust, 2013, Between Amsterdam and Warsaw: Commercial Networks of the Ashkenazic Mercantile Elite in Central Europe).

2b. Problem 2: Buying and Selling Companies

Let’s say Robin is 60 yrs old now. Instead of working 12 hrs a day managing shipping logistics, they want to retire and get out of the shipping business. So they want to sell their Ylisse Shipping Company stock.

Well, the problem is stock is held with paper certificates managed by the company to prove ownership. And to sell it you need to transfer the paper from one person to another.

This is laborious and a pain in the ass. Travelling to a company’s headquarters just to change ownership might be difficult. This also limits investment to “people who can actually travel to the HQ address”.

Now, Robin could withdraw their stock certificates from the Ylisse Shipping Company HQ and try to sell the paper itself. This has the advantage that it’s much more convenient to buy and sell stock since you’re no longer geographically restricted. It also reduces the administrative burden to the company, who can focus on running the company than managing and safeguarding a giant pile of stock certificates.

But paper is easily destroyed, lost, or stolen. And carrying it around is a huge risk when 99% of the time you don’t actually need it. The company also now doesn’t know who actually owns it and is going to have to deal with stock certificate forgeries from criminals trying to commit fraud.

This isn’t a unique problem to Robin. It’s a problem every single stock owner is going to face.

Well… this sounds a lot like the same problems as owning gold bars:

• Gold bars are valuable;
• They’re a pain in the ass to store and safeguard; and
• 99% of the time you don’t actually need them lying around except when you’re finally selling it.

We invented banks as a way for people to store and safeguard gold bars. And it’s more efficient to have one single entity specialized in storing and guarding things with a dedicated security budget than multiple people with smaller budgets.

So why not have a “bank” for stock certificates? And it also has the advantage of being a centralized location to easily find people to buy shares from or sell shares to. And the “stock bank” can manage the “master record” of all ownership to prevent fraudulent stock certificates.

And thus the central clearing house was invented. A place that provides the convenience of managing the administrative bureaucracy of stock certificate ownership (for both the company and stock holder), security to safeguard stock certificates, and a market to make burying and selling stock easier.

This is a huge benefit to both Robin and the Ylisse Shipping Company. So they move all the stock certificates into the Ordelia Stock Exchange.

2c. Problem 3: Separation of Ownership and Control

Let’s say that someone called Byleth is interested in buying the stock certificates for the Ylisse Shipping Company from Robin. And they’re willing to pay more money than other potential buyers because they really love shipping.

There’s just one small problem. Byleth is a busy teacher and doesn’t have time to be involved in the day-to-day management of the shipping company.

This is where we now create the idea of separation of ownership and control.

Buying stock gives you ownership of the company. This also gives you the right to a proportion of the profit of the company based on how much stock you own. However, you can be an owner and not control and manage the company. Instead, you can hire professionals and experts to run the company on your behalf.

This is considered a good thing for two key reasons:

Firstly if Robin can only sell to people who also want to run and work at a shipping company, then the number of available buyers will be extremely limited. This also means Robin can’t get a “fair” price for their stock. A small number of buyers can also lead to price manipulation since there’s only so many people you can go to sell stock to.

Secondly, this lets everyone participate in stock investment. This is especially important for the average person in society. Afterall, companies are where most economic activity in a society happens precisely due to the advantages of taking on large scale activity and risk reduction!

The average person in society also has a limited amount of knowledge they can learn. Separation of ownership and control lets people buy into areas of the economy they are not experts in. A chemical engineer for example might make a terrible banker. But that doesn’t mean they should be excluded from being able to invest their money in a bank, or be forced to only ever invest money in chemical engineering.

Thirdly, separation of ownership and control means you can have many owners of a company. If every owner needs to be involved in managing the business, then it becomes infeasible to have millions of owners of a company.³There are a lot more problems when it comes to the separation of ownership and control, and the resulting principal-agent problems it creates. But for the sake of simplicity, I only want to talk about these problems.

Using some very dumb math here to illustrate a point:

• There’s about 8,000 securities listed on all US stock exchanges according to the NYSE. Not all of these are companies but whatever, let’s pretend they are to really make a point;
• Let’s say the maximum number of owner managers per security is 1,000. This is deeply impractical but sure;
• Let’s say that no person is allowed to own securities in more than one company;
• So the maximum number of stockholders in the US is basically 8 million people. Much less given how generous our assumptions were;
• The population of the US according to the US Census is around 340 million people (July 2024 estimate);

So even in our best case scenario with unrealistically generous assumptions, only 2% of the US population is allowed to invest in stocks.

If you hate economic inequality now, just wait until only 2% of the population is allowed to benefit from stock investments!

2d. Problem 4: The Principal-Agent Problem

Some time passes and now the Ylisse Shipping Company has millions of stock owners including Byleth. The company is also run by a professional management team. Remember, this management team is not the same as the stock owners of the company.

This leads to an immediate problem: How does Byleth know the management team isn’t defrauding them?

You see, the management of the company controls the company. They have access to all the internal confidential information, control all the processes, choose how to spend the company’s money, and can give orders to the workers.

The separation of ownership and control creates incredible opportunities for fraud and crime.

After all, how would any of the actual stock owners know if you secretly just… straight up stole money from the company’s bank account? They’re not actually physically there monitoring you every single day.

And it doesn’t have to be something obvious like literal theft. There’s a whole range of things you can do to enrich yourself at the expense of the stock owners. For example:

• Use the company to fund a luxurious lifestyle such as private jet travel and expensive food / alcohol on the basis that it’s for business purposes;
• Make excessively risky decisions. If these gambles work, you get paid a huge bonus. If they fail, well, it’s not your company anyway right?
• Literally lie and make up financial results to justify paying yourself more money;
• Decide to just slack off and not actually work very hard. The company won’t generate the profit the stock owners expect and they may be paying excessively high compensation to management for no results.

These are all undesirable outcomes from the perspective of the company owners. So we need to put in controls and systems to monitor and manage the conflict of interests between the owners and Ylisse Shipping Company management.

One of these solutions is regular reporting. If we make companies publish their financials on a consistent basis under a consistent set of rules, we can track the performance of the company over time. This lets us understand how well the company is performing, identify issues, and address them.

This also gives the stock owners the opportunity to deal with problems they identify. They can either replace the management team, or just sell their stock if they decide the company isn’t worth investing in. Stock owners don’t have to be “locked into” their purchases.

Letting stock owners inspect the company themselves is deeply problematic. Remember, Ylisse Shipping Company has millions of stock owners now. If even 10% of them wanted to visit, the company is now dealing with 100,000 visitors every year who will want to inspect and audit everything.

This is deeply impractical and means the company will be wasting a ridiculous amount of time and money handling visits from people who might not even be qualified to actually measure and understand what they are even inspecting.

THIS is why we care so much about regular reporting. Regular reporting helps build a safety system that allows the separation of ownership and control to happen.

Stock owners don’t control or manage the company and lack insight into how the company is doing on a day-to-day basis. The management of the company want to focus on running the company and not dealing with millions of micromanagers from hell.

The solution is creating regular reports to keep stock owners updated on how the company is doing.

This is why we care about quarterly results so much.

2e. Problem 5: Reporting is difficult

Now we have a new problem. Companies are now reporting their results every quarter. But that’s a huge number of reports! How do we make sense of all of this data that’s being produced?

The analysis of companies itself needs to become legible. As we know from Part 1 about legibility, legibility demands standardization.

This means that the direct consequence of opening up our economy and allowing everyone to participate in it means that we have to enforce standardization on how companies operate.

This is part of why companies have so much bureaucracy. This is why accounting as a profession is needed to enforce all of these extremely technical rules. This is why company reports all look very similar.

And most importantly, this is why we tunnel in on specific metrics such as profit.

Legibility strips out context and enforces standardization at all costs. It must do so. Because that is what it means to be legible.

This is the consequence of having an open economy where the average person has the right to invest in companies and shares.

And I want to be clear: We didn’t start with “Hey, it’s a good thing if the average person can invest in companies and not just rich people”. And then somehow immediately write down “We need an obsessive focus on metrics like profit” as the 2nd most important action to take.

But this is the natural consequence of an open financial market. Because implementing a functioning open market demands legibility as part of the operating cost of an open financial market.

The alternative is a breakdown in company reporting, which in turn leads to lack of confidence in financial markets and fraud, which in turn leads to the market itself breaking down.

This is why modern capitalism is so difficult to fix. The problems aren’t bugs. They’re explicit features that we actually want. It’s just that these features also cause additional problems.

3. What did we learn this time?

The fundamental lesson here is that companies don’t profit maximize because of quarterly reporting.

Quarterly reporting was created because of the problems introduced by the modern corporate structure where we have separated the ownership and management of a company. And quarterly reporting demands legibility, which in turn means an obsessive focus on key metrics.

This is why we introduced the idea of legibility first in this series on capitalism. Once you understand what legibility is, you can begin to understand how the need for standardization itself warps systems around the standardization process itself.

But without the standardization process, our systems collapse. And we need large scale systems to have large societies.

This is also why replacing capitalism will never fix the underlying problem of economic systems causing misery.

Because any system you implement at a global level demands legibility. And that need for legibility and standardization will warp everything around it too.

This essay was originally intended to be much longer. However, I split it into two parts because it was more than five thousand words long and unreasonable for someone to read in one sitting.

Tune in next time for Part 2b, where I explore some very reasonable questions you may have after reading this.

For example, why does reporting actually have to be quarterly? And even if we need highly standardized metrics to monitor companies, surely we can do better than profit… right?

• 1
  Of course there’s the tail risk that all 20 ships are destroyed by a singular event. Risk sharing can only take you so far and you cannot permanently eliminate all risk in business. But it’s still better for everyone to share risk this way!
• 2
  For instance, in low trust societies where the legal process is weak, you see greater reliance on ethnic or religious ties. When you value your place in your social group because of ethnic or religious identity, then you can trust the other person won’t betray you out of shame. Good examples of this are the Chinese diaspora in South East Asia (Chung, 2005, Western Corporate Forms and the Social Origin of Chinese Diaspora Entrepreneurial Networks) or the Jewish diaspora in Europe (Aust, 2013, Between Amsterdam and Warsaw: Commercial Networks of the Ashkenazic Mercantile Elite in Central Europe).
• 3
  There are a lot more problems when it comes to the separation of ownership and control, and the resulting principal-agent problems it creates. But for the sake of simplicity, I only want to talk about these problems.