Monday, April 22, 2013

Listening to Shareholders Can Be Hard to Do

Firms compete in two primary markets. The first being in product markets for customers and the second in capital markets for capital. Shareholder activism increases when stock prices fall based on declining product market performance. The stock price decline reflects a value gap between a firm’s current business model and a higher alternative value strategy. This becomes most pronounced during periods of rapid industry changes, a creative destruction, due to technology, regulation and deflation. Currently, the industries with the greatest change and activism are energy (e.g. Hess), tech (e.g. Dell) and banking (e.g. JP Morgan Chase).

Activism is an external mechanism along with hostile takeovers to prod slow changing firms. It usually reflects weak corporate governance. A substantial value gap, usually greater than 30%, is needed to incent a financial activist like Carl Icahn and others to risk their capital. It is frequently a last step before a more serious product market failure like that which occurred at Eastman Kodak.

Understandably, management and their supporters dislike being told they need to change. This attitude was perhaps best expressed by the early 20th century German banker Carl Fuerstenberg who stated:

                  Shareholders are stupid and impertinent-stupid because they gave their money to somebody else without any effective control and impertinent because they ask for a dividend as a reward for their stupidity.

Typically, management alleges the industry changes are cyclical not structural and that consequently, shareholders should be patient. Activist, are frequently attacked as short –term in nature and unable to see the true long term value of the firm they are questioning. This attack is based on the short holding period of the activists as shareholders. Nonetheless, value is based on the market’s investment horizon, not the holding period of a firm’s shareholders. Thus, the key issue is-are firms targeted by activists under-valued, as management believes, or under- managed as the activists contend?

Eventually, change affects all companies-even formerly successful market leaders. As Schumpeter taught us-we are only king for a day. Just look at the turnover in the S&P 500 during the first 12 years of the 21st Century. Over a third of the firms have been replaced through decline, failure or merger. Examples include Texaco, Sears, Circuit City, and Quaker among others. Andy Grove was right-in such a rapidly changing environment only the paranoid survive.

No one likes being questioned. Sometimes, that is exactly what is needed before it becomes too late to change. So, listen to those “stupid and impertinent” shareholders. They may just have something to say that is worth hearing.


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