Monday, December 15, 2014

Shareholder Activists: The Empire Strikes Back

Activists have become victims of their own success. The number of activist campaigns is near 300 this year-the highest level in years. Furthermore, their success rate is increasing as is the funds under management by such investors. These facts have an out-sized fear factor impact on corporate America. Consequently, they and their shills, Harvard Business Review, New York Times and corporate law firms inter alia, have attacked activists as being responsible for income inequality, slow growth, under investment, and reduced competitiveness. I think they will also be blamed for global warming. Let’s look at some of the charges.

The first attack is activists are not long term shareholders and thus do not seek to advance the firm’s long term interests. Consider the following:

1)     There is no evidence activists are short term investors.
2)     Even if they are-so what? Firms are valued based on the market investment horizon-T- and not on the investor holding period. Does the value of your home depend on whether you own it for 1 year or 5 years?
3)     Long term is used as an excuse for lagging short term performance. Remember, the longer you must wait for value, the more value you must receive.  It is as if the steepness on your treadmill increases. Look at what happened in Japan with their massive over investment in the 1980s, and what may be happening in China now. The size of the investment should be proportional to the expected long-term risk adjusted cash flows. Companies not following this rule like Nokia and Blackberries end up destroying wealth unless stopped in time by activists or the board.
4)     The short termism frequently seen at under- performing firms concerns the perversion of incentive compensation schemes by management and a compliant board toward short terms measures like EPS and earnings growth.

The next attack states that returning funds to shareholders via dividends or stock repurchases instead of reinvesting the funds in the firm is harmful to the firm and the economy. This is related to #3 above. The argument is more investment, regardless of its risk adjusted return, is better. This mistaken approach neglects, or should I say mistrusts, the role of capital markets. If a firm cannot earn enough to cover its cost of capital, then the excess funds it has should be returned to shareholders. Over investing in under-performing projects helps no one-the economy, the employees or the firm. The funds returns do not sit idle. They are reinvested and recycled into new more productive endeavors as part of the creative destructive process.

The last attack is that firms should not be managed solely for the benefit of its shareholder owners, but more broadly for all stakeholders. The problems with the stakeholder theory are as follows:

1)     Faulty premise: long term wealth creation is not based upon the exploitation of stakeholders. Communism is dead. Stakeholders, whether they are employees or suppliers have alternatives.
2)     Which stakeholders and who chooses what they get?  This is a political issue best left to the political process and not CEOs.
3)     Capital goes where it is welcome and stays where it is treated well. Taking from shareholders will always be supported by the “takees”. The result will be a higher cost of capital and less wealth for all.
4)     A simple clear objective is needed to hold management accountable. It is no wonder managers like stakeholder theory. If you are accountable to everyone, then you are accountable to no one.

Bottom line, activists may be rough around the edges, and you may not want them going out with your daughters. Nonetheless, they provide a valuable check on managerial excesses. The problem is not with the activists, but with the breakdown of the internal control system i.e. the board, which typical gets captured by management.

Sorry for rant, but these attacks are totally baseless. The empire should just be honest and say ”let them eat cake”.


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