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 20^th 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 21^st 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.

Joe

Do Unto Yourself

Ralph’s suggestion to leave nothing on the table to reduce hostile takeover risk is a wise one. Hostile bids are a struggle by competing management groups over the control of corporate assets and strategies. Firms compete in two different markets. The first is the product market for customers and revenues. The second is in the capital markets for capital. Product market changes, such as new regulation, impact firm performance. It requires management and strategic adjustments. However, organizational inertia keeps management from changing strategies that have previously  been  successful. The delayed adjustment depresses returns on equity and equity values relative to underlying asset values. Furthermore, management continues to invest despite the unattractive returns believing the poor operating situation is only temporary, which worsens the problem. The depressed returns and weakening stock price attract bidders who believe they operate the firm more efficiently.

The key characteristics of takeover risk include

•  Fundamental structural change as opposed to cyclical industry change
•  ROE less than cost of equity
•  Sum of the parts exceeds the firm’s market value

Firms operating with these characteristics have two choices. Either adapt yourself or someone else will do it for you. A good example of this was provided by the 2007 takeover of ABN AMRO by a banking consortium of Royal Bank of Scotland (RBS), Banco Stantander (BST) and Fortis (FT). The trigger was an on-going war of words initiated by TCI (The Children’s Investment Fund) a UK hedge fund. TCI had been complaining of ABN’s subpar returns Also, TCI demanded in February, 2007, that bank management should consider a break up the bank as the sum of its parts was worth more that the bank’s current market value. TCI deemed ABN’s response as unsatisfactory and threatened action. TCI lacked the capacity to take over a bank of ABN’s size.They hoped other strategic bidders would join, and they did.

ABN’s suffered for years. It was an unfocused global conglomerate with little synergy among the countries in which it operated. Management was aware of the problem and making some incremental progress. They could not, however, make the difficult psychological choice to break up the bank. 

The consortium was a novel approach to handle the size and complexity of ABN’s business. RBS essentially took the international network (with the exception of Brazil and Italy which went to BST). The Benelux business went to FT. ABN tried to bring in Barclays as a white knight and sold their regional Bank, LaSalle, to B of A as a crown jewel defense to defeat the consortium. It failed and ABN was sold in October 2007 at a substantial premium to its pre TCI price.

One could argue that RBS and FT over paid and conducted inadequate due diligence. The market timing was also unfortunate as the transaction closed shortly before the great financial crisis of 2008 and both RBS and FT failed. Nonetheless, ABN’s sale released billions in trapped shareholder value. Additionally, the consortium did in the end what ABN managers should have done in the beginning-namely break up the bank. This illustrates the principle of doing onto yourself before others do unto you.

Joe