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”.

J

Shareholder Activism Coming to Europe

Shareholder activism involves a minority shareholder with a significant non control ownership, 5 - 10%, seeking to influence of a firm’s strategy. It is directed at firms suffering from performance and governance problems. It has been active in U.S. and to certain degree in the U.K. Its shareholder economic impact is deemed largely positive - although activism is somewhat controversial with management and directors who do not like being second guessed. The same forces that spurred its rise in the U.S. and U.K. appear to spreading supporting an increase of activism in continental Europe-at least in certain countries.

The slow European recovery and resulting lagging company performance is encouraging investor groups to become more aggressive in change proposals. The investor groups include well known U.S. firms like Pershing Square and Elliot Associates expanding into Europe. European groups including Cevian and The Children’s Investment Fund also exist and the list is growing. It is somewhat harder to gauge the level of Euro activity as much of it takes place behind the curtains compared to the more public U.S. activity.

The financial crisis traumatized firms. Survivors, understandably, focused solely on surviving to the detriment of performance. In the U.S. investors started asking about performance again in 2011/2012 resulting in numerous activist actions. These actions were at first remedial, focusing on the return of cash, divesting noncore subsidiaries and reducing expenses. Now they have turned to strategic growth concerns - including the possible sale of the firm itself to better owners.

Europe appears a few years behind the U.S. in this regard with the current focus on remedies, primarily the return of cash through record dividends, not strategies. In Europe there is probably some more room for remedies. Euro firms tend to be more unfocused than U.S. firms. Consequently, Euro firms suffer from a much higher conglomerate discount. Shareholders, including long term pension funds and not just the alleged locus short termers, want to know about management’s longer term growth plans-internal and external M&A. Thus, Europe appears to offer rich pickings for activists.

The problem with Europe is it is a set of countries each with different rules and cultures. Consequently, activists need to recognize the process will be different in Europe. Based on the following:

1)     Legal System(s): the proxy rules differ not only from the well developed U/S./U.K. legal system, but also by country. Legal predictability is most predictable in Holland, Germany and Switzerland, and much less so in France, Italy and Spain.

2)     Nationalism: French firms are less likely to meet with upstart brash American activist firms than fellow French firms.

3)     Shareholder Ownership Structure: many continental countries have concentrated ownership among founding families, governments, foundations, and banks. These types of investors will side with management and likely remain hostile to any outsiders.

4)     Strategic/White Knight Acquirers: will have the upper hand compared to activists. Management may size on a sweetheart deal to protect itself at the expense of minority investors.

My prediction is activism will continue to increase in Europe, but at a slow speed than hoped for by many investors. Next it is likely to be local affair - French activists for French firm. Finally, activism will supported increased Euro M&A activity - both offensive and defensive.

J