By Francesco Guerrera
 

Can a lion be confused with a dog? In Luohe, China, the answer is a resolute “no.” Visitors at the local zoo weren’t impressed last week when they found a Tibetan mastiff in the cage earmarked for the king of the jungle.

When it comes to activist investors, though, the situation is less clear-cut. On Wall Street, this breed of hedge-fund manager engenders extreme reactions. Some lionize them as intrepid champions of shareholders’ rights in the face of corporate ineptitude. Others accuse them of terrier-like aggression, snapping at executives’ heels with short-term demands that end up harming companies.

The debate has taken on new urgency as high-profile activists such as Carl Icahn, William Ackman and Daniel Loeb have taken on the likes of Apple Inc., J.C. Penney Co. and Sony Corp.

Investors and corporate executives are watching, because activists punch above their weight. They control just over $84 billion in assets, according to HFR, a drop in the bucket when compared with the trillions of dollars managed by passive funds. But activists’ campaigns can often move share prices because of their following in the market.

Mr. Icahn’s tweet last Tuesday saying he had taken a large position in Apple, sent its shares up nearly 5% on the day. That added some $20 billion to the company’s market value, while, as The Wall Street Journal reported, Mr. Icahn owns a stake of around $1.5 billion.

Are such share-price moves—and the passions they generate among supporters and critics—justified?

Activism investing is just another way to try to beat the market by picking undervalued stocks. The difference is that activists don’t wait for the market to recognize a company’s value, they try to make things happen on their own terms.

Current conditions are almost ideal for activists. With interest rates so low and stocks at record highs, pension funds are desperate for ways to beat the market; companies are sitting on record piles of cash earning measly returns; and since the financial crisis, boards and executives have to be more responsive to outsiders.

“Right now there is a convergence of factors that are making conditions very ripe for all styles of activism,” says Clifton Robbins, chief executive of Blue Harbour Group LP, an activist fund that eschews boardroom fights.

Others argue that they fulfill a market need. “Activism is not a cure-all for every situation,” Mr. Ackman told me last week. “The vast majority of capital in the world is passive. These investors control the votes. If they think an activist is wrong, they won’t support him. But at least they have a choice.”

On this point, I found rare common ground between Mr. Ackman and Mr. Icahn, despite their recent squabbles over the nutritional-supplement maker Herbalife Ltd. “The big thing we do is we make the CEO and management accountable,” Mr. Icahn said. “[Activists] must do the job that, with exceptions, boards are not doing.”

Mr. Icahn and his peers aren’t getting much gratitude from boardrooms for this work.

The veteran corporate adviser Martin Lipton, for one, can’t stand activists’ I-want-it-all-and-I-want-it-now attitude.

“It’s not good for companies to be subjected to short-term pressure and it’s not good for the economy as a whole,” said Mr. Lipton, a founding partner of Wachtell, Lipton, Rosen & Katz. “It deters investments and in the long-term it reduces the rate of growth of GDP.” A recent academic study appears to contradict that assertion but Mr. Lipton’s views are widely shared in corporate America.

Which is exactly the problem in the eyes of a seasoned activist such as Ralph Whitworth. “The people who are saying that are usually just saying: ‘Hey, give me more time to make the same mistakes,’ ” Mr. Whitworth, a founder of Relational Investors LLC, said. “This is what I always tell these people: We bought the stock from your long-term shareholders. And if I am here, I am the longest-term shareholder you’ve got.”

Chris Young, who heads a Credit Suisse AG unit that advises companies against activists, maintains that boards and executives should be ready before Mr. Whitworth & Co. come knocking. “It’s the old Boy Scout’s motto: ‘Be prepared,’ ” he said. “Your defense is performance and preparation—understanding where your weaknesses are and how an activist might come at you”

Paradoxically, activists’ long-term performance has been superior to their short-term one. Since 2005, the activist hedge-fund index compiled by HFR has done much better than the S&P 500 (including dividends). This year, however, the two are almost on level terms.

Unfortunately, most individual investors don’t get to buy into activists’ funds and are relegated to aping their moves after they are announced. And that is where the perils lie.

Because of the time lag of regulatory filings, those who buy after an official announcement are almost certain to have missed out on any big share-price movement. At that point, the best strategy is to hold the stock and ride with the activist fund, hoping its proposals will work out for the company.

Or, put another way, hope that what you hear from the activist’s camp is a roar and not a bark.

Francesco Guerrera is The Wall Street Journal’s financial editor. Write to him at:currentaccount@wsj.com and follow him on Twitter: @guerreraf72.

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