The Conference Board Governance Center Blog

AUG
25
2016

“Activists Are Not the Culprit: So Don’t Shoot the Messenger”

By Charles M. Nathan, Senior Advisor, at Finsbury

The Conference Board Governance Center has been heavily engaged in the current discussion in the marketplace on “long-termism versus short-termism,” most notably with our publication of the report “Is Short-Termism Jeopardizing the Future Prosperity of Business.” At the Governance Center, we believe in presenting differing points of view. In the following post, Charles Nathan presents a contrarian view and challenges some of the conclusions of our report. We encourage others to engage in the debate and consider other points of view.

In current discussions about the reasons for our weak economic recovery, a number of propositions have achieved the hallowed status of articles of faith among public company managements, many notable observers of our economy[i], the financial press, the political classes and great swathes of the public. Three of the most cherished are that short-termism is bad, long-termism is good and activist investors are responsible for much of the short-termism afflicting corporate America. These alleged truisms are based on a series of critical fallacies.

Fallacy One: Increasingly rapid portfolio turnover and high frequency trading contributes to corporate short-termism.

Proponents of this thesis ignore the underlying reality. First, the bulk of institutional investors—the mutual fund complexes (whether actively managed or indexed) and managers of public and private pension funds and foundations–are long-term investors. The rise in average portfolio turnover statistics on which the fallacy is based is not attributable to conventional institutional investors, even those with discretion over their portfolio positions. Rather, it is due to misinterpretation of the meaning of the statistic. The often cited increase in average portfolio turnover is not an accurate portrayal of reality because the statistic gives equal weight to every fund regardless of its size and regardless of its investment objectives, thereby overemphasizing both smaller funds and funds with extremely high portfolio turn-over. A more accurate measure of institutional portfolio turnover is the asset-weighted turnover rate. In 2013 the average asset-weighted turnover rate for the entire mutual fund industry was 41%, well below the average of the past 34 years and belying the assertion that investors are more short-term oriented than ever.[ii] Moreover, portfolio turnover (however measured) does not have an appreciable effect on company behavior. Rather, companies are influenced by the balance of supply and demand for their stocks. A public company is relatively indifferent to the investment strategy of purchasers of its shares and their targeted or actual holding periods. Rather a company cares about whether there are more net buyers than net sellers. True, a company would always prefer that demand for its shares come from long-term holders, but at the end of the day it is the movement of the price of its shares that motivates its behavior not the holding period of its shareholders.

Fallacy Two: Activist Investors are Short-Term Investors.

Activists, like all qualitative investors, want to make a profit on their position, and they are willing to hold a position for years if they believe it will result in gains. Indeed, a number of studies have demonstrated that, on average, activist investors maintain their position for a matter of years, not months.[iii] Moreover, there is no rational reason to think that long-term shareholders (whatever that term means) have greater insights into or understanding of corporate decisions and strategy than short-term investors. For example, if the long-term holder is, as increasingly is the case, an index fund, by hypothesis its investment has nothing to do with a company’s strategy or business decisions, and the investment manager has no basis to claim any special knowledge or insights into the reasons for the company’s performance.

Fallacy Three: Long-term is good and short-term is bad.

Castigating a corporate strategy as short-term, rather than long-term, simply misses the point. The issue is not the duration of time required for implementation, but rather the value creation potential of the program. No rational investor, or company manager, would (one would hope) advocate adoption of a longer-term strategy over a shorter one, if the shorter one had a higher value creation opportunity.

More fundamentally, there is nothing innately virtuous about the long-term, whether it be the duration of a portfolio position or a company strategy, nor is there anything innately evil about a short-term holding period or implementation period for an alternative company strategy. Notwithstanding this obvious truism, critics of activist shareholders consistently assume short-term is bad and long-term is good. Repetition of these baseless assertions may have its purposes, but describing reality is not one of them. The reality, of course, is that there are both good and bad short-term strategies, just as there are good and bad long-term ones. The only relevant issue is determining which strategy will create more net present value for the company and its constituencies, not which one will take longer or shorter to implement.

Fallacy Four: Activists stampede boards into adopting the activist’s program.

Activists are not alchemists who nefariously transmute relatively small share ownership positions into the power to compel companies to adopt wrong-headed policies which are rightly opposed by their boards and managers. Rather, activists are wholly dependent on the support of at least a majority of a company’s other shareholders to achieve their goal of changing some aspect of a company’s business or strategy. The activist investor’s typical game plan is simple and consistent.

• First, identify a company that is undervalued in the market because it is not fully realizing its potential.[iv]

• Second, propose a solution to management that the activist believes will unlock the full value of the company.

• Third, if management is unwilling to work with the activist to improve the company’s operations or strategy, bring the activist’s proposed plan to the company’s shareholders who have the final say on company policy though their ability to vote at shareholder meetings.

There is nothing nefarious about giving the owners of a company a choice between competing strategies or alternative business plans. Nor is there anything wrong if a majority of shareholders agree with the activist, rather than management. To suggest the contrary is to advocate a corporate system in which management has the final say on all matters, and shareholders have no power to vote managers out of office—a model that might be conventional in Russia but is antithetical to the very premises of our corporate system.

Put simply, the argument against activist investing boils down to a classic case of blaming the messenger. Activists don’t possess some magical power which allows them to bewitch shareholders. Rather, they present a case for their proposed solution to what they perceive as a company’s shortcoming, and management presents its case. Whether management’s case is in defense of a long-held strategy adopted in good faith by the board, or a recently created attempt to “be your own activist”, the bottom line is that shareholders are the ones who get to decide. If they decide against management, it is hardly the fault of the activist. Viewed rationally, it is the fault of management, either because their program is not as persuasive or because they fail to articulate it successfully.

In the same vein, if shareholders opt for a shorter-term program and reject management’s longer term proposal, the outcome is not wrong because management disagrees. Even if shareholders are pre-disposed to favor shorter-term programs for extraneous reasons (such as concern for quarterly and annual performance rankings on the part of active money managers), it is not because of something inherently bad about activists. Nor is the solution to penalize activists for their success in harnessing shareholder wishes.

Fallacy Five: Activists prevent company management and boards from implementing wise, long-term programs. The ultimate fallacy of the anti-activist mantra is that somehow, for some reason, it shouldn’t matter that a majority of shareholders often embrace activist campaigns. There is no principled reason to believe that boards, management and their advisers know better and should be freed from the distraction, stress and risks of a debate over their corporate stewardship. The paternalistic and patronizing view that management always knows best is simply an inversion of the reality of shareholders’ ownership and rights under our corporate governance system. Defenders of management against activist investing all too often dismiss the reality that boards and management are accountable to shareholders on at least an annual basis and that our corporate governance model is based on the fundamental principle that shareholders are the owners of the company with the ultimate right to decide their company’s future.

Conclusion: Critics of short-termism need to understand and effectively address the market’s bias for shorter-term solutions.

To be sure, critics of short-termism do not always blame the phenomenon entirely on activist investors. They also frequently indict so-called “quarterly capitalism”, as manifested in the stock market’s decades-long focus on quarterly earnings announcements, earnings management, quarterly “guidance” and all the other accoutrements of quarterly financial reporting. They also blame investors for “overly” discounting the risks of long-term corporate strategies and thereby not giving management’s value creation predictions sufficient credence.

There is undoubtedly some truth in these criticisms, but what is the remedy? It surely is not to berate activist investors who at best prescribe desirable changes in a company’s strategy and at worst favor financial restructuring over investment in long-term but uncertain business plans. Nor is it to demand that the market somehow just abandon its sometimes preference for shorter-term programs over management’s longer-term preferences.

The simple, unalterable bottom line is that the institutional investment managers who manage the overwhelming majority of funds invested in the stock market, are motivated by a single over-riding imperative—gathering funds to manage and retaining those funds. The source of these funds ultimately is the American public, whether through personally managed accounts or, far more commonly, through mutual funds and public and private pension plans. People who save money, through whatever mechanism and whether directly or indirectly, all share the same very obvious goal—to increase the amount of money held for their account.

To be blunt, the custodians of the vast bulk of the American public’s savings, the institutional Investment managers, dance the tune that the American public plays. In the immortal words of Walt Kelly’s Pogo: “we have met the enemy and they is us”. If an investment manager out-performs her benchmarks, she will be rewarded by being given more funds to invest. If she underperforms, no matter how loudly she protests that given time she will do better, far better, than her benchmarks, she almost certainly will lose funds under management. Inveighing against quarterly capitalism and its hand maidens, no matter how impassioned, is just not going to change the stock market’s behavior.

So what is the answer to whatever short-term bias affects the stock markets? The only rational one is that managements and boards have to do a far better job of convincing their investors that their long-term programs will, in fact, create greater net present value than the shorter-term alternatives. If companies can do this, their investors will not reduce their ownership of the companies’ stock during periods of relatively lower earnings (or even losses) because investors will have confidence that in the longer-run management will turn out to be right. A notable number of our most successful and admired companies have been able to do just this—think Amazon, Tesla, Facebook, and Google. Quite simply, this is the only real antidote to investors’ bias towards shorter-term alternatives.

*****

The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board or the Governance Center.

[i] including The Conference Board.  See “Is Short-Term Behavior Jeopardizing the Future Prosperity of Business?” (2015).

[ii] Investment Company Institute Research Commentary “Mutual Funds and Portfolio Turnover”, Nov. 17, 2004; Investment Company Institute 2014 Investment Company Fact Book at pp. 36-37 (54^th Ed. 2014).

[iii] FTI Consulting, “The Shareholder Activists’ View/2015 Second Annual (Part II of II); Prequin Special Report, Activist Hedge Funds (June 2014)

[iv] The Conference Board recently published a paper, “How Activist Investors Identify Their Targets” (2016).

About the author:

Charles Nathan is a senior advisor at Finsbury, a global strategic communications firm.  He also is an adjunct professor at both Yale Law School and Columbia Law School where he teaches an advanced M&A seminar.  Mr. Nathan was formerly a partner at Latham & Watkins where he co-chaired the firm’s global M&A Group and Corporate Governance Task Force.  Finsbury is a member of The Conference Board Governance Center.