Aswath Damodaran is a professor at NYU and recently put together some thoughts about activist investing. Here’s the highlights.
Activist Investing: Fact and Fiction
Are activist investors good or bad for markets? How about for the economy? Do they create or destroy value? These are questions that evoke strong responses, both pro and con, from everyone. Since both sides of the divide seem to draw on mythology rather than reality when they make their cases, here is my list of the top misconceptions that I see on each side.
Most companies are well run. A common refrain you hear from those who dislike activist investors, and especially from incumbent managers who are or fear being targeted, is that left to their own devices, managers tend to run companies well and that bad management is more the exception than the rule. Using the difference between return on capital and cost of capital at a company as a simplistic measure of whether managers are doing a good job, my conclusion from looking at 41,800 publicly traded companies at the start of 2015 is decidedly more negative. About 60% of all companies generate returns on their investments that are lower than their cost of capital and more than half of these companies have been underperforming for more than a decade. From my perspective, good management is more the exception than the rule and an astoundingly large proportion of companies have a long record of value destruction.
The typical company targeted by activist investors is well run and well managed. The reality is very different. The typical target for an activist investor earns less than its cost of capital, under performs its peer group both in profitability and stock price performance, and has managers with little or no stake in its equity. In many cases, it is a mature company that is refusing to act its age, by continuing to invest, finance and pay dividends like a growth company.
Activists are greedy and short-term focused. If by “greedy”, critics mean that activists want to earn high returns on their investment, all investors are greedy, since that is the focus of investing and I see no basis for the argument that activists are greedier. As for “short term”, the typical time horizon for an activist investor is far longer than that of a portfolio manager or most individual investors and definitely longer than most managers at public companies.
Activist investors are smarter than the rest of us. This presumption of smartness comes usually from focusing on successful activist investors in the news, and assuming that their success must be attributable to their smartness in targeting and fixing companies. Not only is there a selection bias in this process, where we don’t get to see, hear from or read about all those activists who don’t succeed, but even those who are successful at activist investing are often one-dimensional investors, with little that sets them apart from the rest of us. In fact, activist investors often are guilty of many of the behavioral biases that have been noted with all investors, insofar as they often hold on too long to their losers, fall in love with their winners and let pride get in the way of good sense.
Activist investors are shareholder advocates. As an individual investor, I have benefited from activists targeting firms that I have held shares in, but I am not naive enough to buy into claims that activists are motivated by the larger interests of shareholders. Thus, when I held shares in Apple, and Carl Icahn raised the heat on Apple to borrow money and pay out more to shareholders, I gained but I did not operate under the delusion that Icahn cared about anyone but himself in the process.
You can make money by imitating activist investors. There are many investors who obsessively track leading activist investors, buying shares in companies that they have targeted and hoping to piggyback on their success. The research here on whether you can make money from this strategy is mixed, since the bulk of the returns to activism come on the disclosure that the activist has targeted the company and not in the periods after. If you combine this with the reality that activist investors are as likely to make mistakes in investing as the rest of us and that they are driven by self-interest, again like the rest of us, the dangers of following activist investing are magnified.
Activist investors make big operating changes at targeted companies. Both supporters and opponents of activism seem to start with this presumption, with the division between the pro and con groups primarily on the effects of these changes. Thus, those who dislike activists argue that they slash investing and R&D at targeted companies, putting jobs, growth and the future of these companies on the chopping block. Those who are in favor believe that the changes in investing policy are for the best, and that the money saved can be shifted to other companies with better investment prospects. Both groups seem to agree that activist investing is far more focused on financing and dividend changes than it is on investment policy. In fact, if you look at activist investors as a group, the critique is that they are not “activist” enough on the investing dimension.
Activists make easy money. To the question of “Do activists make high returns?” both parties seem to agree that the answer is yes. That conclusion, though, may be based not only upon looking at the most successful, high profile investors in the group but also listening to the hype around them. Bill Ackman, Carl Icahn and Nelson Peltz have all had their share of bad investments, and looking collectively at all activist investors, the returns to activism are modest. In fact, given the cost of being activist, a large proportion of activist investors barely break even. Activist investors are almost as often wrong as they are right in their claims about companies, but I do believe that they are a necessary and integral part of a well-functioning market. I view them as market laxatives, irritants that challenge the status quo and disrupt the system. Removing, banning or restricting them from markets, as some critics would have us do, would lead to clogged markets, where managers remain unaccountable, and shareholders get ignored.
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