Beware shareholder activism when agitators want to start running the business themselves

It’s part of the human condition to root for the underdog. The outsider. The anti-establishment figure who points out whatroytopol is wrong, confirming what we just “know” to be true. So when shareholder activists take aim at executive management teams , we warm to them. Or occasionally, like in the case of the famous American corporate raider Carl Icahn, thousands of us place our bets behind his. Such is Icahn following that his tweet of a $1bn investment in Apple led to such strong coat-tailing demand that the value of the business rose $17bn as a direct result. As our blogger Roy Topol of Investec puts it in his piece below, that turned Icahn’s 140 characters tweet into the most expensive 140 characters in history. But as Roy also writes, not all activists are successful. Not by a long shot. Indeed, their record doesn’t stand scrutiny when they interfere in the operations of business itself.  His research suggests that when they do so, it becomes as much of a “sell” signal as their original announcement of purchases may encourage one to  “buy”. Here’s Roy’s well-written, thoughtfully argued blog that draws on numerous real life examples. Always the best way to tell any story. . – AH    

By Roy Topol*

The financial world was astounded last week when Carl Icahn, the wealthiest hedge fund manager in the world, tweeted that his fund had invested $1bn in Apple shares, causing the value of the company to increase by $17bn in the next few hours of trade. It must be the most valuable tweet in history.

But more interesting is what this new trend could mean for the market – are we entering an era of powerful activist shareholders, or is this merely group of multibillionaires throwing their weight around Wall Street to feed their egos?

While shareholder activism used to be primarily in the small cap domain where fund managers could gain influence more easily, nowadays the spats have moved to larger companies, with hedge fund managers becoming more active among bigger companies as their vast assets under management (AUM) have grown. According to the Wall Street Journal, activist hedge fund AUM has grown from $12bn to $65.5bn in the last 10 years.

Carl Icahn has been the fund manager with the largest following at the moment, not only because of his vast wealth (according to the live Bloomberg Billionaires index he is currently worth $18.8bn), but also because he has gone public with three high profile investments this year.

At the beginning of the year, Icahn spoke on Bloomberg and CNBC television about his position on Herbalife. This was after Bill Ackman’s well publicised presentation (in December 2012) on his short position in Herbalife. The Herbalife share price dropped over 35% in the following days as Ackman gave a price target of zero, saying that the company should be closed down as he felt it was an illegal pyramid scheme and not a legitimate business. Carl Icahn (and fellow hedge fund manager Dan Loeb) saw through his presentation and took an opposing bet, buying shares in Herbalife and publicly stating that the company is an undervalued and legitimate business. The Herbalife share price has doubled this year thus far, causing hundreds of millions of paper losses to Bill Ackman’s fund (thus far), and a sensational following of Icahn’s next moves.

In another public spat, Icahn has opposed the Dell buyout, saying that company is undervalued and that it should remain listed. Michael Dell, the founder and largest shareholder (Icahn is the second largest), has subsequently increased the offer, benefiting existing shareholders.

Then came the bombshell when Icahn tweeted that “we currently have a large position in Apple. We believe the company to be extremely undervalued.” It caused the share price to almost instantly rise by 4% after news came out that Icahn had built up a $1bn investment in Apple shares over the last month.

But is shareholder activism good for investors and is it a necessary part of healthy market and capitalist society?

Last week three professors from Harvard, Columbia and Duke Universities put out a comprehensive study, based on empirical evidence, which proves that hedge fund activism is good for shareholders, both in the short-term and the long-term. The research, titled “The Long-Term Effects of Hedge Fund Activism” is based on 2000 interventions of activist hedge funds from 1994 to 2007. The conclusions drawn from the study proved that during the five years following the intervention month, on average the operating performance of the companies improved relative to peers. Most notably, those companies that were targeted had significantly below average performance during the three years prior to the intervention. The study also found that while on average those shares spiked 6% in the period following the intervention, there was no notable negative share price performance in the period that followed.

But while shareholders benefit from hedge fund activism, is it appropriate for fund managers to be actively involved in the management of the respective companies?

Buffett, one of the original activist shareholders, details in his biography “Snowball” how he took control of Berkshire Hathaway as a young millionaire in his thirties. Later on in his career, he realised that it was one of the worst investment decisions he ever made (despite Berkshire becoming the holding company for his future investments). In a bid to take control of Berkshire, remove the management and eventually close down its non-profitable mills, he wasted a fortune of badly allocated capital (never mind the time consumed to do so) which could have been spent better elsewhere. He later matures into the grandfather of investing who we all know today, realising that his core competency is in allocating capital, not running companies.

Perhaps it’s a lesson that Bill Ackman could learn from his failure to change things at US retailing giant J.C. Penny. Ackman, in what can only be termed shareholder activism gone wrong, built up a massive 17% stake in the company, was appointed to the board, bought in a new CEO and then presented his “extreme makeover” plans in May 2012. Ackman had no hands-on experience in retailing, but was convinced that he could turn things around at the struggling retailer. However, things didn’t pan out as expected, with the share price of J.C. Penney down 70% in the last 18 months, while the CEO and Ackman have both left the board recently and Ackman now ready to sell his stake in the company.

Active shareholders are fine if they can help unlock value by improving the structure of the company and putting pressure on the managers of the firm to make them more efficient. But the core focus of an asset manager should be about allocating capital – spending time trying to find undervalued companies and investing in them for the long-term – not trying to get involved in management of the underlying investments. Yes, provide input if called upon and give your opinion on balance sheet structuring, share buy-backs, dividend payouts, mergers and acquisitions. But don’t try and manage the operations. Leave that to those who have experience in that department.

* Roy Topol is an Investment Manager at Investec Wealth & Investment. He qualified as a chartered accountant and joined Investec W&I from Deutsche Securities at the beginning of 2010

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