Carl Icahn, David Einhorn, Bill Ackman, Nelson Peltz, Boone Pickens… do those names ring a bell? If they do, you probably know what this article is all about, but for the benefit of all readers, these guys (who also happen to be billionaires) are what the financial industry labels as activist investors.
A simple but powerful example of activism in action was when Carl Icahn tweeted that he believed Apple was grossly undervalued and the stock instantly jumped US$8 billion in value for all shareholders.
Since joining Twitter, Icahn has been using it as a platform to announce his new targets and almost all the time, the target firm in question would experience the “Icahn Lift” — its share price rocketing due to Icahn’s reputation for buying undervalued companies and enacting change to make it more competitive. And it’s not just Icahn, this happens with most other activists as well after they announce a new stake in a target company.
So what makes an activist investor? In general, it’s someone, or a fund, purchasing a substantial minority stake in a target company with the ultimate aim for effecting change. Changes include:
- Obtaining board seats within the board of directors
- Calling for resignation of the CEO and/or other key personnel
- Boosting or initiating share buybacks
- Boosting or initiating dividend payouts
- Change in general management strategy
- Disposal of certain assets
- Changes in R&D and/or operating processes
The Agency Problem
Why do activists bother to do that? It all boils down to the key issue of agency problem — the conflict of interest between principal and agent. In this case, the principal would be the company’s shareholders and the agent would be the company’s management which are the board of directors and chief executives.
Agency problem occurs when instead of acting in the best interest of shareholders, management engages in ill-advised pursuits such as unnecessary asset purchases or disposals, loading up on too much debt, withholding dividends or share buybacks, or is simply lacking in competence.
Moreover, a company’s management also has asymmetrical advantage over shareholders wherein they know how the company operates, have inside information on the future direction of the company, and all the other smaller details many shareholders don’t possibly have the time to investigate. Ironically, the owners of the company are at the mercy of the people they hire to run the company.
That being said, not all managers are bad. There are numerous companies out there with excellent management, therefore the owners of the company lavishly reward them to retain their talent.
As owners of the company, shareholders have the right to decide what’s best for the company, and should hire effective managers that share common interests. However, this isn’t the case for most companies around the world as many shareholders of companies are passive. Nothing wrong with that because how many of us honestly have the time and money to start a war with management? So this is where activist investors come in.
Activist investors are usually met with fierce resistance by the incumbent management because let’s be honest, an outsider is coming to either fire you or make radical changes you wouldn’t be happy with in the very company you’re in charge of. Therefore management may employ certain tactics to deter activists.
Management Tactics against Activist Investors
Poison pills – Allowing existing shareholders to buy more shares at a discounted price, or allowing shareholders to buy the acquirer’s shares at a discounted price after a merger. This act dilutes the activists’ stake in the company which diminishes their voting influence greatly.
Media campaigns – Slamming, shaming and discrediting the activist. They usually vilified as “corporate raiders” — the term used during the 1980s during the leveraged buy-out heydays with Carl Icahn making headlines particularly.
One example now would be the highly entertaining mudslinging between activists Bill Ackman and Carl Icahn over Herbalife. For context: Ackman shorted Herbalife accusing them of fraud and that the company was running a pyramid scheme, but Carl Icahn, a Herbalife shareholder, refuted Ackman’s allegations. Herbalife’s management frequently appeared on financial media outlets airing their frustration with Ackman discrediting him. The media fracas reached a high point when CNBC invited both Ackman and Icahn to state their points and it turned ugly fast.
Engaging with other activists or acquirers – This can happen if the management feels it doesn’t like being targeted by Activist A and would rather be sold to Activist B because B offers friendlier terms or is a better fit with management’s interests.
An example is Bill Ackman buying a stake in Allergan and dangling it as some sort of carrot for bigger players like Valeant to acquire the company. Ackman and Valeant are on friendly terms and tried to convince Allergan to sell but management wouldn’t budge. They instead opted to be bought out by Actavis for US$66 billion. A loss to Ackman? Hardly, as Ackman’s Pershing Square fund netted roughly US$2.6 billion in profit.
Which Types of Companies Attract Activists?
So we’ve seen the qualitative factors that attract activists like bees to honey. What are the quantitative factors? Normally one might think it’s generally companies that are in financial trouble, indicating weak management, but evidence suggests otherwise.
Large cash hoards, instead of high debt loads, attract activists more. A large cash hoard shows that management doesn’t know what to do with the cash – they don’t know how or where to reinvest their monies, and refuse to return cash to shareholders in the form of buybacks or dividends.
One such company comes to mind: Apple.
In 2013, Apple had roughly US$136 billion in cash on its balance sheet. When cash just sits there, its gets eroded by inflation and with an amount this huge, the depreciation or opportunity costs are massive as well.
This cash pile attracted two famous activist investors, Carl Icahn and David Einhorn. They’ve called on Apple multiple times to return cash to shareholders. After repeated attempts, Apple eventually initiated a share buyback mandate worth US$40 billion. They further announced another US$130 billion return of capital via buybacks and dividends and Apple’s stock price skyrocketed — making Apple the most valuable company in the world with a market cap of US$700 billion.
Cash hoarding is debated often in corporate finance as defenders argue that holding cash enables companies to have a safety net in their balance sheet and to ensure ample liquidity in times of crisis.
David Einhorn contested the argument for cash hoarding in his presentation on Apple’s cash hoard problem:
“Finance theory suggests that an unlevered or net cash balance sheet should be rewarded with higher P/E multiples. In practice, the market assigns a discount for this level of overly conservative long-term capital management.
Not only does the cash earn a return below the cost of capital, it is evident that future profits will probably also be reinvested at a low return. As a result, the market not only discounts the cash sitting on the balance sheet, it also drives down the P/E multiple due to the anticipated suboptimal re-investment rate for future cash flows.
Cash hoarders looking to rationalize their hoarding like to postulate, “If you distribute cash to shareholders, doesn’t that signal that you are no longer a growth company because you have no good use for the cash?” My first thought is, doesn’t letting tens of billions of dollars accumulate on the balance sheet for years on end also reveal an inability to find good use for the cash?” – David Einhorn
Activist funds target different companies based on their staff’s expertise in certain industries but the general targets are companies with high cash and high return on assets with below average price-to-book and other relative valuations.
Are Activists Effective?
Do they add value to shareholders in the short-term and the long-term? Research by Brav et al. in the Journal of Corporate Finance (2008) studied hedge fund activism in corporations during the period from 2001-2006 and concluded that activism does add value to shareholders.
But the opposite can also happen whereby an activist investor shorts a target company’s stock with the aim of effecting change through a hostile and controversial approach. Reasons for that to happen include:
- Questionable accounting
- Environmental degradation (stakeholder mismanagement)
- General corporate malfeasance
Now this may seem more familiar to Singaporeans as we’ve seen recently the “short seller” attacks against Noble, Olam, and Silverlake Axis. That is also a form of activism albeit a highly aggressive one.
Were they effective? Was change effected in the three?
Certainly. The news scared the market into selling the three stocks into freefall; Olam was ultimately taken over by Temasek Holdings, Noble engaged auditors to verify their accounting standards, and Silverlake Axis invited Deloitte to investigate their books whilst slamming the short-sellers in the media.
What This Means to You as a Retail Investor
You own shares in companies you believe to be run well, or are undervalued, but you might not have the time, money, and energy to tell the management how to better run your company except for the rare chance at speaking at an annual general meeting. (The AGM is perhaps your only chance to question management, so don’t just eat the free food but ask hard-hitting questions.)
You’d also need more than 10% ownership of the company to demand a poll. Although recent changes in the Companies Act reduced it to 5%, it still takes a lot of money. This is hugely advantageous to big activists but not a mom-and-pop investor.
Recent changes in the Companies Act passed in late 2014 has made it easier for activism to take place in Singapore. Institutional investors can now send more than two proxies to vote, which is huge because institutional investors own roughly 5% of big cap stocks in Singapore for their indexing strategies and have significant voting influence now that they’re allowed to represent the owners as nominees. Before the amendment, an institutional investor like Blackrock (which owns a whopping 120 million shares in Ascendas REIT — 5% of the total float) could only send two proxies to vote — the same as a retail investor like you and me. This was highly disproportionate. This is key because Institutional investors play a huge role in activism as activists usually court them first due to their outsized voting influence.
Sometimes activism can take place without a famous activist. One such example is Neratel shareholders rejecting a takeover offer by ST Electronics. This case shows how Neratel shareholders collectively rejected the bid as they believed it was too low and you still see Neratel trading on the SGX today.
Activism is still relatively new and rare in Singapore as our market is small and many companies here are majority-owned by the government or are family-controlled. However, activism is growing as witnessed by the short selling in Noble, Olam & Silverlake Axis, and the increased scrutiny and pressure on public companies. The future of activism in Singapore is here to stay due to implicit government support and action for a more open and transparent market. Activism is a force to be reckoned with and it’s good for the markets in the long run as it polices the actions of the few who manage the companies we own.
“There is very little altruism in finance. Wars against corporate managements take time, energy and money. It is hardly to be expected that individuals will expend all these merely to see the right thing done. In such matters the most impressive and creditable moves are those made by a group of substantial stockholders, having an important stake of their own to protect and impelled thereby to act in the interests of the shareholders generally. Representations from such a source, in any matter where the interest of the officers and the owners may conceivable be opposed, should gain a more respectful hearing from the rank and file of stockholders than has hitherto been accorded them in most cases.” – Benjamin Graham, Security Analysis, 1934