This piece is cross-posted from my Medium account. Check it out for more posts like these.

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Introduction

In executive circles, activist investors have a terrible reputation. And historically, for good reason. Their notorious 100 page presentations and malicious insults have kicked out many a pitiful CEO. In 2005, Daniel Loeb of Third Point, one such activist firm, branded one CEO as “one of the most dangerous and incompetent executives in America”.

High-profile incidents throughout the years have crafted their reputation for wolfish corporate raids focused on short-term gains. Add to that collateral damage caused by ruthless worker layoffs, and it’s no wonder why activist investors so hated.

Sometimes, these characterisations are accurate. But more often than not, activist investors are playing a crucial role for capitalism. And several recent trends have made their bitter medicine increasingly important. 

Trend 1: Passive Investing

First is the rise of passive investing, which aims to mirror the return of an index. Firms providing passive funds boast about their lean organisational structure and low fees. They proudly refute stock picking and investing only based on the stock’s inclusion in an index. The rise of passive investing allows firms’ stock to rise along with the rest of the index, regardless of their fundamentals. This placates shareholders, who see little reason to fire executives. As such, the tolerance for incompetent executives has increased.

With inept managers sticking around, many companies, like GE, declined in competitiveness and innovation. Enter activist investors like Nelson Peltz of Trian Partners. Peltz urged for operational restructuring and efficiency enhancements. These interventions pushed GE towards divestitures, cost-cutting measures, and a strategic focus on core businesses. This revitalised the company’s prospects and unlocked shareholder value.

Trend 2: Misalignment of Management’s Priorities

Second, the focus on growth above profits makes activist investors’ harsh wisdom needed. The past decade has had, for the most part, low interest rates. These low interest rates make debt-fueled growth more attractive. This has nurtured a myopic growth-at-all-costs mentality among businesses, causing misplaced business priorities. When interest rates started rising in 2022, distant profits became much less valuable. As a result, managers’ decisions backfired. Many unprofitable growth-chasing companies collapsed in value.

For example, Pinterest’s “growth above profits” approach caused its share price to plunge more than 80%, peak to trough. This attracted the attention of Elliott Management, a renowned activist investor. Elliott advocated for strategic changes, including a focus on monetization and cost management. These changes have set Pinterest down the path of enhanced operational efficiency. As a result, its stock price has bounced back by over 70%. As today’s higher interest rate environment persists, activist investors will be pivotal in promoting companies’ focus on profits over growth.

Trend 3: ESG

Third, the volatile Environmental, Social, and Governance (ESG) landscape makes activist investors important. ESG initiatives, while noble in intent, have occasionally masked managerial incompetence. In some cases, it has been a lack of adopting ESG initiatives that showcases management’s ineptitude. Take ExxonMobil for example. ExxonMobil is a stalwart of the oil and gas industry. Many have criticised it for its environmental impact and slow adoption of other energy sources.

Enter activist investor Engine No. 1, who successfully led an activist campaign against ExxonMobil. Engine No. 1 installed three directors on ExxonMobil’s board, urging a shift towards renewable energy. This activism catalysed a seismic shift in the company’s direction. ExxonMobil pledged substantial investments in clean energy and setting ambitious emission reduction targets, aligning its strategies with ESG imperatives and restoring investor confidence. In this way, activist investing not only benefited ESG initiatives, but also shareholder return. ExxonMobil’s stock is up 136.67% since Engine No. 1 started its campaign in December 2020.

This is not a blind pitch for wokeness. Management should not be using ESG as a shield for incompetence, and would do well to bear their responsibility to shareholders in mind. Rather, the point is that activist investing can help improve shareholder return in two ways. 1) by curbing back overly ambitious ESG initiatives that excessively sacrifice shareholder return, or 2) by promoting ESG initiatives that enhance long-term shareholder value.

These initiatives have also made passive investors more actively exercise the rights to effect change. Three passive investing giants — Blackrock, Vanguard and State Street — own significant portions of many public companies. Historically, they have been extremely reluctant to use their voting rights to effect change. However, this is changing, in no small part due to activist investors.

Take the ExxonMobil example above. Engine No. 1 only held 0.02% of Exxon’s shares. It would not have been able to execute any campaign if not for the support from the big three, who held almost 20% of Exxon’s shares. Clearly, activist investors are waking up passive money.

But what about their criticisms?

Of course, activist investing is not perfect. But many of its primary criticisms are either outdated or inaccurate.

First, that by and large, they are adversarial to management. Activists are often characterised by their hostile insults and aggressive proxy fights. Critics argue that these factors distract executives from doing their day-to-day jobs. Again, this criticism is outdated. Today, most activist investing is low-profile and collaborative. Today, activist investors’ standard play is seeking board representation with management support. For example, Trian Investment Partners’ Nelson Peltz joined the Unilever board after announcing his stake. He has been collaborating with management since. Adversarial fights with management still occur, but they are a small minority. One study found that activist hedge fund tactics are non-hostile almost 80% of the time, even in the US. Even the most aggressive activist investors have begun to soften the tone. One can look no further than Third Point’s Dan Loeb, historically one of the most unsparing critics of target companies, calling Amazon’s CEO Andy Jassy a “talented and focused new CEO”.

Second, that they are exclusively focused on short-term gain. This may have been true in the past. Then, activist investors’ modus operandi was to take aggressive short-term measures like divesting business units and trim workforces, at the expense of companies’ long-term performance. However, this is no longer accurate. Many activist investing firms lock-in their investors for several years. They do this to keep invested in companies over multi-year periods to effect long-term change. This emphasis on long-term holding periods indicates a move toward longer-term engagement and value creation strategies rather than quick gains.

Third, that they have primarily self-serving interests. While it’s true that activists have their interests in mind, these interests often align with those of other shareholders. Activists typically advocate for changes they believe will enhance the company’s performance. Consequently, this pushes up the company’s stock price, benefiting all shareholders. For instance, pushing for improved corporate governance, increased transparency, or operational enhancements benefits all shareholders, not only the activist investor.

There is only one major situation in which activists’ incentives don’t align with other shareholders’. This is when they pursue short-term measures, at the company’s long-term expense. These measures usually include aggressive cost-cutting, share buybacks or divestiture proposals. Such proposals boost specific short-term metrics like earnings per share, while hampering the company’s long-term growth prospects. Again, it is true that such short-term, selfish activist investors exist. But they are a small and diminishing group. (See the paragraph above on short-term gain.)

But performance…

But there is one criticism that does hold water: that activist investors have a patchy track record.

One study by Lazard found that activist investors have consistently provided an immediate “pop” in stock price, but that short outperformance often fades to long-term underperformance.

Target companies’ stock usually “pops” once activist investors get involved. But this short-term outperformance often fades to long-term underperformance. 

Doesn’t this refute the entire point of this article? No. Activist investors have a purpose beyond merely seeking to outperform benchmarks. They make all companies less complacent and more focused on creating shareholder value.

Activist investors often propose financial and operational measures to create long-term shareholder value. These measures typically include share buybacks, dividend increases, and debt reduction, cost-cutting, and departmental restructuring.

These initiatives often warrant consideration. They may not be right all the time, but simply keeping these options in mind can promote more prudent management.

Moreover, these benefits can extend to non-target companies too. One 2016 study found that when companies in a certain industry experienced activist campaigns, there was a “spillover” effect on their peers. These peers made operational and financial changes, similar to those made by activists in target companies. These changes caused the peers’ valuations to increase and lowered their risk of being targeted themselves.

This makes sense. Activist campaigns pose an immense threat of public humiliation to executives. They also threaten executives’ jobs. Although campaigns have gotten more collaborative, it’s understandable that executives don’t want to risk their jobs regardless.

As a result, executives are often looking out for activist campaigns. This is true not only for their own companies, but for their peers in the same industry too. If firm A faces an activist campaign, you can be sure that firm B will be rushing to replicate the activists’ suggestions (before B faces an activist campaign too).

In this way, the mere threat of an activist campaign often compels executives to make proactive operational changes. And in general, these changes appear to increase shareholder value and longer-term profitability.

Conclusion

Overall, activist investors serve as a crucial component of the American corporate environment. Apart from some highly publicised incidents, their campaigns are often noble and low-profile. Perhaps more importantly, the very threat of their campaigns is often enough to keep managers wary and focused. After all, the best way managers can fend off activist investors is ensuring they’re running their business well.