By Brett Arends
Company X is on its knees. The stock has been falling for years. The company’s brands are tired. Its operations are inefficient. Its management is sleepy. Profits are falling. Assets are being allocated inefficiently.
Then you wake up one morning to learn that Joe E. Godzilla, the hedge-fund manager, has bought a 5% stake in the company and is demanding sweeping changes. He says the stock should be worth five times as much as the current price.
The stock pops 10% on the news. But if Mr. Godzilla is correct, there are still big profits to go for. Should you buy the stock? Is Mr. Godzilla correct?
Take a deep breath, and tread very carefully. A new, detailed study of these campaigns, even while claiming that they add value for stockholders, actually reveals just how treacherous these situations can be.
“Preparing for bigger, bolder shareholder activists” is a fresh report into activist investor campaigns by three consultants at McKinsey & Co., the worldwide strategy consultancy where I began my career.
Over the past three years, so-called activist investment funds in total have launched more than 700 campaigns against public companies, reports McKinsey. That’s an average of about 240 activist campaigns a year — a new one for almost every work day.
The rate is double the number seen just a decade ago, according to the study, which appears in the latest edition of the McKinsey Quarterly.
In theory, these campaigns ought to be a good thing. Activist investors buy significant stakes in underperforming or distressed companies and try to force the management to make positive changes. Think Carl Icahn versus eBay. Think Bill Ackman at J.C. Penney (oops).
The idea behind activist investing is that management are mainly concerned with protecting their own jobs, and are often sleepy or incompetent or reluctant to embrace major, painful but needed changes. A really sharp outsider can buy up a lot of the stock at low prices, and then use that stake to force the company to pull up its socks. In theory, management respond, sooner or later, the stock rises and the farsighted investor gets the reward.
Does it work? Yes, claims McKinsey. It studied 400 such campaigns over the past decade, looking at how the companies performed before the hedge-fund manager launched his or her campaign, and how they performed afterward. “Shareholders generally benefit,” write McKinsey analysts Joseph Cyriac, Ruth De Backer and Justin Sanders. Among the 400 cases it studied, “the median activist campaign reverses a downward trajectory in target-company performance and generates excess shareholder returns that persist for at least 36 months.”
But here’s the problem. The fine print of the research tells a different story.
During the first year of the activist stockholder campaign the median “outperformance” is just 5%. That’s the median amount by which total stockholder returns (share price plus dividends) for Company X outperformed Company X’s rivals.
And in years two and three there is no further outperformance at all. None.
Five percent. Seriously.
When you turn to Exhibit 2 of the McKinsey report, the impact seems even less impressive. The outperformance is less, barely a couple of percentage points, when measured against the broader stock market index, the S&P; 500. And this in turn only relates to campaigns launched against bigger companies, namely those with revenues above $1 billion.
For companies with revenues below $1 billion, total shareholder returns over the subsequent year actually underperformed the S&P; 500 index.
Oh, and one more thing: The median isn’t the message anyway. There is a huge range of outcomes. In a lot of these cases the stock underperformed the index.
The news isn’t all bad. The campaigns do seem to be followed by a change in direction for the stock. Before Joe E. Godzilla gets involved, on average, the stock is plummeting. Afterward it typically stabilizes, even if it doesn’t then beat the market by very much.
But that may be a case of “post hoc” not equaling “propter hoc” – “after” doesn’t mean “because of.” The stock might stop falling because Joe E. Godzilla got involved. Or it may be that Joe E. Godzilla got involved because by that stage the stock had fallen so far the only way was up.
If these activist campaigns don’t really generate huge rewards, you might wonder why they take place. And here hangs a tale. McKinsey reveals that the funds involved in these activist campaigns are benefiting from all the publicity and attracting lots of new money. “[T]hey’ve enjoyed a higher rate of asset growth than [non-activist] hedge funds and attracted new partnerships with traditional investors,” says McKinsey.
In other words, these campaigns amount to marketing. And why not? As I’ve observed over and over again, the overwhelming beneficiaries of hedge funds are neither their investors nor the rest of the economy, but the managers themselves. They reap huge fees and enjoy a “heads I win, tails we flip again” reward structure.
Brett’s Third Law says that “everyone is in sales, whether they admit it, or even know it, or not.” Your doctor isn’t in the business of medicine, he’s in the business of selling medical services. Your lawyer isn’t in the business of solving legal problems but selling legal services. And so on. And hedge-fund managers aren’t in the business of making their investors rich or improving the economy. Their job is to sell hedge-fund management services.
Stockholders? There’s one born every minute.
See related stories:
Activists here to stay as war chests near $100 billion;
Corporate raiders and activist investors: a field guide
Why a California teachers pension likes activists
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