The Case for Activist Investors

In 1926 Benjamin Graham wrote a letter to Northern Pipeline with a simple request. He had a small stake in the company, and he’d noticed that it owned millions in railroad bonds and other securities. The man who would one day be known as the dean of Wall Street and the father of value investing wanted it to sell those securities and distribute the profits to shareholders in the form of a dividend. The company’s executives weren’t pleased. “Running a pipeline is a complex and specialized business,” they responded, “about which you can know very little, but which we have done for a lifetime.” Graham was undeterred. Over the course of a year, he met with anyone who owned more than 100 Northern Pipeline shares and tried to persuade passive investors including the Rockefeller Foundation to join his campaign. “Initiative in this direction should properly come from the shareholders rather than the management,” he wrote in a letter to the foundation. “The determination of whether capital not needed in the business is to remain there or to be withdrawn, should be made in the first instance by the owners of the capital rather than by those administering [it].” The battle was over competing ideas of capitalism. To Graham, managers were hired by shareholders to run their company. The folks in charge at Northern Pipeline believed it was their company and that investors had no understanding of the business—their only contribution to its success was cash. In the end Graham got his way, and the era of the activist investor was born. Ninety years later, shareholder capitalism is rightly under fire for creating an economy that is overly focused on the short term and prioritizes investors above workers and communities. But the case against activists is not so clear-cut, as two recent books demonstrate. In Dear Chairman, from which the Northern Pipeline example is borrowed, Jeff Gramm, a hedge funder and Columbia University lecturer, has compiled a history of activism organized around written communications between public companies’ shareholders and boards—something he sees as required reading for his students. “A good letter…teaches us how investors interact with directors and managers, how they think about their target companies, and how they plan to profit from them,” he explains. These communications are sources of strategic wisdom. Searching for insights in the ransom letters of corporate raiders (the preferred term in the 1980s) might sound strange, but Gramm has collected more than demands for dividends. Consider Ross Perot’s 1985 letter to GM Chairman Roger Smith: “I do not believe that GM can become world class and cost competitive by throwing technology and money at its problems. The Japanese are not beating us with technology or money. They use old equipment, and build better, less expensive cars by better management, both in Japan and with UAW workers in the U.S.” Agree or don’t, but Perot was offering a strategy. My favorite, though, is a 2005 letter from Daniel Loeb to Irik Sevin, the chairman of Star Gas Partners. In it Loeb made a simple point about corporate governance: You shouldn’t appoint your 78-year-old mother to your board. “Should you be found derelict in the performance of your executive duties, as we believe is the case,” Loeb wrote, “we do not believe your mom is the right person to fire you from your job.” If Dear Chairman resembles the case method, plumbing individual instances of activism for business lessons, Deep Value, by Tobias E. Carlisle, reads more like an academic literature review. Heavily footnoted but nonetheless enjoyable, it makes the case for value investing—the search for undervalued stocks—and explains why practitioners such as Warren Buffett, whose 1964 letter to American Express is in Gramm’s book, and more strident activists such as Carl Icahn, whose 1985 letter to Phillips Petroleum is also featured in Dear Chairman, have been able to beat the market. For starters, they’re all following in Graham’s footsteps. They recognize that public companies are sometimes valued at less than the sum of their parts—the amount they could generate if they were liquidated. They are, as Graham wrote, in the “best judgment of Wall Street…worth more dead than alive.” If you’re a shareholder in such a company, the worry is that it will fritter away its remaining cash, run down its machines, and end up worth even less than when you invested. But by persuading management to break up and sell, or at least issue a generous dividend, you’ll make some return on your investment. Further Reading Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism Jeff Gramm HarperBusiness, 2016 Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations Tobias E. Carlisle Wiley, 2014 Over the years, of course, activists have expanded their repertoire. In the 1980s they might threaten management with a takeover and demand that the company buy their stock back at a premium—so-called “greenmail,” which is now illegal in several U.S. states and heavily taxed by the federal government. Today activists are more likely to push a company to accept an acquisition offer, sell off certain parts of its business, or improve operations. That means they’re helping to drive strategy, as Gramm suggests. But are their ideas any good? Perhaps surprisingly, the answer seems to be yes, at least by some measures. Research shows that activists apparently make companies more profitable and productive, on average—not just in the next quarter but three years after the fact. And although their intervention may be followed by a decrease in R&D spending, the companies appear to become more innovative in the years following. One study found that activists often target firms that are lagging in IT and then help them catch up to their competitors. The social impact of activists is less well understood. In the above-mentioned study, researchers found that worker pay did not increase alongside profits and productivity at targeted companies. For a society grappling with inequality and wage stagnation, that’s deeply troubling. (Then again, activists also have a record of limiting CEO pay.) But it’s telling that when the Roosevelt Institute, a think tank, released two excellent papers about short-termism in November 2015, activists weren’t mentioned once. The Icahns and Loebs of the world are easy political targets, because they publicly rattle sabers and make billions by pushing the envelope of activism. And Icahn’s recent campaign against Apple is a reminder that some of their attacks are still just about demanding payouts. But we can’t blame activists as a group for all the problems created by shareholder capitalism. Shorter CEO tenure and passive investors’ focus on quarterly earnings are also to blame. Executive compensation is another major culprit, as William Lazonick explained in HBR in 2014. CEOs who are paid in stock have an incentive to boost their short-term share price through buybacks, whether or not activists are in charge.

The Case for Activist Investors

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