Markets Aren’t That Stupid

In finance, there are rarely battles between good and evil. Instead, you have battles of, say, greedy and corrupt versus greedy and ruthless. This is roughly the case in the debate between entrenched corporate CEOs (and boards) and activist hedge funds.

Activist hedge fund managers, like Daniel Loeb or Bill Ackman, buy large blocks of stock in a target company and agitate for change (new board members, asset sales, dividends or buybacks, etc.). The idea is that either they will get their way, or the company will respond to the pressure by doing a better job for shareholders; either way, the stock goes up, and they sell at a big profit.

Entrenched CEOs and boards (and their lawyers) don’t like this because, well, they don’t like outsiders telling them what to do and stirring up shareholders to vote against them. They have responded by trying to make life more difficult for activist shareholders, both in the courts and with the SEC. Of course, they can’t come out and say that activist investors are bad for them as people, because that would seem too self-interested. Instead, they say that activists are bad for the companies they invest in and their other, “long-term” shareholders.* But they have to make this claim despite the fact that news of an activist investment typically causes a company’s share price to go up—which, if you believe in more or less efficient markets, means that activists are good or companies. So they have fallen back on another claim: that activists are bad for the company and the stock price in the long term, even though they appear to be good in the short term.

Unfortunately (for them), it just isn’t true. Martin Lipton, the king of the insider defense bar, said that activist investors’ impact on companies had to be judged over a 24-month period. So Lucian Bebchuk, Alon Brav, and Wei Jiang looked at how those companies did over a five year period (paper; WSJ summary). The bottom line is that, if anything, activist investors tend to improve the companies they invest in. They target companies that are underperforming (by operational measures); they improve their performance on those operational measures; and they provide an initial bump in stock price that does not get reversed over the next five years.

This shouldn’t be too surprising. The theory that activist investors are good in the short term but bad in the long term, while appealing, rests on the premise that there is something you can do that will help a company’s stock price in the short term but not in the long term. The problem with this premise is that a company’s stock price at any moment incorporates market expectations about how it will perform for the rest of time, so it is already a long-term measure. To pull off such a trick, you would have to do something that the market doesn’t know about or understand properly.

This is certainly possible: for example, you could engage in accounting fraud, pulling in revenues from future quarters. That would clearly boost stock prices in the short term at the expense of the long term, so long as the fraud was kept secret. But that’s illegal, and it isn’t as if there’s some lever you can pull that says “increase profits in short term while lowering profits in long term without anyone knowing about it.”

Sure, activist investors do stupid things sometimes (Ron Johnson as CEO of JCPenney?). But on balance, they seem to be a good thing—except for the CEOs and board members they push out.

* Whatever this means, in a day when the majority of trading is done by high-frequency traders, and even the typical actively managed mutual fund turns over its whole portfolio multiple times in a year.