Activists at the Gate, part 1
Updated: Oct 19, 2022
Readers, I come to you from Stradbroke Island where I am attempting surf after a three-year hiatus. British readers, I’m not sure why your forebears stumbled upon this subtropical paradise and thought “prison”, but I’m glad they did. Then again, you also stumbled upon Boris Johnson and thought “Prime Minister” and left the EU largely to prevent immigration from Pakistan. If the UK were a company, the activists would very much be at the gate - which oddly enough, will be the topic of the next few articles.
Activism – the practice of shareholders trying to encourage change at a company – is hardly new. Even Papa Buffett has given it a go. I think we’re going to see a lot more activism, and soon. ESG is growing in importance while economic conditions will make some companies softer targets – activists everywhere are licking their lips at the prospect. I thought I might lend a bit of insight into what goes on in activist campaigns. Today I’ll look at the history of activism and the predictors of a successful campaign. I’ll go into the various activist strategies next week.
“CEOs are paid for doing a terrible job. If the system wasn’t so messed up, guys like me wouldn’t make this kind of money” – Carl Ichan
I remember reading Jeff Gramm's excellent book “Dear Chairman” a little while ago. It details the history of shareholder activism with the original letters and some helpful commentary from Jeff. What struck me the most was the difference between the early days of activism and today.
For those of you short on time I’ll give you a brief summary. Early letters to chairmen and boards were created on typewriters, signed with a fountain pen, and went something like:
We would like to ask, if you would be so generous, whether or not you may have considered a future in which you might possibly think about having polite talks that could lead to positive discussions about the chance of envisaging a future in which you think about improving margins from their present levels.
But of course, those was the early days and much has changed since then. Today, shareholder letters are likely to continue in much the same way they begin:
Having been an activist shareholder for a good part of my career I thought it’d be worthwhile outlining it to those of us who are not so familiar with the concept. The first point I’d make is that activism is not some sort of financial alchemy. It can’t turn lead into gold. Activism cannot create value, it can only unlock it. The potential for fundamental change must already be there.
Something else worth noting is that all shareholders are activists in one way or another. Some exercise soft power and indicate their preferences or make suggestions in private meetings with management. Others are more confrontational; the classics of this genre being Carl Icahn, Bill Ackman, Peter Singer and at one stage even Warren Buffett, to name but a few.
Proponents of activism would say that it’s a way of improving company performance, strengthening governance, and a way of creating your own catalyst. If management end up doing what you ask (or the activist succeeds in changing management) it is entirely possible that revenue growth, margins and investment will improve, cash flows will grow and (hopefully) the share price does too.
Critics of activism says that it’s usually not all that effective, it takes an inordinate amount of time to generate not much additional alpha, and that the “create your own catalyst” angle is merely a marketing ploy to get allocators/investors to give you more money. The truth, as usual, lies somewhere between the two extremes.
Activist investing takes a substantial amount of time. Fights can stretch on for months and in bad cases turn extremely bitter extremely quickly. They take up enormous intellectual and emotional bandwidth. Campaigns are frequently in the financial press, so success or failure and even the steps that led to it will be widely known by the financial community. This affects your credibility in future campaigns.
Furthermore, participants are often completely unreasonable. This is to be expected, as professional reputations are on the line. I’m talking people displaying the emotional range of a Batman villain and the emotional maturity of a teenage cyclops. It is frequently the least reasonable person who wins the fight. I’ve seen companies launch smear campaigns against proposed directors and bitter battles in the press. I've heard stories of people being followed by private detectives for weeks at a time and seen people dig through social media to attack someone’s character. Make no mistake, public activist cases are a blood sport.
You have to make sure that the return on time or to use a favourite of mine, the alpha per hour, is commensurate with the time invested. To put it Bill Ackman’s way: ensure the return on brain damage is worth it. In short, don’t start a three-month fight for only modest outperformance.
Now we’ve understood the labour involved, we should look at the predictors of success. The thing that matters in activism is not, as you might expect, the strength of your arguments. Nor is it how much venom and bile you can pack into a single letter. The only thing that matters is whether a substantial portion of other shareholders are willing to back you. If they’re not on-board you won’t have enough voting power to generate change. So meet with them before you decide to launch a campaign.
I think it's time to share a few tales of bravery. I’ve seen incredibly strong, well thought out and thoroughly researched arguments fail simply because other shareholders weren’t sufficiently annoyed. Take Bill Ackman’s campaign against ADP, the payroll processing company famous for the ADP jobs report. Let me be clear from the outset: Bill Ackman is a fantastic investor, but no one is infallible. He released an almost 200-slide deck a few years ago detailing why ADPs margins were below their potential and could improve substantially. His argument went: margins are around 15% now but they could be 30%. The “simple” steps outlined in the next 150 slides explain how. (TL;DR, raise prices, reduce costs).
The problem wasn’t that he was wrong. He was probably right. The problem was ADP’s margins had already increased a lot, from ~8% to ~15%. Other shareholders didn’t care that they could be higher still - they were already at multiyear highs. The failure of this campaign illustrates the point that it doesn’t matter if you’re right, to be frank, it doesn’t even matter if you’re wrong, all that matters is that other shareholders are - pardon the pun - on-board with you.
Conversely, I’ve seen successful campaigns whose arguments amounted to: “we don’t like you, please do better” – seriously they had the intellectual depth of a Peppa Pig episode. Professional courtesy prevents me from naming the perpetrators. But other shareholders agreed, so the campaign succeeded, at least in changing some directors if not in substantial share price appreciation.
The only thing you seriously don’t want to do is make incoherent arguments which turn your activist campaign from a rallying cry for improvement to the bellicose ramblings of a facile intellect. If this happens, it will seriously harm your reputation as an activist investor. Remember, it’s a blood sport. Don’t give your opponents a free pass by allowing them to point to your previous campaigns and say “this person is obviously a clown”. If that happens, you may have to weigh up whether you’d have more influence if you simply died and haunted the management team.
It’s also much harder to cut your losses and move on because you must at least look like you care and have the interests of all shareholders at heart. Abandoning a campaign makes it seem like you weren’t all that keen on it in the first place. Not to say you shouldn’t cut your losses at some point, just that the optics are bad.
I've painted activism as a pretty difficult game here and some of you are probably wondering why would you ever do this? The first reason is that if done correctly, you can generate a lot of alpha (risk-adjusted return) and that, after all, is the only reason investors should do anything. The second reason is that it tends to improve companies. Capital is allocated more appropriately, operating performance improves and management are more likely to act in shareholders' best interests if they know that some of them may bite. That, and it's one of the most stimulating challenges you'll ever undertake.
I’ll wrap it up here as the way markets are going, you’ll need every second you can spare. Next week I’ll look at the three types of activist campaigns, what Smaug the Dragon has in common with CFOs, and discuss short-side activism.
Until then, good luck out there.