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What are activist investors and how do they work?

Activist investors continue to challenge companies in search of change and profit. But what is shareholder activism, how does it work, and how can it impact your portfolio and trading strategy?

Source: Bloomberg

‘Shareholder activism works when activists understand something about the characteristics of a business that the board doesn’t,’ – co-founder of venture capitalist Andreessen Horowitz, Ben Horowitz, 2012.

Activists have a very simple mission: to stimulate change in a business in order to make profit.

Shareholder activism is showing no bounds, with investors finding new ways to hold company’s feet to the fire and flex their influence, track records and use vast amounts of capital to induce change at companies of all sizes, from blue-chips to penny stocks, around the world.

The influence and role of shareholder activism is growing. The amount of publicly-listed companies that came under fire from activists rose by 48% over the three years to 2016 before experiencing a drop in activity in 2017, when over 800 firms were subject to activist demands.

While fewer companies were targeted last year, activists paid more attention to the larger companies and with the likes of Procter & Gamble, General Electric, General Motors, Nestle and AkzoNobel all having to deal with activism last year, it is clear few companies can escape the activist’s radar. One in five of all activists’ targets carry a market cap of over $10 billion.

Activists may have a simple goal but they must navigate complex channels to achieve it, and the impact activism can have on companies, share prices and other investors means opinion is split. Are activist investors taking advantage of stock markets for their own gain or playing an integral role by holding companies to account and maximising value?

What is an activist investor?

An activist investor can be an individual or a group that makes a substantial investment in a company with the view of using its influence to seek change within the business. An activist can spring into action for several reasons, including if it thinks the business is poorly-structured, being mismanaged and underachieving, or if disagrees with the strategy or state of the balance sheet, for example.

In a nutshell, activist investors try to seek out flawed businesses to invest in, with the aim of improving them one way or another in the hope the company becomes more valuable as a result, allowing the activist to sell-up and book a profit.

There are some activist investors that are dedicated to the cause and only invest in companies with a view of seeking change, while some use it as a tool within a wider investment strategy. A hedge fund, for example, may primarily follow an investment strategy and only undertake shareholder activism when necessary, such as when its existing investments are under threat by mismanagement.

Shareholder activism tends to start at a fork in the road. When a shareholder looks to change something within the business, they have two choices – seek to negotiate with the company’s board and reach some form of agreement on the matter, or challenge a company by using its stake to call a meeting for all shareholders to vote on whether they back the activist’s proposals.

Negotiating is a significantly more successful strategy for investors, but many are willing to take their chances in a proxy fight in order to try to push their ideas. Look at the success of activists last year that sought to make changes to a company’s board – they won more than five times as many seats by negotiating with the company than they did through shareholder votes. When it did end up in a shareholder vote, the success of activists was more mixed, winning only slightly more battles than they lost.

In addition to activist investors, there is another group that look to short companies in the belief they are grossly overvalued. These short-selling activists find companies which they believe are worth considerably less than what the market has priced them at or (in many cases) nothing at all.

Learn more about short-selling

So what’s the major difference? While activist investors look for companies they believe they can squeeze more value by making changes, short-selling activists look for those that they believe will see a large-drop in value because they think the companies are fraudulent in some way. These two types of activism are very different to one another, and have a different impact on company share prices. Sometimes activist investors ploughing money into a business can be beneficial to share prices, whereas an activist shorting a stock is rarely good news for a stock’s value.

The main thing they both have in common however, is the ability to influence. Individual retail investors do not have the ability to push for change without pooling together, as they can rarely afford to take large enough positions on a stock to have any influence on their own. Activist investors and short sellers are both able to back their opinions up with both the cash needed to grab everyone else’s attention, and the track records needed to gain respect from the market. It’s worth noting that some use both methods of investing and shorting.

It is evident that there isn’t a company, regardless of size, that is immune from the threat of activists. Companies are now constantly looking over their shoulder to check if any activists are looming, and many now regard potential shareholder activism as a major risk. As a result, many have introduced measures to counter potential activism, such as improving shareholder engagement and governance practices, to prevent any wandering eyes from finding an excuse to make them their next target.

Activist investing: a global overview

‘Spurred by an increase in activism in recent years, boardrooms across the globe have begun pre-emptively taking a closer look at their companies’ performance, strategic direction, board composition, and governance practices. Nonetheless, activism shows no signs of slowing down,’ - The Activist Investing Annual Review 2018.

The annual review released by Activist Insight (AI) in association with Schulte Roth & Zabel paints a picture of how prevalent activist investors continue to be, and provides a look at what is driving activism in international stock markets:

Why do activist investors target companies?

Activist investors launch campaigns against companies for several reasons, whether to protect an existing investment or because it has invested specifically to push for change.

Companies, big or small, face the same pressure from activists, but the largest businesses, with their complex nature, are often targeted for governance issues surrounding issues like dual-class shareholder structures, use of the universal ballot, amending bylaws, or redeeming poison pills.

Large-caps are also challenged more on director pay than mid-cap and smaller stocks, which face more pressure to make changes to their board, and are questioned more about how they plan to generate growth leveraging their balance sheets and mergers and acquisitions (M&A) options.

Reasons for activism against publicly-listed companies in 2017

Reason Large-caps Mid/small-caps
Board-related 28% 50%
Remuneration 12% 4%
Strategy 8% 7%
M&A related 7% 15%
Balance sheet 4% 11%
Other governance 38% 11%
Other 2% 2%

(Source: Activist Insight, large-caps defined as having a market cap of over $10 billion while mid/small-caps defined as below $10 billion)

What sectors are most vulnerable to activist investors?

A wide variety of companies are targeted by activist investors, with notable attention being paid to the services industry and the financial sector.

Where do activist investors thrive and what countries do they target?

The US in the unrivalled hub of activist investment. A total of 461 companies headquartered in the US were subjected to activist demands last year and one in four of them was a large-cap stock. Some activity did shift overseas, however, as activists had a harder time finding undervalued businesses following the rise in US stocks.

The UK and Europe as a whole saw less activism activity last year, but reached a record high level for Germany. The EU introduced a major catalyst that should spur on activism going forward, after enforcing a shareholder rights directives that encourages more engagement between investors and businesses. 

Trends over the past three years have shown that larger European companies are being targeted by activists more often, partly because activists that have previously targeted big US stocks can relate to the global operators listed on the Continent.

Asia is a relatively quiet region, with the exception of Japan, which saw a notable jump in 2017. While activity in the region is not expected to explode any time soon, activism is expected to increase over time as attitudes and practices change. Japan’s Prime Minister Shinzo Abe, for example, has backed reforming governance in his country which in the past has been seen as immune to activist efforts.

Canada has seen shareholder activism decline in recent years, partly because activity correlates to the state of the energy and financial sectors which makes up the vast majority of listed stocks.

Activist investors and their role in M&A

Activist investors can either promote M&A to the company it is invested in, or it can be against it - blocking a deal because it believes the return on their investment should be higher or promoting a deal to monetise and exit its investment. Activists can do well to uphold valuations in these scenarios, but can also be a big barrier to other shareholders who want to cash in on a deal the activist doesn’t support.

In some cases, the activist has invested specifically to encourage the firm to strike some form of deal to grow faster, for example, while some play their cards because a company they were already invested in has sourced a deal on its own.

Businesses have done well to take cash out of their industries in recent years, and with more companies getting their balance sheets and their overall house in order, activists are looking for other options they can use as leverage – whether that be M&A or board changes, to name two.  

In turn, this will place companies under pressure to prove they can deliver adequate organic growth to stave off prying eyes of any activists keen on pushing M&A as a faster and more rewarding way of delivering growth.

This is thought to be the catalyst that will drive more activism in Europe, according to AI, as there are more M&A opportunities for activists to take advantage of M&A-related demands dropped in the US last year and grew in Europe, Asia and Canada.

With one in five of all activist demands relating to M&A, find out who the top M&A contenders are for 2018

What are the pros and cons of activist investors?

So, are activist investors using companies as pawns in their search for profit, or helping hold the corporate world to account? In truth, regardless of what the activist’s motive, they always have their own agenda and ultimately operate to make returns on their investment.

It is important to understand that activist investors, just like the companies they invest in, are not always right (hence why the board and the investors often disagree). Holding a position on a stock that has fallen into the crosshairs of an activist investor therefore, can be positive or negative for your investment.

The positives of activist investors spawn from the amount of influence they can wield. Activists, particularly if they find themselves in a proxy fight, will often state it is arguing on behalf of other smaller shareholders that would not otherwise have a voice, and begin lobbying for support.

Activists should not be complainers, and most are not. If one is to claim a company’s strategy is all wrong and the board should be thrown out as a result, then you must put forward an alternative vision for the firm, and nominate who is fit to run the company. However, this has also prompted many companies to claim in the past that investors are taking small but substantial stakes in businesses in order to take control of it by gaining board seats and deciding on strategy.

Activists can bring new ideas to the table and, management willing, help turn around a company or maximise its potential. The more the market supports the activist and its vision the more support is thrown behind its share price.

On the other hand, activist investors can have a devastating effect on other investors in the business. If the activist becomes frustrated and unable to achieve what they want, then it is highly likely they will sell all of their shares at some point to book in any profit they can, or to minimise any losses. As they hold such a substantial holding, the activist’s decision can prompt a large sell-off of shares and send prices tumbling.

The characteristics activists look for and how to spot their investments

While not sure-fire, there are ways to evaluate whether or not a company is likely to be on the radar of any activist now or in the future. More obvious signals would be profitable businesses that the market is valuing lower than its book value, and those failing to deploy large amounts of cash effectively through shareholder returns or M&A, for example. In turn, if a company is undergoing a lot of M&A activity, whether selling off units or buying businesses, it is more likely an activist will emerge to ensure valuations are upheld.

Activists are also increasingly pouncing on companies when they are vulnerable and transitioning to new leadership, such as a new chief executive. Leading directors considered likely to leave or retire could signal opportunity for an activist to enter depending on the wider situation. In turn, directors that attract vast amount of unhelpful media attention or any material displeasure about management among other shareholders can also lead to an activist finding an opportunity to capitalise on.

Publicly-listed companies have to disclose whenever an individual shareholder holds a significant stake in the business, usually over 5%. These can provide investors of a way of identifying where activists are deploying their cash and trying to track their investments before any action is taken. In London, for example, these disclosures are distributed through the Regulatory New Service, whereas in the US these are filed through the US Securities & Exchange Commission.

If a material proportion of a company is owned by an investor known for taking activist action in the past then this would also flag high potential. While no company is invincible, those largely owned by their directors are more immune from action, due to their ability to block any shareholder votes.

Read more about the biggest activist investors and how they can help your portfolio

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