All That Glitters

Stock-market Activism Rides to the Rescue of Free Markets

Whether it’s a protester with a megaphone or a big investor earning place in the boardroom, activism helps companies both in Israel and abroad.

For some, loud activism against the affairs of any business is perceived as harmful. This seems logical. Fending off criticism consumes management’s time in the short run and impairs long-term management even more – and therefore value for shareholders. Plenty of top executives in Israel would agree.

In the United States, “activist” hedge funds buy 5%-plus stakes in companies and demand changes to management and strategy. In response, managers, their lawyers, academics and members of Congress seek to change the rules, adding regulations that shield companies from such activism.

The premise is that “insulating boards serves long-term value” – the idea is to limit the influence of minority shareholders. But studies led by Harvard’s Lucian Bebchuk, an expert on law, finance and corporate governance, debunk this approach both quantitatively and theoretically.

Bebchuk and fellow professors Wei Jiang and Alon Brav examined all 2,000 cases between 1994 and 2007 of a hedge fund acquiring more than 5% in a company and demanding management changes. As expected, share prices surged in the short run, but they also did pretty well in the long term.

Over the five years following the typical fund’s intervention, operations and share prices improved. This was particularly the case when the fund’s demands – such as taking on more credit, increasing dividends and cutting back on new investments – seemed likely to endanger the company’s long-term stability.

And there was no deleterious effect from the funds’ swift entries and exits. Neither was there support for claims that companies attacked by activist funds were less prepared for the global financial crisis.

Bebchuk concludes that there is no evidence supporting the claim that management protected from shareholder activism functions better. If anything, insulation of management and the board could impair long-term performance.

Although the issue involves many legal and financial considerations, the upshot is simple: Stock-market activism is good for capitalism – and there’s nothing more capitalist than the capital market.

Case in point: IDB Development

Investors’ involvement in management also boosts company value in the short run and improves – or at least doesn’t harm – value and performance in the long term. Anyone who thinks a company needs to be run without interference from the public is mistaken.

An excellent example in Israel is IDB Development, the holding company with a controlling stake in firms such as Cellcom, Clal Insurance and supermarket chain Super-Sol. U.S.-based York Capital Management bought a large block of IDB bonds, claimed that Nochi Dankner’s group was insolvent and went to court demanding new management and a comprehensive recovery plan. It’s unclear how all this will turn out, but one thing is clear: Since the purchase by York, IDB Development’s bonds have soared 150%.

Could these findings also hold true for the broader economy? Over the past two years battles have been waged in Israel and around the world between protesters and the establishment. Israel has seen clashes between activists and the gas companies, and against the banks. There have also been the protests that spawned the Trajtenberg Committee on socioeconomic change, and the protests against tycoons and the so-called pyramids of companies they control. This led to anti-concentration legislation that is still being fought out in the Knesset.

The economic establishment claims that activism and the regulation it generates will harm companies. These arguments are similar to the claims examined by Bebchuk in the U.S. stock market – that taking public opinion into account impedes companies’ management in the short term while regulation hinders companies’ growth in the long term.

There are no signs that the protests have damaged the economy. It seems that most nightmare scenarios coming from the establishment haven’t materialized.

In gas exploration, drilling continues despite the higher royalties. Banks remain profitable and stabile despite regulations on executive pay and customer fees. Nobody ever claimed that public pressure against forgiving tycoons’ debts, as in the case of Bank Leumi, would hurt the banks. On the contrary, public pressure only strengthens bankers in their efforts to collect debts from the high and mighty.

The truth about stock-market volumes

And what about claims that stock-market volumes have collapsed due to excessive regulation? Actually, volumes have fallen throughout the world at a similar rate due to changes in investor preferences. Now volumes are again on the rise thanks to a renewed appetite for stocks, without any change to the rules of the game.

From studies in the United States and from sheer experience, it’s clear that activism efforts of every kind – from megaphones and signs to class-action suits and investments that get you into the boardroom – not only don’t harm the capitalist economy, they strengthen it.

Anyone who has mistakenly associated protest and activism with “socialism,” “communism,” or anything “anti-business” simply overlooked the results. In most cases activism has led to an improved free market, more competition and lower prices (though it’s true that activism has sometimes hurt interest groups that previously enjoyed a competitive advantage that filled their pockets).

The same is true for much of the criticism against “regulation,” a word that people distort based on their own interests. When someone earning money without effort is stung by regulation, he’s usually against it. Whenever the market is free and competitive, the big players demand regulation – to put a lid on imports or competition, for example.

As Bebchuk has made clear, the managements of publicly-traded companies – the standard-bearers of capitalism and the free market – actually want more regulation, but the kind that limits shareholders’ ability to influence management, even though such influence benefits the companies.

So the next time you read about “socialism against capitalism,” “regulation,” “protest,” “free market” or “let business thrive,” don’t be confused. In most cases the speaker is talking up his own interests without any concern for the economy, “capitalism” or the “free market.”

Daniel Bar-On