Investor Relations

Hedge Fund Activism Helps Targeted Companies

Such activism is not just the short-term money grab that efforts to rein in hedge funds suggest, according to a new study.
David McCannAugust 5, 2016
Hedge Fund Activism Helps Targeted Companies

Activist hedge funds, take heart. With the raging debate about activist investing showing no signs of abating, a new study that can fairly lay claim to being the largest and broadest investigation of activism yet undertaken yields evidence that amounts to a solid endorsement of it.

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The new research, to be presented at the forthcoming annual meeting of the American Accounting Association in New York City, Aug. 5-10, analyzes the largest sample of activist events yet examined — some 5,000 initiatives over the course of 21 years. The study finds that above and beyond the short-term boost in share prices that it occasions, hedge fund activism generally results in superior stock performance and strengthened company fundamentals over a long term.

“Activism is widely seen as a way to make a quick buck — so much so that the Brokaw Act was recently introduced in Congress to keep activist hedge funds from capitalizing on short-term profits at the expense of companies’ basic finances,” says Edward Swanson, a professor of accounting at Texas A&M’s Mays Business School, who carried out the research with doctoral student Glenn Young.

However, the research found that, on average, these initiatives “turn out to be a plus for the firms they target,” Swanson says. “Activists are not just good pickers of underpriced stocks; their interventions improve companies’ long-term financial health.”

Besides analyzing companies’ stock performance during the two years following the announcement of activist initiatives, Swanson and Young investigated the response over that span of three kinds of informed investors: analysts, short sellers, and institutional investors. They also gauged firms’ financial fundamentals over the same period. By each measure, activist interventions emerged as having positive effects.

The researchers obtained information on activist events (that is, initiatives by investors that take a large position in a firm’s stock for the purpose of increasing share price through changes in company operations) from 1994 through 2014. Events were identified through two large databases, and ThomsonOne, that specialize in investor-activism campaigns and defenses against them. In all, the study embraced 4,870 activist campaigns involving 2,652 unique firms.

Findings include the following:

Stock performance: Unsurprisingly, stocks of targeted firms enjoyed a cumulative market-adjusted return of about 3.4% in the week following announcement of an activist initiative. The largest boost, about 13%, occurred in campaigns advocating sale of part or all of the business, with campaigns having other goals (for example, changing company strategy, board composition, or corporate governance) averaging 2.5%.

But in the two years following initiative announcements, cumulative market-adjusted returns averaged about 10.6% overall — 21.6% for campaigns aimed at sales and 9.6% for other initiatives.

Analysts: “Buy” endorsements by stock analysts fell from 54% of recommendations two years before campaign announcements to about 42% at the time of announcements, then rose slightly to about 44% a year later, then more quickly to about 49% a year after that.

In contrast, a control group of non-targeted companies similar to the targeted ones in other ways experienced no such striking falls and rises, with the percentage of buys declining slowly from about 53% to about 51% over the entire four-year period.

In the words of the study, “The pattern of recommendation changes shows that analysts respond favorably to activist interventions and provides further support [to the belief] that, on average, shareholder activism is beneficial for target firms.”

Short sellers: Short interest in targeted firms, reflecting doubts about their viability, was about 4.7% at the time campaigns were announced, which was not significantly different from the 5.0% for the control group. Two years later, short interest in the targeted firms had fallen to less than 4.1%, compared with a significantly different 4.6% for the control group.

“Over at least a two-year period, short sellers behave consistently with the perception that activist targets are better off in the post-announcement period,” the researchers wrote.

Firm fundamentals: Swanson and Young assessed company fundamentals with F-scores developed by previous researchers as a way to identify underpriced and overpriced firms based on accounting measures that capture profitability, changes in leverage and liquidity, and changes in operating efficiency. Each of the nine scores that firms receive is classified as good, for which it receives one point, or bad, for which it receives zero.

In the two years before activist events, the F-scores of targeted firms dropped from a mean of 4.36 to 4.13 from which they proceeded to rise in the succeeding two years to 4.48. Both the falls and rises were significantly greater than those of the control group.

Institutional Investors: Targeted companies experienced a sharp decline in ownership by transient institutional investors (those with high portfolio turnover and highly diversified holdings), from a mean of about 16.7% at the time of campaign announcements to about 14.8% two years later. The comparable percentages for controls hover at about 15.5% over the entire four years.

Meanwhile, ownership by dedicated investors (those with long investment horizons) rose slightly at targeted firms in the two post-announcement years, from about 10% to about 10.6%, while comparable percentages for controls hovered steadily at about 9.5%. In the words of the study, “these results are inconsistent with activism inducing short-termism at target firms.”

The authors see their findings as having timely public-policy implications, given Congress’s consideration of the Brokaw Act. Further, “Presidential hopeful Hillary Clinton has taken aim at ‘hit-and-run activists whose goal is to force an immediate payout.’ Even billionaire investor Warren Buffett has criticized activists whose ‘short-term objectives have eroded faith in corporations’ continuing to be the foundation of the American free enterprise system.’”

The paper, entitled “Are Activist Investors Good or Bad for Business? Evidence from Capital Market Prices, Informed Traders, and Firm Fundamentals,” will be among hundreds of scholarly presentations at the American Accounting Association annual meeting.

Image: ThinkStock, Jane Kelly

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