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The Dangers Of Activist Investors For Innovation

Short termism is deadly for innovation

13Nov

There has been a big trend in recent years for activist investors who have made billions by taking over companies that many consider to be mismanaged. The general way this works is that these investment firms will take a big stake in the company in order to aggressively install somebody from the fund onto the board and then force through sweeping changes to the company in order to change the stock price in their favor.

On the face of it this seems like sound business logic, as an increasing share price should be indicative of a successful company in good health. If you take this as a given then these activist investors are a good thing as they are improving the company and making it more successful, while making money for themselves in the process. However, the idea that a higher share price means a healthier company is only true at the moment that stock is at its highest. The idea that high share price is somehow indicative of a healthy company is not true at all. After all, a reliable way to see an upward tick in share price is for a company to announce increased profits, which doesn't always represent health. Profits aren't always increased by improving business practice, it can often be done through significantly cutting costs. If a company lays of 50% of its employees, then there will naturally be a small spike in profits, but what happens after that with only half the workforce to try and undertake the same amount of work?

Think about it this way, Enron's share price was on a steep upwards trend right until the point it collapsed. It was not a healthy company at the end of 2000 and then poorly run in 2001, but if we were to judge health on share price then that would certainly have been the case.

As the aim of an investment company is to get a return on investment in a short period of time, this leads to short term thinking, which in turn impacts innovation. When companies are simply trying to maximize their profitability in the next quarter, there is little focus on long term innovation because ultimately R&D is a cost that will pay off 4+ quarters later. This in turn means that although the share price will spike in the short-term, when it comes to long term business health, this can have devastating consequences.

This is not to say that all investors are a negative thing. Even when investors take a controlling stake, it is not always a negative thing. It is certainly true that hedge funds and activist investors often do significant damage because they are looking at short term gain, but private equity companies can also be a force for good as they are looking to improve the company and sell the entire thing in the future rather than focus on changing the share price. It isn't to say that there aren't private equity companies who destroy companies, but their model isn't inherently flawed to restrict innovation like activist investment.

However, many companies are not simply allowing this to take place, with Proctor & Gamble, one of the most innovative companies of the past 20 years, being a prime example. In a recent high-profile battle between Nelson Peltz and the company, Peltz fell just short of the votes needed to gain a place on the board. This was after one of the most expensive board elections in history, with P&G and Trian (Peltz's hedge fund) spending over $100 million between them. Peltz had been arguing that after Trian took a $3.5 billion stake in P&G that they should have a place board, but this had been vigorously fought by senior members of the board given Peltz's insistence on certain changes.

David Taylor, P&G's President & CEO, said, 'He's proposed some things that could be very dangerous to the short term, which is reorganize the company right now, and he's proposed something very dangerous for the long-term future of this company, and that is eliminating our corporate R&D.' One of the most damaging changes in the long-term would be the combination of the two as the close co-operation and R&D has reaped some huge rewards for P&G. When asked to give examples of this, Taylor went on to say 'I can give you several examples: the sachets that are often used for samples in the U.S. and they're sold by the hundreds of millions in developing markets — the process to make them faster than anybody can make them commercially, and at a lower cost, was developed using our liquids understanding from our liquids businesses and our converting capability that comes out of our paper businesses... If you had separate businesses with separate R&D, you wouldn't have made that connection and would have missed the opportunity to take advantage of a real plus.'

Ultimately it is little surprise that activist investors have become so beloved by investors around the world, because ultimately they are doing exactly what every investor wants to be able to do - actively change the share price of a company from the inside - but it isn't a good thing for the long-term health of a company.

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