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Shareholder Activism: Council of Institutional Investors

NEWS

The Council of Institutional Investors unveiled their new "focus list" of 20 US companies that it said had consistently underperformed their industry peers. The Council, which represents most of the largest public pension funds in the US, has been publishing its annual list since 1991. (Financial Times, October 8, 1996)

ANALYSIS

Objectives
The report is an attempt by the Council to pressure managers into acting in the best interest of shareholders. The role of the Council is to coordinate shareholder activism. Acting on behalf of the shareholders, the Council is looks out for the interests of the shareholders as a group. This is necessitated because of the interests of the shareholders (principal) and stockholders (agents) diverge, this conflict has been named the principal-agent problem.

 Some Background
Ownership in U.S. companies is fragmented in that there are a very large number of shareholders, each of which holds only a very small fraction of the total number of shares outstanding. This creates the principal-agent problem. Without a major (core) investor(s), the current shareholders might not even agree on what management should do. Moreover, even if they agree that management is not maximizing their wealth, coordinating their actions to influence management action (and potentially firing them) is extremely hard.

Let me give you an analogy on coordination. In western movies, horses were tied together at night, so that even if all the horses wanted to run free, they wouldn’t be able to go anywhere as each would be pulling in a different direction. I guess I need to watch more MTV to give you better analogies.

Meanwhile, the board of directors, as a "middleman" between the principal (shareholders) and the agents (managers), has not been effective in aligning the interests of these two groups. Shareholders should aim at designing effective incentive plans to align these interests.

There seems to be a surge in shareholders getting more involved in seeing that their interests are better served by the board of directors. Executive stock options are aimed at encouraging managers to take a long-term view on shareholder value creation. Substituting a compensation scheme that is based on a cushy pension plan with one that is based on distributing shares of company stocks has a similar objective. By the same token, if a member of the outside directors (i.e., board members who are not part of the management team) does not care about what managers do, and if the managers do not do a good job, then the board member would suffer as the value of his/her compensation dwindles as the price of the stock goes down. Moreover, to make the compensation even more effective, the shareholders add a further requirement of allowing the board member to sell stocks only after several years, thus discouraging shortsighted tactical objectives that might be pursued by managers.

How Successful Is The Council?

One of the issues that the council will pursue is that six companies do not have a majority of independent directors on their boards. Moreover, 12 of these company managers are protected by poison pills. (For more information on Poison pills, see the "Bloopers" section)

The council noted that nine of its under-performers had appointed new CEOs in the past three years. Two changed CEOs within two weeks of being told by the council that they would appear on the list.

The council defended its tactics, pointing to academic research which showed that "this type of activism adds value". It quoted research by Ohio State University and Southern Methodist University showing that share price performance by the companies named in the lists of 1991, 1992 and 1993 was significantly better than that both of their sector competitors and of the Standard & Poors’ 500 (S&P 500) index.

Measuring Performance
Performance is measured in terms of price performance over the one- and five-year periods to the end of July this year being compared against their industry group medians. Those that underperformed the S&P 500 index over five years, and whose returns were furthest below the average for their sector, were selected for the list.

The business press talks about outperforming the market based only on comparing actual return on an asset to a benchmark such as the S&P 500 index. A more sensible approach is that of finance textbooks that also incorporates risk. Financial pricing models, such as the Capital Asset Pricing Model (CAPM), provide investors with a tool to guide them as to what a "fair" or minimum acceptable rate of return should be. Once you have this benchmark, then you can examine actual performance and compare it to what a model would have predicted.

Thus, underperforming the market should mean the following: The stock under-rewarded (under-compensated) its investors for the amount of risk inherent in the stock; the actual returns were lower, on a risk-adjusted basis, than predicted by the model. Typically the CAPM is used to measure the risk-adjusted required return/reward.

Nonacademics would probably respond by saying that maybe the CAPM is an inadequate model, or at least has limitations. This might be a valid argument, but the issue remains that you need to include risk in comparisons; just looking at return can be futile.

List of Companies
The full list of companies on the list includes: A&P (Great Atlantic & Pacific Tea), Advanced Micro Devices (AMD), Autodesk, H&R Block, Community Psychiatric Centers, Dillard Department Stores, Fleming, Giddings & Lewis, Kmart, Moore, Navistar International, Niagara Mohawk, Nordstrom, Novell, Oryx Energy, Outboard Marine, Shoney's, Stride Rite, Unicom and Unisys.

By Alex Tajirian