Markets Aren’t That Stupid

By James Kwak

In finance, there are rarely battles between good and evil. Instead, you have battles of, say, greedy and corrupt versus greedy and ruthless. This is roughly the case in the debate between entrenched corporate CEOs (and boards) and activist hedge funds.

Activist hedge fund managers, like Daniel Loeb or Bill Ackman, buy large blocks of stock in a target company and agitate for change (new board members, asset sales, dividends or buybacks, etc.). The idea is that either they will get their way, or the company will respond to the pressure by doing a better job for shareholders; either way, the stock goes up, and they sell at a big profit.

Entrenched CEOs and boards (and their lawyers) don’t like this because, well, they don’t like outsiders telling them what to do and stirring up shareholders to vote against them. They have responded by trying to make life more difficult for activist shareholders, both in the courts and with the SEC. Of course, they can’t come out and say that activist investors are bad for them as people, because that would seem too self-interested. Instead, they say that activists are bad for the companies they invest in and their other, “long-term” shareholders.* But they have to make this claim despite the fact that news of an activist investment typically causes a company’s share price to go up—which, if you believe in more or less efficient markets, means that activists are good or companies. So they have fallen back on another claim: that activists are bad for the company and the stock price in the long term, even though they appear to be good in the short term.

Unfortunately (for them), it just isn’t true. Martin Lipton, the king of the insider defense bar, said that activist investors’ impact on companies had to be judged over a 24-month period. So Lucian Bebchuk, Alon Brav, and Wei Jiang looked at how those companies did over a five year period (paper; WSJ summary). The bottom line is that, if anything, activist investors tend to improve the companies they invest in. They target companies that are underperforming (by operational measures); they improve their performance on those operational measures; and they provide an initial bump in stock price that does not get reversed over the next five years.

This shouldn’t be too surprising. The theory that activist investors are good in the short term but bad in the long term, while appealing, rests on the premise that there is something you can do that will help a company’s stock price in the short term but not in the long term. The problem with this premise is that a company’s stock price at any moment incorporates market expectations about how it will perform for the rest of time, so it is already a long-term measure. To pull off such a trick, you would have to do something that the market doesn’t know about or understand properly.

This is certainly possible: for example, you could engage in accounting fraud, pulling in revenues from future quarters. That would clearly boost stock prices in the short term at the expense of the long term, so long as the fraud was kept secret. But that’s illegal, and it isn’t as if there’s some lever you can pull that says “increase profits in short term while lowering profits in long term without anyone knowing about it.”

Sure, activist investors do stupid things sometimes (Ron Johnson as CEO of JCPenney?). But on balance, they seem to be a good thing—except for the CEOs and board members they push out.

* Whatever this means, in a day when the majority of trading is done by high-frequency traders, and even the typical actively managed mutual fund turns over its whole portfolio multiple times in a year.

38 thoughts on “Markets Aren’t That Stupid

  1. Whatever this means, in a day when the majority of trading is done by high-frequency traders, and even the typical actively managed mutual fund turns over its whole portfolio multiple times in a year.

    I think this cuts to the essence of the issue, and makes me wonder how you can say The problem with this premise is that a company’s stock price at any moment incorporates market expectations about how it will perform for the rest of time, so it is already a long-term measure. To pull off such a trick, you would have to do something that the market doesn’t know about or understand properly.

    That clearly is not true. Stocks move up and down based on very short-term effects, analyst opinions, quarterly results, etc. Active traders will buy a stock and then take profit at the first opportunity. I’m not sure if the “long term investor” even exists in a meaningful way, but at least they are no longer the primary driver of stock value.

    It is absolutely possible, for example, for a technology company to cut R&D and spend that money on marketing, stock buy-back, or dividends. Similarly, a manufacturing company can cut it’s maintenance budget and get away with it for at least long enough to show improved quarterly results. Any of these actions will tend to goose the value in the short term, but will probably damage the company in the long term.

    I am not taking a position on whether or not activist shareholders are a good thing or a bad thing. I’m just taking issue with your suggestion that the stock market is good at valuing companies over the long term. That may have been true at some point in the past, but it seems obvious by inspection that it is no longer the case.

  2. Technical analysis, professional chartists, 60 moving averages, That is the tail wagging the dog. Long term investors are just suckers waiting to be taken to the cleaners the first quarter that a company fails to exceed analysts expectations. Ask Jimbo ‘Booyah’ Cramer and his Mad Money. .

  3. There is something to be said for the sentiments expressed in previous comments. But I have two words for you: Warren Buffett. There are many ways to play the investment game. I submit to you it is becoming increasingly difficult to win at the game when you play your observations and your broker’s execution against computer algorithms and split second trading. But if you had the courage to buy GE at 7 back in 2009 because you knew that was a ridiculous price, you are now sitting comfortably around 25 in 2013. That’s technically “long term” investing… at least tax-wise. :-) It does rather feel like some additional regulation might help manage the greed, corruption, and ruthlessness. Don’t hold your breath.

  4. Surely there are excessively short-term strategies that could be followed. To name a few:

    – Focusing R&D on current cash cow products without creating a transition to new products or technologies.
    – Changing the work/benefits balance against the workforce, so that you get higher output now but high turnover and low morale later.
    – Acquiring companies that have good public image and cash flow but are a poor fit to the greater organization.

  5. Let’s see. There’s a company with a good product, good R&D, well-treated employees with good working conditions, having paid off its initial debt and sitting on a bundle of cash in preparation for new expansion or a rainy day.

    Mr. Bain comes in, borrows a ton of money to buy out the company (at an inflated price, as the shares go up), downsize the workforce and reduce their working conditions (increasing productivity), take on new debt, declare special dividends for the shareholders, sell off “underperforming” assets, and then return the company to the public — as a shadow of what it used to be, almost a carcass.

    Markets aren’t stupid, in the same sense that gravity isn’t stupid. People are stupid, and in the short-to-medium-term, the stupids win out — at the expense of a long-term crash or disaster.

  6. Dear James,

    Another great post which leaves open the question you only allude to about straight out accounting fraud and letting us all remember the less immediately visible effects of Special investment Vehicles set up to keep Enron looking like a hot stock and the size of the repo market before Lehman tanked.


  7. ‘Active traders will buy a stock and then take profit at the first opportunity. ‘

    They’ll also take losses. So the question becomes, are short term investors, on balance, more successful than long term, buy and hold investors? There’s a boatload of evidence that they aren’t.

    There’ also a boatload of evidence that outside non-investors; government agents or regulators don’t know any better either. So why is this blog so enamored of regulation as a solution to anything?

  8. It’s simply that good regulation is better than bad regulation, but the majority doesn’t know any better either, so they juggle anything in sight to keep the linear circus a going till death do we part.
    It’s apparently what we do, and since we have all the money that makes us right, so we can debate at dinner and sleep at nite, or at least pretend too once and awhile.

  9. Think of top managers as politicians that balance different interest groups and make implicit contraxts with them – unions, government, capital holders, creditors…..

    Now an “activist investor” comes in, destroys all those contracts and puts equity holders above all other legitimate interests, so stocks rise, great. No good there for society, since all the other interest groups wont trust any long term commitments anymore and just demand their share now now now.

  10. ‘It’s simply that good regulation is better than bad regulation….’

    No kidding? You ought to write a book. Tell the world how we can insure we only get the good kind.

  11. Been there, done that, and you were found to be in denial, so we had to do it the hard way.

  12. Interesting read. None of it matters. Who cares about the conjurings or machinations of the predatorclass boards or ceo’s or hedge fund serpents. They are all predatorclass!!! None of these den of vipers and thieves do ANYTHING to advance the best interests of the poor and middleclass, they all serve and are opulently rewarded by or a card carrying member of the predatorclass – and so they are an arch enemy of the people, – the voiceless, faceless, jobless, hopeless, abused, neglected and abandoned 99%.

    Burn it all down! Reset!!! It’s the only hope for the 99%!

  13. “Asian policy makers see Yellen as less beholden to Wall Street than Summers is — he made millions from Citigroup Inc., Nasdaq OMX Group Inc. and hedge fund D.E. Shaw & Co. LP. She is also perceived as more supportive of the regulation needed to avoid another crisis; Summers helped trim back those safeguards.”

    “President Barack Obama will make “a very aggressive” case to win bipartisan support for his choice for the next U.S. Federal Reserve chairman, a decision that remains weeks away, his spokesman said.” – In others words, the President will be spending a part of his vacation (taxpayers picking up ½ the tab for the new home at Martha’s Vineyard), “mulling” over and making sure to select the person that won’t give Liberal Democrats much comfort.”

  14. @TonyF, “the voiceless, faceless, jobless, hopeless, abused, neglected and abandoned 99%….”

    Ah yes, blessed are the peacemakers….

    Now what kind of mathematical genius ignores the exponentiality impact on the non-renewable resources of a faceless, jobless, hopeless, abused and neglected/abandoned 99% – like where are you talking about when it’s *GLOBAL*? A country? A temporary spin in virtual land – the land of the 99%?

    Isn’t 99% of any amount in a algorithm a ridiculous mathematical process to model as an abstract algorithm? Yeah, bozo, that’s like deleting gravity from the current laws of physics on the books….that’s not a plan….

  15. name that tune or better yet, name a U.S.-based TBTF other than Citibank as operationally “actually worse run than our banks”…….”They’ve got some very weak banks, huge banks, actually bigger than our banks, relative to their economies. They’re actually worse run than our banks, if you can believe that. So that remains a very big vulnerability for their economies going forward.” Referenced from:

  16. What happens when we have more and more rules (and more and more laws which are chosen not to be enforced) that protect only wealthy individuals and powerful banks??? Then you have a situation which isn’t a “free market” but closer resembles the decision of a politburo committee. For example read the below two links and ask yourself “What exactly does this look like??” Some of us might even call it a “redistribution of income”. But the use of that term (“redistribution of income”) is only allowed for jerkwads like Newt Gingrich and Eric “I profit from default” Cantor:

    After you’re done with the above mental exercise to the decipher difference between a free market and a standing politburo committee which decides how prices are determined, you might try another mental exercise. Ask yourself if you were transacting a trade on your computer at home and had accidentally pressed in erroneous numbers and Goldman Sachs was on the other side of your trade “What would have happened then??? Would Goldman Sachs let me cancel my trade for my ‘ooopsy’???”

  17. For those who missed the main subtext of the comment, (due to my poor writing, not comprehension), the above blog comment could have been sub-titled “Why Are Democrats Such Pussies, And CONFER To Republicans Rights Of Usage Of The Term ‘Redistribution of Income’ ????”

  18. In this article, the interviewees are largely hypothesizing. But these are educated men. What OTHER answer would there be for a 3 hours shutdown with similar characteristics to prior hacker attacks?? I would surmise that if there is another answer it would relate to incompetence on the part of the exchanges. I would also say that incompetence may in fact be a worse answer than “we were hacked”.–denial-of-service-attacks/2687323/

    Either way, does hiding the truth (however wince-inducing it may be) benefit small individual investors??? To me it’s a rhetorical question with only one obvious answer, but I’ll let BaselineScenario readers use their own judgment.

  19. Save this video for the serious talk with your children on the effects of crack cocaine. By sharing this video with your children you are helping in fighting an epidemic:

  20. First Lady of Wall Street dies……from too many bad bets and worthless subprime securities: “Muriel Siebert was the founder and president of the nationally renowned stock brokerage firm Muriel Siebert & Co. In 1967, she became the first woman to own a seat on the New York Stock Exchange. To this day, Siebert & Co. remains the only nationally known brokerage headed by a woman. On August 25th, 2013, Siebert passed away at the age of 80, leaving a remarkable legacy on one of the most iconic streets in the world, Wall Street.”

  21. Yea, seems as if she invested a bit to heavely with those, sinking indentures funds. And got shorted on the scale of years of life index to me. Oh well, life happens.

  22. The Leveraged Buyout Of America by Ellen Brown
    Giant bank holding companies now own airports, toll roads, and ports; control power plants; and store and hoard vast quantities of commodities of all sorts. They are systematically buying up or gaining control of the essential lifelines of the economy. How have they pulled this off, and where have they gotten the money?
    Part 1:
    Repoed! How The Fed And Depositors Fund Banks’ Big Bets by Colin Lokey
    Repoed, Part 2: A Deeper Look At Banks’ Source Of Dry Powder by Colin Lokey
    Repoed, Part 3: Proof Deposits Are At Risk And A Disappearing Act Explained by Colin Lokey
    Change your first line to: “In Hell, there are rarely battles between good and evil.”

  23. All “activists” are not equal…some are Hot as Dell:
    By Dave Warner [excerpts]
    WILMINGTON, Delaware (Reuters) – Activist investor Carl Icahn’s legal effort to derail a $25 billion takeover of Dell Inc stalled after a judge refused to fast-track his lawsuit against the personal computer maker, blunting an integral part of his months-long opposition campaign.
    Delaware Court of Chancery Judge Leo Strine on Friday waved off Icahn’s request to accelerate the lawsuit, dismissing claims that the company and its board wronged shareholders by accepting an undervalued offer from Chief Executive Michael Dell.

    Icahn had hoped to head off a September 12 special shareholders’ vote on a takeover proposal that the hedge fund billionaire and other major investors argue cheapens the company
    “The broader conflict between CEO Dell and Icahn adds more uncertainty to a company that once ruled the global personal computer market, but is now trying to move into the relatively unfamiliar field of enterprise computing services as mobile devices pummel sales of computers and laptops.”

    “Dell marks the latest board skirmish for the 77-year-old New York investor, who specializes in buying stakes in companies in flux and agitating for change. He has recently had run-ins with management at Biogen and Transocean Ltd

    By Roy Topol
    “…three professors from Harvard, Columbia and Duke Universities put out a comprehensive study, based on empirical evidence, which proves that hedge fund activism is good for shareholders, both in the short-term and the long-term. The research, titled “The Long-Term Effects of Hedge Fund Activism” is based on 2000 interventions of activist hedge funds from 1994 to 2007. The conclusions drawn from the study proved that during the five years following the intervention month, on average the operating performance of the companies improved relative to peers. Most notably, those companies that were targeted had significantly below average performance during the three years prior to the intervention. The study also found that while on average those shares spiked 6% in the period following the intervention, there was no notable negative share price performance in the period that followed.”
    But judging fruit in a mixed basket may not be very wise. The time period between 1994 and 2007 has some very specific characteristics. To borrow credibility currently from a study done prior to 2007 concerning “activist” intervention is highly questionable methodology without specifying the characteristics (reform/ conform /deform & bankrupt for profit…) precisely before presuming what a leveraged activist is intending. Hedge Funds today along with Private Equity generally are looking for new (victims) to capture and market. There is more money than cents going around, and true reform has to work against self-interests and “pricing” factors on the Stock exchanges. Quality is not necessarily the priority in succession planning and sustaining wealth growth agendas.
    Hedge funds have transformed eac year since 2000, and the article cited above refered to certian specific increases that would certanly change the playing field as well as the players in what is being glossed over as benign “activist” interactions in markets and Corporate structure. Consider:
    ” While shareholder activism used to be primarily in the small cap domain where fund managers could gain influence more easily, nowadays the spats have moved to larger companies, with hedge fund managers becoming more active among bigger companies as their vast assets under management (AUM) have grown. According to the Wall Street Journal, activist hedge fund AUM has grown from $12bn to $65.5bn in the last 10 years (Ibid).”

    When Public Private Partnerships first arrived on the scene they were a mutual interest synergistic process of resourcing that had efficient and selective processes at work. Today PPPs are tricky deals for private interests to get in the back door to public resources and privatize them in asset grabbing schemes that are a dime a dozen all over the country. One can expect that opportunists will take opportunity where it exists, and any merit to “activist” interventions will soon become big money and right wing capture for control fraud in vulnerable, tactical or strategic corporations. Power is power, and power in this time of history is ultimately abused and corrupted as tactics become methods of self service and private gain.

    Real News Network: (with transcript)
    Youtube: Part 1.
    How is Privatization Failing America?

    Real News Network: (with transcript) Ways Privatization Failed America – Part 2
    Youtube: Ways Privatization Failed America – Part 2

  26. I don’t think this type of behavior by activist shareholders helps. I think it distracts. Good case in point, look at Apple since Steve Jobs passed away in October 2011. Thanks largely to outside pressure the company has spent days, weeks, months debating and babbling what to do with the money they have on the books. Activists want the dough, Apple didn’t have a history of giving the dough. Big waste of time. They spent all the time talking about past performance (money on the books) meanwhile Samsung and Android are starting to eat their lunch. Best to leave the operation of a business to the leadership, unless they demonstrate they are truly not up to the task.

  27. The way this conversation has been going since the publishing of the book is akin to the disappointment certain kind of intelligent children feel when they realize that the bug that they have been studying is dumb when taken out of the role the bug was programmed to function in… so then to deal with such a neutral observation of fact for a normal mind, they then take out their dissedappointment on the bug – torture it because that is a more exciting input of psychological information about power for them.

    Yeah, we may all be human, but not all have humanity in them.

    Who stole how much out of Nasdaq the other day to pay for – well, what the heck are we going to call this? A free Fireworks Celebration for the entertainment of the Syrian refugees living outside in the hills somewhere…?

    The boss told me to go make a “statement” with our weapons.

    Now the boss is snickering, “….Let’s see what he comes up with – if it succeeds we take credit, if he fails we blame him….”

    Obambi had no clue…but then again, how many would care about truth and justice when the ego rush is “President of the United States of America”.

    I guess failing to provide enough economic security for a third of your population of citizens that had interesting lives at one time in USA wasn’t on the Prez political to-do list?

    It took 40 years to wreck the system – like water flowing over a rock everyday.


    DImon and his ilk act like it is bad manners for the people who they stalked for over a decade, setting up the transfer of wealth, stick around in the ‘hood. We admitted to having “failed” the American people. Go away…let us continue to live OUR interesting lives with your money….

    Wars launched and taxes taken to shove their lifestyles in your face….but that translates into the social manners of “…Bad form to stick around ol’e boy….” Yea, pops, except the algorithm I launched is a “perpetual” loop…I can steal to infinity and beyond…

    There are NO peace talks. Too expensive? Not being funded because of sequestration? CORPORATIONS can’t make $$ off of life-maintenance anymore, am I right? Man to land ratio…

  28. (One caveat: How long before Private Equity, the competitive Hedge Funds or aggressive rogue raiders begin to use this ‘political process’ of “minority ruling over the majority” to establish leveraged quasi-takeover formats that capture and control directorships over and against legitimate corporate leadership attempting to establish long term corporate equity and services over short term profits?).

    An activist shareholder uses an equity stake in a corporation to put public pressure on its management. The goals of activist shareholders range from financial (increase of shareholder value through changes in corporate policy, financing structure, cost cutting, etc.) to non-financial (disinvestment from particular countries, adoption of environmentally friendly policies, etc.). The attraction of shareholder activism lies in its comparative cheapness; a fairly small stake (less than 10% of outstanding shares) may be enough to launch a successful campaign. In comparison, a full takeover bid is a much more costly and difficult undertaking.

    Shareholder activism has gained popularity as “management compensation” at publicly traded companies and cash balances on corporate balance sheets have risen.
    A 2012 study by London-based research firm Activist Insight showed that the mean annual net return of over 40 activist-focused hedge funds had consistently outperformed the MSCI world index in the years following the global financial crisis in 2008[.
    %20-%20Nov%202012.pdf] The research firm stated findings: “Activist Insight Ltd has published a new index which displays the mean annual net return of over 40 activist-focused funds since 2006. Barring periods of almost equal performance in 2009 and Q1 2012, the ‘Activist Insight Index’ has consistently outperformed the MSCI world index in the years following the global financial crisis in 2008. This trend is most notable in 2010 when the average activist-focused fund returned 20.54%, outperforming the MSCI world index by 10.99 percentage points. It is also worth noting that an investment strategy tracking the MSCI world index would incur fees not represented by the index, making its outperformance by the AI Index all the more
    Meanwhile: the Institute for Policy Studies demonstrates that the “Leadership” (CEOs) have been gaming the system for personal gain for more than 20 years at progressive rates. This perverted incentive for CEOs may well become the underlying “MOTIVATION” for organized Activist shareholders rebelling against the trend.
    Executive Excess 2013: Bailed Out, Booted, and Busted

    “This 20th anniversary Executive Excess report examines the “performance” of the 241 corporate chief executives who have ranked among America’s 25 highest-paid CEOs in one or more of the past 20 years.

    The lavishly compensated CEOs we spotlight here should be exemplars of value-added performance. After all, sky-high CEO pay purportedly reflects the superior value that elite chief executives add to their enterprises and the broader U.S. economy.

    But our analysis reveals widespread poor performance within America’s elite CEO circles. Chief executives performing poorly — and blatantly so — have consistently populated the ranks of our nation’s top-paid CEOs over the last two decades.”
    Executive Excess 2013: Bailed Out, Booted, and Busted
    By Sarah Anderson, Scott Klinger, Sam Pizzigati
    Nearly 40 percent of the CEOs on the highest-paid lists from the past 20 years were eventually “bailed out, booted, or busted.”


  30. I hadn’t seen an updated list (since maybe around 2009) that I felt represented business blogs very well. In my opinion one of the hardest things about these is ranking them on what they actually do, for example there is a somewhat definitive difference between finance blogs and economics blogs. And some writers change pretty drastically. Mike Konczal used to be a very good finance writer, but now, since hooking up with Roosevelt Institute, he sees his gravy train as making extreme political arguments for the left. I should say I am a lefty, but I’m not a lefty just for the sake of being a lefty, or for the sake of running to the rhetorical rescue to put out fires everytime Pres Obama messes up (say for example broadcasting military actions to the world days/weeks in advance of actually doing them). Strange how Israeli Defense Forces have never tried this “tell them days in advance of striking” stratagem. Oh, you know those silly J E W S, always doing things the INTELLIGENT way. We Americans would hate to go down THAT silly road. Anyway….

    Here is a pretty good representative list of the most popular “economic” blogs now:

  31. I often woundered Bruce, how some CEO’s who are niether street smart, nor court smart, nor book smart, ended up with so much money. It’s like they read the Bible once, didn’t retain a thing, and all they have left to hold on to are those precious words on the greenback, “in God we trust”, and since they have plenty of it, they do. For now.

  32. @Moses – considering that only 9% of USA citizens – yes, that is NINE PERCENT – one out of ten people

    believe that “intervening” in Syria is warranted

    you need to specify who, exactly, are the STUPID Americans announcing that they are cuming…

Comments are closed.