Are activist investors good news for shareholders?

In the past few decades we've seen the rise and rise of the CEO.

While entrepreneurs have always been lavishly rewarded, it's now common for those running established companies to get huge packages running into the millions, or even tens of millions.

Some argue that those who can deliver top returns for shareholders deserve every penny they get. But it's increasingly clear that many CEOs are taking advantage of their power to put their own interests above those of the company.

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For example, we don't know how aware the management were of VW's problems. But the fact that the CEO resigned clearly suggests he wasn't doing his job properly.

Some investors aren't happy about this, and are taking a much more active role in the day-to-day running of the companies they have a stake in. Some even invest in firms they see as poorly run, with the aim of changing them from within. So should you follow them?

Ownership and control aren't always the same thing

In a nutshell, the problem is that the people who run the firm (CEOs) are separate from the ones who own it (shareholders).

Before the industrial revolution, individuals ran most firms. These owner-managers had every incentive to focus on the bottom line, since the only people they'd be cheating were themselves.

However, the rise of heavy industry meant that large sums of money had to be raised in order to buy machinery. Most of this money came from shareholders. Suddenly, instead of one person owning a company, you now had large numbers of people owning a small stake, with all but a few having no direct role in the company.

This is a particularly big problem in large global firms.

To take one example at random, the largest shareholder of Apple is the Vanguard Group of tracker funds, which owns around 6% of shares. In contrast, CEO Tim Cook owns less than 0.2% of shares. But who has more influence on the day-to-day running of Apple? The answer is clear. And a similar story can be made for virtually all the other large-cap companies in the major indices.

This breakdown between managers and owners matters, because it makes it hard for individual investors to get involved in the running of their firm. The fact that managers tend to have relatively little of their own money invested in the company, means they might not always act in its best interest.

In some cases this shows itself in self-serving behaviour executives voting themselves large salaries and lavish perks, such as trips on executive jets and expensive holidays. In the worst case it can lead to executives cooking the books or turning a blind eye to corrupt practices.

However, the consequences of lax oversight aren't usually that dramatic. In most cases it involves managers getting away with poor performance. While firms still have to deal with pressure from competitors, there have been countless cases of well-known firms aimlessly drifting, or sweeping problems under the carpet, until it is too late.

How can investors gain more influence?

Some investors use activism as an investment strategy. In this case they buy big stakes in poorly performing firms and use their power to force a change at the top, hoping that this will boost the share price.

Of course, not every intervention works. In some cases an activist investor's ideas might be rejected or ignored. In others, they might be counterproductive.

Indeed, there has been growing criticism that activist hedge funds and private equity groups make it hard for executives to take tough decisions that will boost returns in the long run. In other cases, they have even been blamed for asset stripping and getting firms to take on too much debt.

However, the evidence is that, on balance, activists boost performance.

A recent study by the Wall Street Journal looked at 71 campaigns by activist investors. It found that the median campaign increased returns by 5% a small but significant amount.

This boost doesn't seem to have been at the expense of long-term performance either, with capital spending increasing more times than it fell. Another study by The Economist found a similarly positive outcome.

How can you profit from this?

A cheaper alternative is to buy the shares of companies targeted by activists, or which have recently made changes to their management under pressure from activists.

One such company that has recently made major changes due to activist pressure is Alliance Trust (LSE: ATST). This investment trust has had a mediocre record, and trades at a discount to the value of its assets. However, it has promised to make major changes, including slashing fees. We've given our verdict on it in this week's issue of MoneyWeek magazine.