A progressive’s liberal’s answer on why we don’t do shareholder Activism

Jason started an interesting discussion in off the cuff, so I’d like to use an FP post to answer it.

The reason you don’t see active takeovers or stock holding en masse as a way to organize activism are as follows:
1. Collective action problem.
In order to make a sufficient difference via shareholder activism, you need enough money and shares to make the board listen. To do this you need to pool a certain amount of money, and coordination problems are the rule here. (H/T to Dr. James Hanley for making this point earlier and bringing my attention to it.)

2. Profitability & Feasibility
Once the collective action problem is solved by pooling the money through some sort of financial instrument, you run into the problem of needing to make money. It’s for this reason socially responsible investing (where you support practices you like) is far more prevalent than Bruce Wayne/Tony Stark fantasy capitalism (where you, with huge controlling stake in a company sack board members that advocate types of businesses you don’t like and practices you abhorr).

When a firm behaves abominably, it’s likely that to some extent it’s doing so in order to maintain margins and thus its value. If you go in and end these practices, at the very least in the short-medium term the value and profitability of the firm is likely to suffer immensely and your own investment return on the capital you threw into acquisition (which would pretty substantial) would lose value.

Depending on the business model, it’s even possible you’ll drive that firm into bankruptcy in the process, which wipes out most of your value.

Meanwhile for socially responsible investing, you make a firm behave well in order to attract your money. You don’t have to actually take over the firm and more actively manage it, much less risk losing money over it.

So let’s say you have a billion dollars.
You can either use it to buy a controlling stake of firm A which is worth 1.5 billion dollars, or add shares of firms B, C, D, E and F, which are all worth about half a billion dollars.

Firm A does terrible things, like use Chinese slave prison labor to keep costs down, uses napalm to clear spaces it wants to extract resources from and kicks puppies in the stomach every day. This allows them to undercut their competition, but when you make the purchase you lose market share because your pricing increases by some decent margin allowing the other “behaving” firms to compete. As a result firm A is only worth 750 million dollars, your own share value has gone from 1 billion to 500 million, leaving you with less money on your next venture.

By contrast when you invested in firms B, C, D, E and F as part of your socially responsible portfolio that made sure you only invested in firms that didn’t do the things firm A was doing in previous example, you only gave them about 200 million each (a 40% stake or so). Of the 5 firms, B and C went flat out bankrupt. Meanwhile D and E managed to add about 20% more value while F has doubled its value due to capital improvements.

This means your 200 million shares worth became:
B = 0
C = 0
D = 240
E = 240
F = 500

Leaving you with 980 million dollars at the end of it. Granted, you lost money (and your fund manager’s not gonna be happy explaining that to your investors) but you still have far more money than in firm A’s case, and you have 3 firms doing things you like. Further the firms themselves are collectively worth substantially more (1 billion vs. 2.2 billion) meaning presumably, their influence on the economy and on practices is larger.

(*Note: This example is a gross simplification and does not effectively match the realities of the market. I know this, it’s done for the sake of illustrating an example)

3. Standard setting/Norm Creation
Finally, I think the reason “progressive” behavior focuses on things like third party verification and socially responsible investing is that these things do something that single company takeovers don’t: They create standards and set norms for corporate behavior.

While the firms might only half-heartedly embrace these measures (as you’re only one shareholder among many), they are more likely to do so in a climate where the norm is to do it to help attract capital. Standard setting and demand generation are both extremely important elements of non-governmental solutions to a lot of liberal pet issues like wages, environmental impact and human rights abuses. By choosing to focus on broad, “bird shot” scatter shot techniques, the goal is more to create demand and set norms of behavior.

I suppose if one wants to compare it to the IR realm: Jason’s solution is a lot like invading a single country to keep it away from Weapons of Mass Destruction. Sure, it can work, but it has enormous costs and the potential to ruin you in the process. Much better to work to set international norms toward disarmament, by making efforts to create norms through treaties like the NPT, and to give carrots to states that do what you want by providing technological assistance.

P.S. – I’m open to the idea that I’m wrong, and would be happy to have counter-examples brought up on why this overview is inaccurate. I’m also curious if anyone has read any research papers on whether or not shareholder activism (and what level of shareholding is required) is effective in modifying firm behavior in any macro sense.

P.P.S. – This should actually read “A liberal’s answer”…I’m a liberal not a progressive, dammit.