Shareholder Activism, Mutual Fund Style

The battle over the future of  Dell has appeared prominently in the financial media lately. Founder and CEO Michael Dell wants to take the company private in partnership with a private equity firm, while some major shareholders oppose the deal.

When investors clash with company managements, mutual fund advisors typically aren't among the players. By and large, these dramas feature hedge fund chieftains such as Daniel Loeb and Bill Ackman. But in the Dell saga, Southeastern Asset Management, advisor to the Longleaf funds, has been a leading participant. In mid-May, Southeastern teamed up with investment heavyweight Carl Icahn, going so far as to publicly propose an entirely new deal as an alternative to the plan presented to Dell shareholders by Michael Dell and the Dell board of directors.

While this level of shareholder activism is rare for mutual fund advisors, it's not unheard of. Moreover, recent features in the New York Times and Wall Street Journal highlighted how some big mutual fund shops have increased their attention to corporate-governance issues of the companies held in their funds' portfolios, albeit in less contentious or public ways.

All this talk may have roused some fund investors' curiosity. What is activism? Why do mutual funds adopt this tactic? Why don't more do so? What are the arguments for and against?

What is Shareholder Activism?
In a formal sense, activism could be defined as the time when an investment firm files a document with the SEC that officially changes its status from a "passive" shareholder to an "active" one. That often means it will actually play a role in critical company management decisions such as whether to divest an important unit or accept a takeover bid for the whole firm.

But the concept can be interpreted much more broadly, too. An investor can agitate for change without taking this formal step; for example, by suggesting in private talks with top executives that they consider selling a division or ramping up overseas expansion. That said, when one thinks of "shareholder activism," it does tend to mean more than just siding for or against management in a regularly scheduled proxy vote or passing along advice in a friendly meeting with the CEO.

Good Reasons Not to Become a Shareholder Activist
The disadvantages are numerous, so let's cite those first. Most notably, becoming a shareholder activist can take an enormous amount of time and energy. Even some of the more prominent mutual funds have compact investment staffs, and the portfolio managers may judge the time and effort required to be far out of proportion to the potential gains. That's particularly true if the holding in question makes up a tiny part of a much broader fund portfolio. The potential for distraction from the rest of the job is a clear risk.

Another argument against going activist is that it can limit investment flexibility. When a fund passes a certain point at which it can be deemed privy to inside information, or simply wants to avoid the appearance of trading on such, it must stop buying or selling any shares of the company in question. Needless to say, fund managers don't like having their hands tied for an extended period, especially with a controversial stock whose price might be fluctuating wildly.

Shareholder activism can also involve monetary costs, especially if the dispute goes to court.

A final reason to shy away: If an advisor gains a reputation as a rabble-rouser, there's a chance companies may be less likely to engage in the regular, friendly meetings that fund managers and their analysts consider critical to gaining an understanding of firms and their strategies. That's why fund managers who do want to have some input into company decisions are far more likely to provide advice or suggestions informally, outside of the public eye and without having to file with the SEC.

For these and other reasons, mutual fund managers--including those who pursue the activist route on occasion--will almost always simply sell a stock when they're unhappy with management's direction rather than try to become actively involved in altering that course.

Taking the Activist Route
With all these points in the minus column, why go activist? When a fund manager firmly believes that a company in his portfolio is worth much more than its current stock price, and that certain changes would push that price upward, assuming an activist role can seem well worth the effort. Some managers think that selling the stock at what they consider a depressed price would be a betrayal of their duty to the fund's shareholders.

However, even with such conviction, to make such a project worthwhile several other factors should be in place. The stock should be a substantial portion of the fund's portfolio; no matter how convinced a manager is that a stock is worth far more than its current price, it's not worth going activist if that stock makes up a mere 1% of the fund's portfolio. That reasoning explains why the relatively few instances of mutual fund activism tend to come from fund managers who have concentrated portfolios.

Another factor is the chance of success. Does the fund own a substantial amount of shares in the firm in question? Does it seem likely that other major shareholders will take your side? If the answer to either question is no, activism is likely not a prudent course, no matter how solid the arguments in favor.

Conclusion
Whether the activist route makes sense, therefore, depends on the specific factors in each case. Engaging in a long, drawn-out battle can seem like a distraction from the manager's investment focus, but a successful effort can pay off with huge rewards for fund shareholders. Mutual fund managers have shown through their actions--or more accurately, lack thereof--that the answer is almost always no. But the shareholder activism card remains available for those who believe the benefits could be worth the cost.