Fortune Insider  Activist Investors

Nelson Peltz and activist investors are not as evil as you think

Activist investors are actually doing something good for the companies they target, the economy as a whole, and quite probably your portfolio.

It’s one of the most fundamental questions in business: Do you issue dividends or re-invest in capital improvements and R&D to strengthen a company for the long-term?

Much has been said recently about the evils of “short-termism.” It’s the M.O. of activist investors who take sizeable stakes in companies, then agitate for changes they think will boost share prices. Take for instance Nelson Peltz’s Trian Fund Management’s unsuccessful proxy fight over board seats at Dupont (DD). Short-termism, critics say, diverts funds from investments that can produce sustained growth — such as workforce training and new product development – but have little immediate payoff. The short-term investors, meanwhile, benefit from a spike in stock prices, and take their money and run.

Or so the common wisdom goes.

Granted, investors have been turning over shares much faster over the past two decades. About 20 years ago, the average share in a public company changed hands about once a year; now it’s once every four months. But short-termism isn’t the scourge it’s cracked up to be. Here’s why:

Short-term trading doesn’t equal short-term decisions by managers.

It’s logical that company executives, eager to appease shareholders, might make short-sighted decisions. Think about it: shareholders receive a return in one of two ways. One is a current dividend; the other is the price at which they exit. Assuming an efficient market, stock price is the properly discounted value of future cash flows. If a company damages its long-term prospects, the exit price is low. That’s something no one wants, especially short-term investors.

Activists play a vital role in markets

Markets are not necessarily efficient for all stocks all the time. Market inefficiency implies mispricing, which is why active investors exist. Based on the horizon of mispricing, active managers specialize. Some, such as Warren Buffet, specialize in long-term mispricing. Others specialize in the shortest-horizon mispricing, e.g., high-frequency traders. Activist investors exist in the middle of this spectrum, two to three years on average. They target firms whose current prices are not necessarily mispriced but are undervalued relative to its potential. Once the undervaluation is corrected, the activists move on.

Dividends remain in the ecosystem

People tend to associate certain policies, notably paying back cash to shareholders, with short-termism. They assume that the funds used for payback disappear from the ecosystem. If cash reserves are parked in T-bills, it’s more productive to put the money back into the hands of shareholders who can then choose to invest in firms and ventures they deem promising. In the end, payouts do not necessarily reduce investments, but allocate the choice of investment from managers to investors.

R&D is a form of investment that should be subject to economic reasoning.

The most compelling defense of activist investors is that they don’t impede innovation. In fact, they help reshape it.

Activist investors don’t slash budgets indiscriminately. They treat R&D as a form of investment where an investment with a positive net-present value will be a profitable one.

Research I conducted along with Alon Brav and Song Ma of Duke University, and Xuan Tian of Indiana University, shows when activists targeted firms with diverse business portfolios, they examined whether outlays for R&D were directed toward the firm’s core competency. If not, those funds were likely to be cut. The activists’ intentions weren’t malevolent; they simply wanted to ensure that companies were highly focused.

Short-termism doesn’t artificially inflate stock price

There is no evidence that investors systematically undervalue firms whose projects are long-term where cash flow is highly uncertain and will take significant time to materialize. In fact, multiple market-wide bubbles were formed by investors’ unrealistically optimistic valuation of such firms.

It’s hard to argue that short-term investors are bad for business. So give them a break. They’re actually doing something good for the companies they target, the economy as a whole, and quite probably your portfolio.

Wei Jiang is the Arthur F. Burns Professor of Free and Competitive Enterprise at Columbia Business School. Jiang is also director of the school’s Jerome A. Chazen Institute of International Business.