The Effectiveness of Institutional Activism

We examined earnings-forecast revisions and stock returns after release of the Focus List of poorly performing companies by the Council of Institutional Investors. Using Tobin's q as a measure of a company's ability to improve performance, we found significant and positive abnormal forecast revisions and post-release stock returns for companies with q greater than 1. For companies with q less than 1, neither forecast revisions nor post-release stock returns were significantly different from zero. For the full sample of companies on the Focus List, regression analysis showed a significant positive relationship between forecast revisions and post-release stock returns. These findings support our proposition that institutional activism is effective for underperforming companies—but only those companies with the ability to respond to the challenge to improve performance. Is institutional activism effective in prodding companies to improve performance? The answer provided by previous research is that, although shareholders can influence governance decisions, such as the adoption of a poison pill, their actions have little influence on equity values. Representative examples of this line of research have found no stock market reaction to public announcements of shareholder-initiated proxy proposals and only insignificant abnormal returns around the date of proxy mailings by activist pension funds. Such studies provide seemingly convincing evidence that actions by institutional investors do not influence management performance in meaningful ways. We took a fresh look at the question by examining the announcement effects of being included on the Focus List published by the Council of Institutional Investors, an association of large pension fund management firms. The CII Focus List identifies underperforming companies. By doing so, the CII hopes that its members will focus attention on these companies and that a collaborative campaign by members will then compel an improvement in managerial efforts and company performance. Increased attention means little, however, to companies that lack the tools necessary to improve performance, tools that may include competitive positioning, cost advantages, and growth opportunities. To measure whether companies on the Focus List had the necessary tools, we used Tobin's q, the ratio of the market value of the company to the replacement value of its assets. We argue that those companies with Tobin's q greater than 1 have the needed tools to improve whereas companies with Tobin's q less than 1 do not. To test the effectiveness of the potential collaborative effort to encourage improvement in performance, we examined abnormal stock returns and revisions in analysts' earnings forecasts for the companies appearing on the Focus List. For the full sample, we report significant mean cumulative abnormal returns (CARs) of −12.33 percent in the three months leading up to release of the list, significant announcement-period returns of −0.91 percent, insignificant earnings forecast revisions, and insignificant post-release CARs. These results support the findings of previous studies. When we split the sample on the basis of q > 1 and q < 1, we found negative pre-release and announcement-period CARs for both groups. But the similarities end there. For the companies with Tobin's q > 1 (those with the necessary tools to improve performance), we found significant positive revisions in analysts' earnings forecasts and significant post-release stock returns of +7.01 percent. Thus, we conclude that the stock market considers being on the Focus List bad news for all companies, but analysts see a silver lining for the companies whose Tobin's q is greater than 1. The analysts apparently use appearance on the list as a sign that these companies will buckle down to improve performance and thus a sign to upgrade earnings forecasts for the companies. And subsequently, stock returns rise to reflect the improved earnings outlooks. For companies with Tobin's q < 1 (those without the tools to succeed), we found no such silver lining. Both earnings-forecast revisions and post-release equity returns were insignificantly different from zero. If we had not split our sample, we would have concluded, as previous researchers have, that institutional activism is ineffective in influencing manager efforts and company performance. Only when we recognized that the sample consisted of two distinct groups did we find evidence supporting the effectiveness of institutional activism. We conclude that institutional activism can be effective but only for those companies with the necessary tools to respond to the challenge to improve performance.