Our recent explanation of constructivist investing leads naturally to a review of the range of potential approaches to activist situations.

These approaches all answer the question, “what about a portfolio company does an activist investors seek to change?” Or, what do you want company leadership to do differently?

As it turns out, constructivist investors don’t have a single, clear answer to this question. Their tactics tend to revolve around basic company operations, like supply chain, marketing, or IT, to name a few areas.

This exercise lends itself to kind of formal listing or taxonomy of potential activist approaches. Thus, some might recognize these different forms of activism:

1. ❖Social
   

2. ❖Governance
   

3. ❖Operational
   

4. ❖Financial.
   

We put together an earlier version of this structure in our white paper on activist investing. Some of the thinking from the white paper continues to apply here. We’ll mention social activism briefly, and discuss governance, operational, and financial activism in more detail.

This structure leads to some striking conclusions about how operational activism has the most impact, how financial activism should be easier to pursue, and how governance activism enables these other two.

Social activists push a specific social or ethical issue, say treatment of animals or disclosure of political contributions. As the white paper argues, few executives or other investors take these activists seriously. So, we like it when certain portfolio companies make appropriately shrewd political contributions, and otherwise have no use for social activist investing.

Governance activists advocate for changes in how a company relates to shareholders. This includes how the BoD works, how shareholders own and vote shares (dual classes, poison pills), and even exec comp. These investors are mostly public pension funds and similar institutions that work through the Council of Institutional Investors.

We (and others, like Nelson Peltz at Trian) think of operational activism as affecting a portfolio company’s income statement or cash flow. It mostly entails company expenses, such as on R&D (the core of the Valeant project at Allergan). We include criticism of executive perqs, like corporate aircraft, here.

In contrast, financial activism concerns the dreaded financial engineering that enrages those that slam activist investors as short-term opportunists. It affects a company balance sheet, say through restructuring debt and equity, and most often, return of surplus cash.

With these dimensions in mind, we have several comments.

1. 1.Some activist investor concerns don’t fit neatly into one or the other. For example, the effort at Darden to restructure the company and its real estate holdings affects both the income statement and balance sheet. (We have in mind a guide, not an absolute rule.)
   

2. 2.Activist projects can include both operational and financial activism, and also governance. The situation at Sotheby’s covered all three areas: expense management, investments, and BoD structure.
   

3. 3.Governance activism really becomes a means to an end: poor corporate governance can block operational and financial activism. Governance activism as an end itself doesn’t have nearly the impact as governance activism combined with the practical business improvements inherent in operational and financial activism.
   

4. 4.To us, exec comp reforms fall within the governance activism category. The size of exec comp packages doesn’t have a material impact on net income or cash flow, or cash balances. Yet, the incentives in a sound exec comp structure can affect both operations and finances significantly.
   

5. 5.Most governance changes make good sense. Companies have reacted accordingly, and implemented many, such as majority voting for the BoD. The problem lies in the effectiveness of these proposals. Extensive research has led to at best inconclusive results connecting governance changes and investor returns.
   

6. 6.Operational activism has a longer-lasting impact on a portfolio company. It improves income and cash flow, which yields benefits for many years. It typically demands deep industry experience and expertise, and detailed operational information not typically found in SEC filings.
   

7. 7.Financial activism is relatively simple. It requires only an appreciation for the risk and reward preferences of the investor, and risk and reward profile of the company. It doesn’t have a long-term impact, seeing as balance sheet changes, in particular return of surplus cash, works mostly once. This of course leads to the (erroneous) critique that activist investors want only short-term gains from their efforts.
   

These last two comments lead to a critical attribute about the different flavors of activism. Considering the business improvements arising from operational activism demands a real debate. Management wants to run the business one way, while investors want to do it another. Valeant and Allergan have different business models, either of which can work well. CEOs can make a reasoned case for most any kind of spending, even on the corporate jet. It takes serious research and effort to persuade company leadership, and other investors, that your view of company operations should prevail.

Financial activism leads to a different, easier discussion. CEOs can’t legitimately and honestly argue about

investor preferences for more cash, or lower taxes, or for other consequences of better balance sheet management through financial engineering.

As for us, we like easier. We‘ll gladly take the short-term results from financial activism, and leave operations to the executives.