It appears that the coming consolidation of the defense sector will be accompanied by a steady diet of shareholder activism. Shareholder dissatisfaction played a key role in the ouster of Northrop Grumman CEO Ron Sugar in 2009, and successor Wes Bush has made a series of moves aimed at improving shareholder returns. Then last year, investor pressure hastened the decision of senior executives at ITT to break up the conglomerate and spin off its supposedly under-performing defense unit. Now another group of activists led by Relational Investors is pressing L3 Communications Holdings to restructure and divest low-margin lines. L3 is one of the military’s biggest suppliers of electronics, and it typically is ranked one or two in the product areas where it competes.
That’s not good enough for Relational Investors, which complains that L3 shares are lagging both the Standard & Poor’s aerospace index and the broader S&P 500. It has bought over 6 million of the company’s shares to become its biggest shareholder according to the web-site 24/7 Wall Street, and it is leveraging its equity position to push for changes in what it calls a “sub-optimal business mix.” Other investors are watching the move closely, with expectations of a change in management strategy driving the shares to their highest point this year.
I don’t follow L3 or Relational closely, but I’ve heard all the standard rationales that are trotted out when aggressive investors decide to take a run at companies with lagging performance. They range from sage invocations of Joseph Schumpeter’s famous observation about “creative destruction” to the more recently fashionable contention that investors should diversify, not corporate managers. Sometimes the rationales sound reasonable, and other times they seem like pretexts for making a quick buck at the expense of long-term stakeholders. What tends to happen when such assaults are mounted is that the makeup of the shareholder population shifts, and its behavior towards management becomes more surly, because many of the newer holders are looking for a fast return.
The thing that most troubles me about investor activism of the type currently being aimed at L3 is the way it distorts the judgment of shareholders and managers at other companies. With ITT and L3 already in the sights of activists, rumors start spreading on the Street about additional companies that might become targets. That leads investors into making speculative bets and managers into launching short-term initiatives to spruce up results at the expense of a company’s long-term interests. Beyond that, anyone who follows defense stocks knows that the reasons companies lag or lead at any given moment often has little to do with management, because the government customer behaves capriciously. And within individual companies, different lines tend to do better or worse over time, so this year’s under-performer may be next year’s star.
Obviously, shareholders have the right to buy or sell shares as they see fit. But I can’t help thinking that a lot of what passes for shareholder activism resembles the behavior of predators on the edge of large animal herds. They isolate and take down the weakest members of the herd, even if the weakness results from a temporary injury that might soon have healed. And they never think about the larger interests of the herd or the savannah because after all, they’re predators. Maybe the survival of the fittest is the most we can hope for in the wild. But is that really the best way to manage our equity markets, when so much taxpayer money has been spent in building up major defense contractors?
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