CHAPTER 7

Engaging with Investors

A quarter of a century ago, corporate power rested in the hands of the imperial CEO, who might simply tell you to dump your stock if you didn’t like what he was doing (and it would always be a “he”). Since then, long-term investors and activists have taken the stage and, along with market forces, are now holding boards to account. In managing their company’s talent, strategy, and risk, and especially in planning for the long term, boards must also manage the relationship with investors, their most powerful constituency.

This boardroom mandate is essential because investors—especially a company’s permanent shareholders—are collectively the primary driver behind the new TSR. These investors are demanding that companies abandon the practices that encourage pursuit of short-term gains—such as compensation structures skewed toward stock market performance and acquisition strategies designed only to buy revenues. A quick hit in the market does nothing for a long-term investor, especially if it hampers opportunities for strategic moneymaking initiatives.

Index funds can’t apply leverage to management by threatening to sell their stock; they buy shares and hold them in perpetuity. Instead, these investors are seeking influence in boardrooms. And their aim is to refocus the attention of management on a different set of priorities—on long-term planning; on improvements in execution; on talent, strategy, and risk.

This relationship between companies and investors is sometimes collaborative and sometimes adversarial, and knowing which way the compass will point is not always an obvious matter. For that reason, the attitude of board members to investors is often wary and watchful and, in the case of activist investors with their frequent pressure for short-term gains, outright distrustful.

We can tell you that distrust is not an action plan. Investors are not created equal—even activists. All have their own objectives. Each will have a frame of reference and a model of investment, and no two investors will have exactly the same one. They collect different information and have different ways to diagnose it and different objectives. Boards must learn what their model is.

In dealing with investors, you must also keep in mind that the failure of an investment has a greater impact on the income of an investor than on the income of a board member and a greater impact on the investor’s reputation, too. If directors fail—if the board fails—they may dent their reputation but lose very little money. The investor loses their paycheck and the ability to raise funds in the future. It’s the investors, not the directors, who take the loss. So do all that you can to understand the criteria on which investors base their decisions and conceive of their risk.

Investors are almost always smart, often with insights about your company and its competitors. Think of your investors—your owners—as a resource. Whether or not they are hostile to your long-term objectives, they have information that can help you and that is worth getting, no matter their aims.

We can help you decide how to manage this relationship productively—how to meet with investors, and when; how to get their useful feedback; how to understand what each type of investor is looking for; and how to deal with activists. And we will show you what one major activist looks like up close. (See figure 7-1.)

Meeting with Investors

Some boards resist talking to investors, leaving the job to management. We believe meeting with investors is an essential responsibility of the board. As we saw in chapter 6, investors can be an independent source of the critical information that boards need so that they know as much as management does and can plan for long-term value. Smart boards are engaging with investors to redress this asymmetry of information.

Take the example of Estée Lauder Companies, which had a policy that discouraged directors from talking directly with investors. The rationale for the policy was that management was already spending a lot of time and resources on investor engagement. Not too long ago, Vanguard asked to have a meeting with the head of the board’s compensation committee. The board went back and forth about whether to take up the invitation. Finally it did.

For Lady Lynn Forester de Rothschild, who sits on the Estée Lauder board, the meeting was an eye-opener. The head of the compensation committee was able to bring back to the board some insights that management hadn’t shared with it about its own interactions with investors. She says, “I was skeptical of board engagement with institutional investors, but I now think it is a really good idea for both sides. It’s one that makes management, for obvious reasons, nervous. But I think we should try to do as much of it as the investment community wants.”

Engaging with big shareholders can help you identify which are in it for the long term and which might align with activists. The big challenge is short-termism—the pressure to make a quick profit. So often, doing so will not be in the best long-term interest of the company. That is why the issue of shareholder engagement is so important. The point at which an activist arrives is not the time you want to inform and educate your major investors about your story and your strategy.

A clear rationale for what you’re doing and what to expect can also keep activists at bay even if your strategy is atypical for your industry. When Raj Gupta, current chair of Aptiv, was on the board of Tyco International, the activist fund Relational Investors took a position in the company. Gupta says, “They came out and met with Ed [Breen, the chairman] and CEO George Oliver, and they walked away and sold their position in three months. They said, ‘You guys are doing just about everything we would do.’”

Communicating clearly with investors can keep them on your side when you stumble. If you do what you promise, you’ll get a pass for hiccups that might occur along the way.

What investors want to know

When you meet with investors, they are likely to ask questions designed to expose your vulnerabilities—operational, financial, and competitive. They will also be probing the effectiveness of your measures for overseeing the management team. Their aim is to ensure that you are managing talent, strategy, and risk to enhance shareholder return. But whether they are angling for a short-term gain or long-term value will depend on the investor.

For some players—index funds and activists, say—you may know their frame of reference going in, and you can tailor your preparation for meeting with them accordingly; for others, you might only learn about their agenda when you hear what they want to know. But in all cases, the work you do to prepare for their questions can also help you crystallize your plans for creating long-term shareholder return.

Among the most critical questions you will face from investors are those focusing on how the board ensures that management isn’t making short-term decisions that hamper value creation. They will seek to know whether the directors—collectively and individually—subject management to sufficient levels of scrutiny or whether they tend to give management a pass.

To prepare for these questions, you have to think like an investor, which necessitates candor in sizing up your fellow board members. In assessing the performance of former CEOs on boards, Dan Riff of Advantage Solutions looks to see whether they bring the same level of expertise and urgency to their board work that they did when they were running their own company in a way that created value for Advantage’s clients. He says, “Sometimes they retire from CEO roles where they were amazing and settle back a bit on the board and rubber-stamp a lot of what the others are doing. When was the last time the board really got in the field and got its hands dirty with upper-middle management?” If the answer is anything other than “recently,” the board isn’t doing its job.

Investors may also ask how the board prepares for succession, both in the company and on the board itself, and how it ensures that the company is building the capabilities it will need for long-term growth. To that end, investors will want to know how the board develops its own sources of information so it can make independent judgments about the market for talent. After all, if the directors don’t have independent information, how can they ask the right questions?

You should be ready to explain the logic of the CEO’s compensation as well. The level of pay, along with the types of compensation and the trigger for enhanced rewards, will tell investors whether the company is emphasizing short-term or long-term growth, or keeping the two in balance. For instance, annual bonuses and rewards often go up when the stock rises. But if the CEO gets a 200 percent bonus for exceeding the targeted share price, that’s a driver of short-termism. If management pulls money from the future to meet short-term goals, investors will want to know if the managers must first seek board approval.

To get a handle on what the board is doing to manage talent, strategy, and risk, investors will look to see how the board is spending its time. What are the biggest debates at the board level? Are they about procedural issues or truly focused on strategic opportunity and risk? How do directors think about the holes on the board? What skills does the board lack as the business is evolving? How much time do directors spend on each important matter in their purview? Is the board engaging with outside experts to help make decisions on large capital allocations?

Investors will ask stakeholder questions, too. What has the board done to help the company be a good corporate citizen, to promote diversity in the company’s ranks, to respond to climate change and the possibility of requirements for zero-carbon initiatives?

Investors may ask how the board thinks about metrics. In most companies, management sets the metrics by which the company tracks value creation. Does the board ever question them or ask management to change them? Whether you speak to the question or not, investors are going to spend time poring over your proxy statements, which may give insight into the metrics that the board considers along with incentives and ownership levels in the company.

The lesson: you should be sure to know as much about your company as your investors do.

When to meet with investors and what to tell them

Boards meet with investors to get the benefit of their information and their analysis, but the same research will support different feedback depending on the investors’ objectives. Still, some principles will govern the ways in which you establish a relationship with any of them.

A key imperative of the engagement is having regular meetings. Creating a relationship with an investor takes time; you want to solidify that relationship before you need their help. Former Xerox CEO Anne Mulcahy would aim to meet the top twenty or thirty investors every eighteen months to two years. She says, “The intent is to have a regular cadence so that you can actually have relationships. It’s both listening and sharing messages that you’d like them to hear on issues that are critical to the board.” She also recommends meeting with any sizable investor who has requested engagement with the board. Mulcahy says, “Try to say yes 99 percent of the time.”

Pacing, though, is important if you wish to keep major investors engaged instead of crushed by information overload. Shelly Lazarus, former CEO of Ogilvy & Mather, recalls a conference call with major investors across the country. Speaking to the representative of a state pension fund, a BlackRock rep said, “You’re inundating us with information. We can’t handle that level of interaction.”

The takeaway: if every management team of every publicly traded company takes as best practice the need to reach out to every major investor, the investors will be overwhelmed. So when contacting an investor, be cognizant of their time constraints. Be focused. Lazarus’s observation: “Know what you want to get out of the meeting. Know why you’re having it. Know the value of the interaction.”

For that reason, some investors advise taking a lighter approach to shareholder meetings. Daniel Pozen of Wellington Management says, “I wouldn’t prescribe boards to interact on a regular basis with all sets of shareholders. It would be responsible practice for a board to invite one shareholder per year to give a presentation on their perspective of the company.” The shareholders should rotate. Perhaps one year it could be a passive shareholder, and another year a long-term active shareholder, and then perhaps a former shareholder who exited for a certain reason, and the next time a shareholder with a medium-term time frame.

What to make of these varied opinions? Tailor your approach to the investor and be honest with yourself about the position of your company. Know that the desire of investors to meet with a board, and the frequency of the meetings, will be a function of your company’s size and the size of their investment.

Who should take the meeting?

We propose that the part of the board best prepared to engage with investors is the talent, compensation, and execution committee. In our model of board committees, the chair of the strategy and risk committee would also be on the talent, compensation, and execution committee. Thus, it’s the one place on the board where talent, strategy, and risk all converge.

Before members of any committee sit down with investors, be sure they are very well prepared. Nothing creates a worse impression on investors for board members to show up at a meeting clueless and ill-informed instead of fully briefed.

Directors should not overreach in what they disclose to investors. While the board should have open lines of communication with investors, the key person in the company to tell shareholders about important information is the CEO. How much should companies disclose? The best practice is to be transparent and then meet your commitments—do what you say you’re going to do, even if it isn’t a particular investor’s favored strategy. For instance, GM has a diverse investor base, with widely different time horizons. The company tries to manage the relationship with each investor, but always doing what it believes to be the right thing for long-term shareholder value.

But since communication is a two-way street, GM’s Mary Barra recommends openness to ideas from any investor. She says, “The first thing we do when we get a suggestion from an investor is ask, ‘Hey, is this a good idea? Let’s go research this.’” After every earnings call, she reaches out to a wide variety of GM’s top investors but also to hedge funds with a short-term focus, and she tries to listen to all of them. She usually participates on three or four of those calls, and the head of investor relations and the CFO do so as well.

Those calls have led GM to undertake some new initiatives, especially on environmental issues, with the company adopting a more cohesive and comprehensive set of sustainability goals. Gathering good feedback is a great way to take advantage of your quarterly earnings call.

Warren Buffett also counsels openness with investors. Indeed, he believes that he should tell stockholders as much about what’s on his mind as he would share with his two sisters if the three of them owned the company together—what things were worrying him, what the businesses were worth and why, how durable their competitive advantage was in one company versus the others, how he would allocate capital in the future.

Buffett says, “The CEO absolutely owes that to the owners. I have a strong feeling that everybody’s entitled to the same information, and that means the important information about valuation prospects, and personnel, if it’s important—exactly what you would tell somebody who was your silent partner if you had a two-person business.” If that job is being done inadequately, he believes the directors ought to say so. He has no problem if people want to talk to his directors about whether he’s living up to what he says or whether there are issues that he just doesn’t get.

But he wouldn’t delegate that job down the line. He says, “The person who’s going to be responsible for the assets and how they’re managed over time is the CEO, and you really want to hear from that person. And you don’t want somebody else writing the report for them. I do not want some investor relations department pulling up a report with a lot of information that’s not important.”

In other words, it’s not the board’s role to disclose anything material about company financials or plans for the future. That’s a job for management. It’s fair for directors to tell investors how they oversee talent, strategy, and risk, and the management team, too. But the board’s main task is to find out what investors think of the company and what they know about it.

Should you give guidance?

One of the thorniest issues companies face in dealing with investors is whether or not to give guidance. Our advice: don’t do it. Or if you must, leave yourself plenty of leeway. Anything else is a fool’s game. We agree with T. Rowe Price, which gives no guidance to its shareholders because it can never be sure what the numbers are going to be. Former chair Brian Rogers says, “As a public company ourselves, we avoid the guidance business like the plague. Companies and managements always want to underpromise and overdeliver, but all too often management teams get caught up in the overpromise because it feels good in the short term. And then if you disappoint, there’s hell to pay.”

Rogers recalls that some years ago, the CFO of J.P. Morgan was in the office, and his company was pushing for more guidance. The CFO said, “Look, all I can tell you is we have a return on equity objective, and you know what our book value is, so you guys figure it out.” That was the extent of the guidance—a figure with a huge band around it where the likely outcomes would be. And that’s really as far as you should go.

Guidance isn’t often very useful for anyone, either. If a stock goes down because of a nonstructural issue, the price will usually bounce back soon, because its ten biggest shareholders—all of them long term—will own at least 50 percent of the shares. The rest will be in the hands of activist traders, and they have to react. But withholding guidance will change the behavior of analysts, and it will change their advice.

Guidance promotes short-termism. If companies can get out of the guidance business, or at least make guidance very long term, they would give themselves more room to follow long-term objectives.

How to Deal with Activists

For companies looking to manage for the long term, activist investors can pose a special threat, especially those who take a sizable position in your stock and press for a quick hit. Our advice: be on guard for the worst, but don’t assume activists are the root of all evil. And even when their goals are misguided, they can be a fount of information.

In our experience, activists do much more extensive analytical work than any other player to identify the deficiencies of a company’s strategy and structure with the aim of creating a higher market value for the shareholder. They might invest millions of dollars to consult experts and interview former and current employees, suppliers, and customers to assess a company’s performance versus its competitors and to identify weaknesses and vulnerabilities. (See chapter 6 for an example of Trian Partners’ work on GE.) You might not want to act on the analysis as an activist would; doing so could compromise your long-term objectives. But activists do get to the bottom of performance issues.

So as you meet with these investors, be prepared to learn from their questions. We have found that their diagnosis of company problems is often superior to the work done by the CFO and outside investment bankers, whose research is often driven largely by statistics rather than by real-world interviews. The board should pay close attention as activist investors probe and discuss their analysis with the CEO. The goal may be bad, but the opinion good. Use it.

Activists also invest resources in evaluating portfolios and mergers and acquisitions. You should be prepared for their inquiries. A typical metric that activists might research is how many of your acquisitions have created value and how many have destroyed it. While your board cannot tell the investor what it will be doing in the future, the investor will consult public information about performance of your past deals.

So in asking questions, the activist is seeing whether your answers gibe with its research. In other words, it is trying to tell how solid the board is and whether it has the necessary skills. Any conversation between investors and the board will have this question lurking just beneath the surface.

What type of activist is it?

Activists themselves come in different stripes, and you need to separate one from the other. Some have no particular orientation; some will want to break apart your portfolio; and some will try to create opportunities for a merger and achieve a new market value. The latter assume that many companies have businesses that do not belong; if they sold such assets to someone else, they would create more value at the unit’s new home and derive more value themselves.

If you’re judicious, you should be able to divide activists into these different camps and identify those that aren’t out for a quick hit. Firms like T. Rowe Price and Wellington Capital Group think a lot like long-term investors and can offer insight that will help companies create value for the future.

The greatest threat comes in dealing with activists with a short time horizon. Jack Brennan, formerly of Vanguard, says, “They may be a sugar high for Vanguard’s index assets, but they’ve got a one-, two-, three-year internal rate of return. You know the activist is there for a cup of coffee. And that’s part of the biggest disruptive aspect of their presence.”

Smart companies do what they can to deal with issues that might make the company vulnerable to an activist investor. For instance, though liquidity is important at a time of crisis, you must balance your need for emergencies against the risk of carrying too much cash on your balance sheet.

The irony is that sometimes management will try to inoculate the company against an activist attack by anticipating investor pressures. As Ed Garden of Trian Partners puts it, “When we go on the board, what we find is that management is the one that is short-term focused. They’ve been conditioned by the market to think short term. And we’re the ones going in there and saying, ‘Stop imagining. Let’s plan and not get stuck in what was 2018.’”

Some investors trace the pressure for short-termism not to activists but to asset owners—institutions like pension funds, sovereign wealth funds, and endowments and foundations. ValueAct Capital’s Jeffrey Ubben says, “They view private equity as their highest-return money but locked up and illiquid, and use public markets as their hyper-liquidity balance. Asset owners have shortened up the public market’s time horizon.”

This observation gibes with our experience in serving on public boards. One of our colleagues who sits on both public and private boards describes the difference between the two like this: “On the private boards I’m on, we have the agility to make changes whenever we need to, but we’re thinking long term. On the public boards, we’re thinking quarter to quarter, but we have no agility to make the changes that we need to.” Try to assimilate the kind of long-term thinking you would find on private boards. When you do, you’ll be thinking like an activist.

When activists make a move

If activists take a position in your company, engage them so they can understand your objectives. You can’t decide who owns you, but you can affect the nature of the conversation.

Though many activists would not want to wait through long periods of poor performance before moving in on an undervalued stock, most hostile suitors don’t act alone. Instead, they will seek the support of one or more big institutional investors. The top ten investors are likely to own 50 percent of the shares of the company. No activist can succeed in splitting up a company or taking out its board or CEO without the support of these large investors.

So the best way to defend against activists who are in it for the short term is to keep your large investors close to you. The board and the CEO must focus on communication with critical investors and persuasion to keep them on their side. What we’re seeing now is that these large institutional investors prefer to use “friendly activism.” They do extensive research and have a point of view they want to share with you, and their main concern is the company’s longevity.

Whatever their goals, though, listening is the best approach in dealing with activist investors. Sometimes you might want to take advantage of their ideas. When Xerox’s Anne Mulcahy was on the board of Target, activist investor William Ackman, whose Pershing Square owned 10 percent of the company, approached with proposals for restructuring. The board heard him out. Mulcahy recalls, “I think everyone would agree that this is not something you ignore. He had one good idea, which was to sell our financing arm, and we did it.”

The lesson: assume that all investors can be a source of analysis and judgment. A lot of them have more of an owner mindset than many board members. Make such investors independent information partners.

When activists join the board

If an activist takes a seat on the board, what should you anticipate? How should you behave? Whatever your expectations, the best policy is to be a good listener and judge them by what they are saying, even if you don’t like how they are saying it. Sometimes you might want to consider inviting an activist to join even if they can’t force you to, especially if they demonstrate a genuine interest in long-term growth and a constructive point of view.

For instance, in some cases, activists come onto the board when the fundamentals of the company are not working and you need to make a change. A prime example is the move that Ubben made after his company bought a big stake in Microsoft. In 2013, he used his clout to place ValueAct’s president on the Microsoft board and edge out Steve Ballmer as CEO. The move came after a failed strategy that saw Micro soft spend $7.2 billion to buy Nokia’s phone business, among other bad bets. The change helped set Microsoft back on course.

Such upheavals can be traumatic, even if in the end they work for long-term value. Look at what an activist investor like Nelson Peltz, a founder of Trian Management, does when he arrives at a company in which he makes a big investment. Typically Trian will set up one of its most knowledgeable industry partners in a war room and insist on visiting and meeting with layers of management. This level of engagement can rattle existing board members. But the expertise that Trian injects can generate better questions for a CEO. The objective is to encourage board members to go beyond the meeting cadence and get their hands dirty.

So keeping an open mind when an activist joins the board can help you create value for your company. In 2013, after Trian took a position in DuPont, the investors sat down with the chemical maker and focused on the three things in the activist playbook: the cost structure, which is a proxy for operating efficiency and corporate governance; the capital structure, to assess whether the balance sheet is underleveraged; and the portfolio, to see if the business lineup is bloated and needs trimming. An idea that Trian proposed early on: to split the company in three. And the firm presented DuPont with a detailed, comprehensive analysis, over forty pages in length.

But according to former CFO Nick Fanandakis, Trian’s numbers were way over the top. He says, “They said we could cut $2 to $4 billion from overhead costs. Well, we only had $4 to $5 billion in costs. So it was hard to swallow.” What followed was a conflict that raged for two years. Trian made its white paper available to the investment community, and DuPont spent much time and money defending its own interpretation.

DuPont narrowly won a proxy fight, but six months later, after a downturn in its agricultural business, things heated up again, the CEO left, and Ed Breen, a board member, took over. Eventually DuPont would combine with Dow, realign their collective businesses, and split into agriculture, specialty, and commodity companies—an amalgam of Trian’s original suggestion for a break-up and DuPont’s for a straight-up merger with Dow.

The transformation of DuPont from a conglomerate to a trio of focused businesses would unlock tremendous value. Among the most productive ideas after Breen took over was jettisoning DuPont’s matrix structure—which dated back four decades—in favor of one based strictly on lines of business. That change led to both direct and indirect savings. Fanandakis says that as soon as the businesses had costs under their control, they were more critical of their expenditures. The effect dominoed and led to greater savings than the shift from the matrix alone. In all, DuPont shaved $1 billion from annual costs—just a portion of what Trian said it would save, but still a windfall.

Looking back to those early days with Trian, Fanandakis says, “Our biggest mistake is that because the information they hit us with was so extreme in the first meetings, we hunched our shoulders and went into battle. If we were going to do it tomorrow, I wouldn’t have been so defensive.” Instead, he would have tried to be collaborative—to show Trian where its numbers were wrong and his were right, and to seek a more measured course of action that would benefit the company and the investor alike. In the end, the boardroom presence of this activist helped DuPont cut expenses, improve its capital structure, and revamp its portfolio, all to the benefit of long-term shareholder value.

Dealing with a destructive activist

Some activists will live up to your worst nightmares and, at the very least, bring a different sort of energy to the room. Vanguard’s Brennan argues that with some exceptions, having an activist on the board changes the dynamic for the worse. He says, “The market should be the force that ensures that boards and management teams are as productive and cost effective and driven to succeed as they can be, which is why they need to get strategy and talent and risk management correct. Having a person with an agenda—that’s different. The activist takes advantage of an aberration or creates an aberration to be disruptive.”

An activist on the board can be destructive in their conduct as well. Shelly Lazarus, former CEO of Ogilvy & Mather, believes tone and behavior count for a lot in the boardroom, and that some activists seem to have gone to a class in how to be confrontational in the most aggressive way. She says, “I think the content of what activists bring is really important, but you don’t necessarily have to have that kind of provocation. If they do insist on coming on the board and the company accedes to it, then behavior does matter. Being constructive does matter. It doesn’t make a board more effective when you have somebody throwing fire bombs every half an hour.”

If an activist does join your board, you might face obsession with minor details and, depending on the type of company you have, a double standard as well. State Street’s Ron O’Hanley recalls the nitpicking and skepticism that Ford CEO Mark Fields encountered despite having what now looks like a pretty good plan, versus the pass that investors were giving Elon Musk when he was talking about Tesla. O’Hanley says, “Not everybody’s a disruptor. We may be asking different questions, but we should have the same level of scrutiny. We let the disruptor get away with the conceptual charts, and we’re boring away at the incumbent, looking at spreadsheet line g42 and saying why is it x as opposed to 1.2x?” If you have an old-line company, an activist who moves in can be a challenge.

Still, even the most challenging relationships can bear fruit, as one novice CEO learned from his relationship with the most challenging activist of all. The lesson he would learn: be open, but don’t be afraid to stick to your guns.

Thinking Like an Activist

In chapter 2, we saw that one of the board’s main roles is to probe how well management does in introducing new products, rebalancing existing lines of business, and making acquisitions. And if it does this job rigorously, the board will be conceiving strategy as an activist would. Throughout the year, at every strategy meeting, as board members question management about new large-scale opportunities, they should always keep activists in mind, helping management strike the right balance between short-term and long-term planning and between the company’s various stakeholders.

The board must be the driver of long-term thinking. Annual investment to build the future is imperative. Boards can take any number of steps to help create a longer-term perspective—say, by adopting an eight-quarter plan instead of a four-quarter plan, with a review of milestones every quarter. If a company invests for the future and short-term performance dips, the only real short-term risk is vulnerability to a takeover. Boards must have the backbone to understand why managers might be pressed to emphasize the short term and back them in taking a longer view.

The CEO’s role in striking this balance is to be aware of all the pressure points and opportunities that activists might identify, and to discuss them with the board. Activist shareholders do their homework. They may exaggerate when they approach management and the board, but the gap between performance and opportunity is often real and well documented. They use McKinsey, former CFOs, and chief executives to advise them, and they can afford the expense, which will be small compared to their investment and potential gain.

Activists analyze companies in a number of different ways. They will look at a company’s capital structure, as Trian did with GE in 2015 before declaring that the company had room for an additional $20 billion in debt to fund growth. Activists also look at cost structure—not just operating cost but marketing cost as well.

Legacy companies tend to see sales, general, and administrative costs as one item, whereas digital companies separate out sales costs and consider it a growth investment. These companies can measure efficiency by comparing their sales expense as a percentage of revenues against their peer group. For example, sales and marketing expense at software company Citrix was 40.3 percent of revenue in 2014—well above the industry average. Activists stepped in the following year.

Activists look at company portfolios, too. Among the questions an activist will ask: If a company has unrelated businesses, does each piece perform better than its peers? Do management claims of synergy translate into dollars and cents? Would any of the pieces be more valuable to somebody else? Managers of diversified companies sometimes allocate cash from a healthy business to a sick business. Sears did so in the 1980s and 1990s and failed to invest enough in IT, which was the linchpin of Walmart’s success.

To avoid luring activists, beware of holding excess cash. Activists look for capital allocation in the form of cash. In the digital age, a high proportion of capital investment is operating expenditure. So a company needs a strategy that lays out how it will generate and assign cash for a minimum of three to five years.

Many companies have become net cash generators, and rates on borrowing are near zero. In the absence of credible plans to use the cash for growth and acquisitions, management may be tempted to use the money for share buybacks and dividends. The board must be vigilant to ensure that share buybacks decrease the number of shares outstanding. Otherwise, something is likely to be wrong, as when an overly large portion of compensation is in the form of stock options, which dilute the shares and suppress stock price. BlackRock CEO Larry Fink leveled this criticism in a letter to CEOs—too many dividend increases and buybacks in lieu of business growth.

Activists look for companies that are slow to adapt to the digital age. Digitization is transforming businesses, and some legacy companies are not moving quickly enough. Common laggards are brick-and-mortar retail stores, where a decline in store traffic is accelerating. A legacy company might think annual growth of 15 percent is fabulous and miss an adjustment for a structural decrease in total store sales.

Activists look for undervalued stock as well. The market may not recognize the potential of a company’s strategy or the value of new initiatives for near- and long-term performance, perhaps because management credibility is low. The board must create allies in the investment community to make sure that management has support for well-founded long-term plans.

One trend that is helping insulate companies is a change in the structure of investments. Brennan of Vanguard says, “Market share gains by indexed investors is a huge win for governance and for corporate performance over time. The ultimate state of grace would be to have a large portion of your stock held by indexed investors who have a very real interest in the long-term success of your company, while also getting shorter-term feedback from the active world.”

Throughout, the role of directors is to build credibility with investors. In so doing, the board should help managers devise a way to meet quarterly performance milestones as they invest to build the company’s future. Before investor calls, coach the CEO to give investors detailed information and head off sell-side questions such as “What is the next quarter’s tax rate?” Connect the long term and short term when responding to investors’ questions. The board should watch for defensiveness on the part of management and within the board. Listen carefully to investor calls, not only the ones for your company but also for a selected peer group.

Smart companies use their investor day as an exercise in how to talk about their strategy. For instance, J.P. Morgan holds a full-day conference for investors every year, covering every line of business, and managers spend three months preparing for it, grilling themselves and asking questions that they might face in front of a big crowd. Each division must boil down those three months of work into a thirty-minute presentation.

In preparing for the conference, Mary Erdoes, in her role as head of J.P. Morgan Asset & Wealth Management, asks her staff to “tell me the truth, nothing but the truth, so help me God.” She says, “There’s nothing like it. I haven’t figured out a way to get my people to feel the pain that I feel because they don’t have to sit up in front of an entire audience of every analyst in the world, in addition to your regulators and your other lines of business. So you prep like nothing else.” That time will pay dividends.

The Alpha Activist: What a Close Encounter Can Tell You

Of all the activists who have engaged with public companies, the most renowned—or notorious, depending on your point of view—is Carl Icahn, whose fame as a corporate raider dates to the 1980s, with his hostile takeover of Trans World Airlines.

Icahn made his overture to Motorola in January 2007 in the form of a voicemail to CEO Ed Zander, who was attending the annual conference in Davos, Switzerland, with his chief operating officer, Greg Brown, today head of Motorola Solutions. Zander was also on the board of Time Warner, where Icahn was agitating for change. Icahn might have been trying to line up help behind the scenes at Time Warner—or he might have been calling to say, “Hello, Moto.” Brown told Zander, “You sure as hell have to talk to him.” Zander called him back. It was “Hello, Moto.”

Icahn took a 5 percent position in the company. His primary motivation: Motorola’s excess cash. Zander had recently appeared on CNBC, and the interviewer asked him what he was going to do with the money. His reply, says Brown: “Probably put it on the ground and roll around in it.” Motorola was also having operational troubles. Its signature product, the Razr cell phone, was popular but getting less so; its price was falling, too. And the mobile phone division, the biggest in the company, was in bad shape and had the potential to crater the whole Motorola conglomerate.

Brown says, “What people saw was Maria Sharapova and David Beckham selling the Razr in a bunch of different colors. But we had dozens of other phones, and five operating systems, multiple semiconductors, three different software stacks. We were a marketing campaign. A very good one. But it masked a terribly managed company.”

Icahn put two representatives on the Motorola board. Icahn’s advice, says Brown, was “break the company up, break the company up, break the company up.” Zander resisted. He thought the cell phone, a business Motorola pioneered, was still the company’s future. Eventually Zander was forced out. Brown replaced him, and Icahn telephoned him shortly thereafter. As Brown recalls, “Basically he said, ‘This company has been mismanaged for years. I don’t know who you are, but you’re the guy who has to fix it. You’ve got six to nine months to move the needle or we’ll get somebody else in there.’”

Brown’s reaction is an excellent guide for how to deal with an activist while protecting long-term value. He concluded that he should not resist Icahn’s advice about what to do just because he was an outsider. “I wasn’t hung up with Icahn or the optics of it. If it’s a good idea regardless of the source, let’s entertain it,” he says. “The natural reaction when Icahn enters the company is for the antibodies to come up. But I said, ‘Look, if he can be a catalyst for change, why wouldn’t I do it?’”

Within months, Brown fired the head of the cell phone business, went to Wall Street and lowered earnings expectations dramatically, and announced plans to spin out the mobile division. Brown says, “I thought it was a tremendous opportunity for management to drive change because we had a massively sick business and we had a vocal, massively muscular activist demanding change. There’s not one change Icahn pushed that I disagreed with.”

Except for one—to sell the remaining Motorola entity, which was focused primarily on public safety and emergency communications, as soon as they spun out the mobile division. It would become their only point of disagreement. It had taken three years to break up the company. Brown was not about to put a for-sale sign on the lawn. Icahn responded that Brown couldn’t be sure he would be able to lift the share price of the company and was just trying to protect his position. Brown pointed out all the moves he had already made at Icahn’s urging, including selling off the bulk of the company. He said, “I’ve shown I’m willing to make changes. Let me run it, and if a buyer comes along, fine. But let me improve operations.”

The board backed Brown. Icahn eventually sold his 23.7 million shares of Motorola Solutions for $49.15 a share. In early 2020, the stock hit a high of $187. “I should have never sold,” he later told Brown. “You screwed me over on that deal.” He was really only joking; it had been his decision to sell. And he still made over $500 million in profits on his Motorola investments.

Standing up to Icahn showed the investor that Brown was ready to take charge. But what really made their relationship was Brown’s decision to accept a change that diluted his managerial control. After Brown fired the head of the mobility division, he sought a replacement with technical expertise to lead the business until Motorola was able to spin it off. Brown found a candidate who agreed to take the job—Qualcomm COO Sanjay Jha. But at the last minute, Brown got word that Jha wouldn’t come unless he became co-CEO of the entire company. Brown thought Jha was bluffing; he would be CEO of the mobile business anyway as soon as it was spun off. Brown’s instinct was to call the bluff. The board said it would back him whatever he wanted to do.

Brown got a phone call from Keith Meister, one of Icahn’s representatives on the Motorola board. Meister asked him what he planned. Brown said that he would think about it, but he didn’t think he wanted to give Jha the co-CEO position, especially after the way Jha had gone about demanding it. Meister told Brown, “Icahn is going to be paying close attention to this decision. Don’t screw it up.”

There was no question in Brown’s mind that Jha was the right person for the job. And he thought there was a 90 percent chance that Jha would take the job even if he didn’t get what he was asking for. Brown talked it over with someone he often turns to when he needs a sounding board—his son Troy—who told him that it was a no-brainer: if there were a one in ten chance of losing Jha, he’d be crazy to take that risk. On Monday, Brown agreed to give Jha the co-CEO title. His take: “To this day Carl Icahn says that it’s the single best decision I made, and it cemented his opinion of me. He tells me, ‘Most people think of their ego and cover their ass, and you made the decision that was right for Motorola and wrong for you.’ That made my reputation with him.”

The relationship with Icahn left Brown with a different impression of activists. Brown describes Icahn as “a combination of Walter Matthau, Columbo, and Professor John Nash from A Beautiful Mind, with a mean streak.” He can be intimidating and in your face, but Brown finds his bluntness and directness refreshing. Brown says, “The beautiful thing about Carl is whatever he’s going to do to the company or the board, he’s going to tell me. Carl comes right at you, in large part to test your fortitude and your own conviction.”

Icahn would often ask Brown the same question over and over again. It dawned on Brown that Icahn knew the answer and just wanted to see if Brown’s answer was the same each time. If there was any deviation, Icahn wanted to know why. In the beginning, Brown feared that constant pounding, but over time, it freed him to be more honest himself. He says, “I could communicate with Icahn. I could say anything. I went from fear to a more comfortable engagement.” Though Icahn exited the company after six years, the two stay in touch and have dinner two or three times a year.

Brown now believes that the goals of most activists are not that different from those of regular investors. He says, “Largely, the activist shareholder and the generalist shareholder have more in common than they don’t. When you say these activists are more short term and hit-and-run, that can be grounded in management’s convenient narrative not to do what activists are suggesting you should.”

Activists break down business issues into a set of facts and numbers with very clear assumptions. It’s up to you to conclude which is right or wrong. Often the management narrative is not converted to shareholder value, so it becomes a debate over the same thing, a difference in style more than substance. Icahn was the right activist for Motorola, and for Brown, at the right time.

Brown learned that the main trick in dealing with an activist investor is knowing when to sacrifice your ego and say yes and knowing when to say no. The aim: always to make the changes that build the long-term value of the company—whether the idea is yours or not.

CHECKLIST FOR ENGAGING WITH INVESTORS

• Reach out to some of your investors every year. Invite them in to make presentations.
• Find out what investors know about you, their sources, and the metrics they use to rate you against your competitors.
• Prepare to tell investors how you ensure that management is focused on long-term value creation.
• Prepare to tell investors about succession procedures and the rationale for executive salary, bonuses, performance rewards, and other compensation.
• Say yes to any investor who requests a meeting.
• Connect with investors after earnings calls.
• Don’t let your company give earnings guidance. If it’s absolutely necessary, express it in a wide range.
• Stay close to your big institutional investors; without their support, no activist can force their way onto your board.
• Don’t rule out inviting an activist onto your board if they show an interest in creating long-term value.
• Keep an open mind if an investor suggests a change. Go by the logic, not the optics of agreeing to it.