UC Davis Graduate School of Management Study Finds Institutional Activism Improves Shareholder Value, Despite Occasional Missteps.

DAVIS, Calif. -- The institutional activism practiced by the nation's largest public pension fund -- the California Public Employees' Retirement System -- can create billions of dollars in wealth for investors while expanding shareholder rights, according to a new study by a finance professor at the University of California, Davis.

But when that activism treads into moral territory, pension funds should defer to their members' views, said Brad Barber of the Graduate School of Management.

His study of CalPERS' renowned Focus List of underperforming companies found short-term benefits of at least $3.1 billion for investors over a 14-year period. In addition, he found that long-term benefits, though difficult to estimate, could run as high as $89.5 billion.

The findings come as CalPERS is expected this week to release its latest annual installment of poor financial and corporate governance performers. CalPERS' Focus List, begun in 1987, draws public attention each year to four to 10 companies in the pension fund's portfolio that produce the lowest long-term value relative to peers and lack good governance practices.

Barber's Focus List research is the latest contribution to an ongoing debate over the propriety and financial impact of institutional activism at CalPERS. The giant public pension fund has for years faced scrutiny for its outspoken stands on issues ranging from corporate governance and labor negotiations to investments in tobacco firms and the independence of corporate board audit committees.

'Double-edged sword'

"Institutional activism is a double-edged sword," wrote Barber. "When prudently applied, activism can provide effective monitoring of publicly traded corporations. When abused, portfolio managers can pursue their personal agendas at the expense of those whose money they manage."

Barber -- who directs a management school program through which MBA students intern at CalPERS and the California State Teachers' Retirement System -- said institutional activism to improve shareholder value should be well-grounded in scientific evidence: "We need to carefully monitor institutions to ensure they live up to these standards."

Focus on 115 firms

In his working paper, "Monitoring the Monitor: Evaluating CalPERS' Shareholder Activism," Barber looked at the theory and empirical evidence for institutional activism.

He examined the nature of CalPERS activism and analyzed the gains of such actions linked to the 115 firms named to the pension fund's Focus List from 1992 to 2005. The paper provides a summary of CalPERS-sponsored proposals on the proxy statements of listed firms.

All CalPERS proposals attempted to expand shareholder rights, most commonly calling on companies to reclassify or to amend bylaws to require a majority of independent directors on their boards.

Barber referred to other research that firms with strong shareholder rights reported mean valuations one-third higher than firms with few shareholder rights. Yet another study documents higher valuations for firms in countries with better protections for investor rights.

"This evidence provides strong support," Barber said, "that the nature of reforms pursued by CalPERS, which are clearly designed to expand shareholder rights, should improve shareholder value."

Calculations

Barber calculated the short-run wealth creation of $3.1 billion by multiplying the market-adjusted return for each listed firm by its market cap. He said the short-run analysis might underestimate total benefits of activism if its announcement is partially anticipated or conveys information about managerial entrenchment. It also misses additional benefits of activism through private negotiations or deterrence of wrongdoing.

Barber estimated the total long-run wealth creation by tracking the performance of Focus List firms for five years after the CalPERS announcement. Over this longer horizon, the total estimated wealth creation grew to $89.5 billion. Though large, Barber noted the long-run estimates of wealth creation are imprecise and cannot be conclusively attributed to the CalPERS activism.

Benefits hinge on two things

Barber said the benefits of institutional activism hinge on two things: the potential conflict of interest between shareholders and corporate managers, and that between investors and portfolio managers. Firm managers may be trying to build their empire or maximize their compensation packages; portfolio managers might be working to advance their own political agenda.

"While portfolio managers can use their position to monitor conflicts that might arise between managers and shareholders," Barber said, "they can also abuse their position by pursuing actions that advance their own moral values or political interests at the expense of investors."

Tobacco divestiture and labor dispute

He noted two cases of CalPERS activism in which there was not clear evidence that action would improve shareholder value. In 2000, the pension fund divested its holdings in tobacco firms. And in 2003, Sean Harrigan, then-president of the CalPERS board and a leader of the United Food and Commercial Workers International Union in Southern California, directed CalPERS to send Safeway a letter encouraging the supermarket chain to end a labor dispute with his union.

"CalPERS manages the assets of over a million public employees, retirees and their families," the paper states. "When there is no clear link to improvements in shareholder value, whether CalPERS activism is in the best interests of those whose money they manage depends critically on the personal preferences of investors."

He noted, though, that CalPERS' own members enjoy benefits of $1.12 million annually from the pension fund's activism. With three full-time professionals devoted to issues related to the Focus List, Barber said, CalPERS' expenditures on activism are probably justified.

Strong oversight could prevent a portfolio manager from pursuing a political agenda, the professor said. Should the portfolio manager and board share political aims, however, the board's oversight may prove ineffective. On the other hand, a board bent on its own direction might try to prevent what would be prudent activism by a portfolio manager.

Moral considerations

To ignore moral considerations, however, is not necessarily in the best interest of investors. "Moral issues are challenging and nettlesome. But do not throw the baby out with the bath water," the professor said.

Barber said institutions should open up lines of communication to understand where investors stand on moral issues that might affect investment policy.

A member of the faculty of the Graduate School of Management since 1990, Barber publishes on behavioral finance, valuation, market efficiency and analyst recommendations. He is currently teaching financial theory and policy.

To download a copy of the full report, please visit http://www.gsm.ucdavis.edu/calpersstudy.