Outlook: P&D looks in the Mirror and sees itself

LIKE APPLE PIE and motherhood, no one can really object to shareholder activism, can they? It is a shareholder's right, nay his positive duty, to bash underperforming, politically incorrect managements around the head, and if necessary to drum them out of their jobs. Nothing should interfere with the pursuit of shareholder value and correct corporate governance, should it?

Well here's an alternative view. Though big companies do occasionally feel the wrath of their institutional shareholders, it tends to be among smaller enterprises that the big investment houses are at their most active. The trouble spots are most often, though not always, found in the Mid Cap or Small Cap indices, not the FTSE 100.

Why is this? Modern investment trends, which favour large global companies, have combined with the economic cycle to ensure that many smaller and medium sized companies have pretty much ceased to figure on the City radar screen.

The bears keep warning about overvalued share prices, but you just look at the ratings on some smaller stocks. Bargain basement is hardly the expression for it. The plain truth is that, as a matter of course, smaller companies now tend to underperform the index.

According to Salomon Smith Barney, Britain's largest 15 blue chip stocks will account for 45 per cent of the entire value of the UK stock market once the present wave of mega-mergers has gone through. This in itself is an extraordinary statistic, but it is also indicative of the sort of pressures smaller companies, as well as out-of-favour larger ones, are now subjected to.

It feels pretty uncomfortable down there towards the bottom of the pile. From cost of capital through to buying power and access to the best advice and talent, smaller companies are increasingly disadvantaged. The upshot is that, to the extent that such companies are not ostracised completely by City investors, they are under intense pressure to improve performance and achieve the All Share benchmark.

From the general to the particular. Some active fund managers have been badly caught out by this growing disparity between the "in" bigger companies, and "out-of-favour" smaller enterprises. Somehow or other, they have to catch up, or they will lose business.

But it is worse than this. In the case of Phillips and Drew, the fund manager behind David Montgomery's removal as chief executive of Mirror Group, a policy of "value" investment has been pursued. This means deliberately targeting underperforming companies in the hope that some way of realising the underlying value can be found.

In the process of pursuing this investment strategy, P&D has built up some exceptionally large positions in a large number of underperforming companies. On top of this, it has for the past three years adopted a consistently bearish approach to the stock market. This may or may not eventually be vindicated, but in the meantime, P&D's own performance has suffered alongside that of its investments. Some clients have deserted or are in the process of doing so.

So not only is P&D itself under intense pressure to perform, to demonstrate that it can do something with the bombed-out stocks it has chosen to invest in, but it also needs to liquidate some of these holdings to pay back clients. Unfortunately, large, illiquid shareholdings, once built up, are by definition difficult to liquidate. Hence the need to generate excitement or merger and bid activity, and hence the shareholder activism - not just at Mirror Group, but among a whole host of similarly underperforming companies in recent months.

None of this means that P&D was wrong to do what it did at Mirror Group. P&D is not alone in believing Mr Montgomery, whatever his past achievements, the wrong man to take Mirror Group forward. But there is a sense in which it can be argued that Mr Montgomery has fallen victim to P & D's own flawed investment strategy.

It cannot be in clients' best interests to build up these large, illiquid positions, let alone the interests of the companies involved. In such circumstances the investment house comes to act more like a venture capitalist than a conventional fund manager, and as a consequence begins to demand rights of ownership and management control that go beyond those normally exercised by investors in publicly quoted companies.

P&D claims to speak for the shareholders as a whole, but actually in many of these situations it is pursuing its own self-interest. This may or may not coincide with the interests of other shareholders. Moreover, P&D would rightly criticise others for attempting to exercise management control from the position of a minority shareholding, and yet this is what it appears to be doing in many of these companies by agitating for a merger or a bid. Shareholder activism is more contentious than it might seem.

magisterial inaction may well be the right policy.