This article on activist investors was written by Net Net Hunter member Bryan Shealy. Bryan worked in the inventory business for 5 years which gives him an edge in net net investing. Article image (creative commons) by stevepb, edited by The Broken Leg.
Can an activist investor boost your returns? Or will they leave the company in shambles, unable to continue after being pillaged and looted?
An activist investor is often likened to the pirates of the high seas. Sometimes known as corporate raiders, activist investors find nice shiny targets to loot and pillage. This leaves the company in shambles and unable to recover, only to run back to port to lick its wounds. Wait a second — is this really what happens with stocks though? The company’s management would have you believe this, but unlike the financiers of the fancy trade ships of old, investors tend to profit.
Shareholder activism goes hand in hand with deep value investing. Deep value companies are often targeted by activist investors because of their dirt cheap prices and untapped value from the underlying fundamentals.
How To Spot A Deep Value Activist Investor
What types of companies do deep value activists tend to target?
They tend to look for companies that are much easier to acquire. Smaller companies are much easier for activist investors to target since they don’t need a large amount of capital in order to purchase a sizable part of the company.
Harvard did a study on potential activist investor targets and found that “in 2014 approximately 70 percent of all activist campaigns were directed at companies whose market value was less than US $1 billion. Activist investors will target smaller capitalization stocks in part because it is less expensive to acquire a sizable position.” (source)
Not only are these companies much easier to acquire, but they also tend to be under-researched and have higher volatility. This can lead to massive undervaluations or mispricings from the underlying fundamentals.
Part of spotting a deep value activist investor is also finding the qualities (other than undervaluation) that deep value activists look for in companies. There are a number of qualities an activist investor looks for when contemplating a particular raid:
- Company has excess cash.
- Company has an underperforming asset that it can sell.
- Close ties with competitors where a merger would create less competition and make the company more profitable.
- Poor performing management and ballooning expenses.
Once you have identified a company that has one or more of these qualities, monitor any large purchases made by a single entity. Activist investors who intend to purchase a large part of a company also have to submit documentation of their intentions. If these intentions include changing seats on the board or changing management, you better believe you have an activist investor on your hands.
Deep Value Activists Create Demand For A Stock
Once an activist investor has been identified and changes begin to take place, shares tend to rise on anticipation of unlocking value. It's important to identify this taking place as early as possible, or even identify companies that have qualities an activist investor looks for.
As noted deep value investor Tal Davidson explains, “Research shows that in most cases activist campaigns are successful in creating alpha and drive performance above market levels.” (source)
There may be a multitude of factors that explain why activist investor campaigns are mostly successful. It may just be that the value already exists with the company, and just having the ability to unlock that value creates a windfall for investors.
Deep Value Activists Bring Much-Needed Change To Entrenched Management
In a famous biography of investor Carl Icahn, the author wrote that “as Icahn had long understood, if corporate management is allowed to remain entrenched and protected, shareholder values often stagnate.” (p. 246, King Icahn)
Management teams often feel they are the sole owners of a company and have all rights on how the company should be run and its assets used — even when they own very little of its stock!
Management is set in their ways and cannot fathom any new ideas or changes in their current operating procedures. Deep value activists will come into a company and shake up the underlying foundation of a business, injecting new ideas and forcing changes into the corporate structure that will benefit the company and its shareholders.
These new ideas might not be entirely welcomed as old management might have more insight into the market and know what may or may not work. The willingness for management to at least try new ideas may prove beneficial if a company is already losing money. If not, then an activist investor may be forced to board the ship and raid it for all of its supplies.
Let's take a look at one such company where activist investors are already starting to make a change.
Support.com: A Deep Value Activist Investor’s Dream?
Support.com is provider of cloud-based software and services for tech support. It operates a call center and computer hardware and software support business.
At the time activist investors began to take over, Support.com was priced below NCAV (net current asset value) with a lot of excess cash. While the company was operating a high margin business that demanded little in terms of fixed assets and had a profitable product, it was still losing money. This was not due to the crowded and competitive sector it competed in but because of inept management.
Support was nearly a perfect deep value activist investor target, so it wasn’t surprising to see the raiders attack. In June 2016, activist investors, already with a large stake in the company, decided to take their case to the company’s shareholders through a proxy battle. A proxy battle is a battle for control or direction of the company where a major shareholder attempts to convince other shareholders to vote for his proposition(s), usually against the interest of management. Ultimately, the activist investor team was successful, and took control of Support, replacing management with their own crop of executives.
This was very different from previous management, who held very little stake in the company and had no real motivation to fix the underlying issues. The new management saw opportunity in reorganizing the company and instituted cost-cutting strategies in order to increase profits. While not quite complete yet, the team’s efforts have already helped the company breakeven. Most likely, these cost-cutting strategies, and strategic operating investment, will create an enormous profit margin.
Once profitability has been realized, the activist investors can do a few things to boost the return on their investment. Either they can sell the company to competitors since it is now profitable, or they can return cash to shareholders. Either option safely unlocks the value for all shareholders involved and provides a handsome profit for the activist investors.
Are Deep Value Activists Only Out For Themselves?
In the 1980s, these were just the sort of accusations leveled against feared activist investor Carl Icahn. Icahn was a beast of an investor, and did anything he could to try to earn large returns on his investment.
“Since your acquisition, you have largely sold, stripped, leased, and leveraged the assets and operating cash flow of the airline in order to repay yourself your original equity investment, increase your percentage ownership of TWA and create a cash hoard for investment purposes.” (p. 297, King Icahn)
This passage shows just how terrible a corporate raid can be to the employees and future of a company. Not everything a corporate raider does is for the good of the company. It’s all about balance. Sometimes it may be better for the company to be stripped in order to make way for something new. While employees may not always end up better after a corporate raid, it's hard to argue that they would have been better off if the raid had never happened. So, how do investors fare after an activist investor?
Many think deep value activist investors are only out for themselves. While this may be true to some extent, they need shareholders to be on their side in order to implement change and unlock value. In the end, activist investors profit alongside other shareholders who have the same goal, profit. It is often misaligned management that is more destructive to overall returns than any activist investor can be.
So, as you can see, joining an activist investor when they buy into a company more often than not makes sense. The Broken Leg can help you find the companies they may target so you can join the action.
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