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Posts Tagged ‘Activist Investors’

Update: See Ryan’s interview on Bloomberg.

Great article from Businessweek about Ryan Morris, the 28-year-old Canadian managing partner of Meson Capital Partners, LLC who “resembles a sandy-haired Mitt Romney,” and seems to be all out of bubblegum:

Ryan Morris spent a week steeling himself for the showdown. Then 27 years old, he was in his first campaign as an activist investor, trying to wrest control of a small company named InfuSystem (INFU), which provides and services pumps used in chemotherapy. In the meeting, Morris would confront InfuSystem’s chairman and vice chairman, two men in their 40s, and tell them that as a shareholder, he thought the company was heading in the wrong direction.

Morris is competitive—his high school rowing teammates nicknamed him “Cyborg,” and he took a semester off college to race as a semi-pro cyclist—but face-to-face confrontation wasn’t something he relished. “I like the thrill of the hunt, but not the kill,” he says. To prepare, Morris outlined questions, guessed potential responses, and tried to anticipate what tense “pregnant moments” could arrive. He built his clout by lining up support from InfuSystem’s largest shareholder as well as a veteran activist investor. Morris knew his own looks—he resembles a sandy-haired Mitt Romney—could help mask his youth, and decided he’d wear a tie, much as he hates to.

The company, with just $47 million in revenue, was spending too much money, and in the wrong places. In the previous year, InfuSystem’s board and CEO earned more than $11 million combined. This was for a company whose stock had lost 40 percent of its value over the previous three years. Morris figured that as a shareholder voice on the board, he could help cut expenses—including the high pay—and, once it was clean enough to sell, reap a return for his own small hedge fund.

On Dec. 13, 2011, he finally sat at a conference table across from the two directors. After 45 minutes of discussion, he still didn’t think his concerns were being acknowledged. So he got to the point: He wanted three board seats.

It’s a great story. Read the rest of the article on Businessweek.

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New research co-authored by London Business School’s Elroy Dimson suggests that investors who actively engage with the companies they own to improve governance and strategy outperform more passive rivals.

The paper, Active Ownership with Oguzhan Karakas and Xi Li, focuses on corporate social responsibility engagements on environmental, social and governance issues.

The authors find average one-year abnormal return after initial engagement is 1.8%, with 4.4% for successful engagements whereas there is no market reaction to unsuccessful ones. The positive abnormal returns are most pronounced for engagements on the themes of corporate governance and climate change:

We find that reputational concerns and higher capacity to implement corporate social responsibility changes increase the likelihood of a firm being engaged and being successful in achieving the engagement objectives. Target firms experience improvements in operating performance, profitability, efficiency, and governance indices after successful engagements.

Figure 1 from the paper shows cumulative abnormal returns around corporate social responsibility engagements (click to enlarge):

Returns to CSR Activism

Dimson is perhaps best known for his global equity premia research (for example, Triumph of the Optimists and Equity Premia Around the World) with LBS colleagues Paul Marsh and Mike Staunton.

A version of the paper can be found on SSRN here.

Via Financial News’ Studies reveal the value of activism.

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Embedded below is my Fall 2012 strategy paper, “Hunting Endangered Species: Investing in the Market for Corporate Control.

From the executive summary:

The market for corporate control acts to catalyze the stock prices of underperforming and undervalued corporations. An opportunity exists to front run participants in the market for corporate control—strategic acquirers, private equity firms, and activist hedge funds—and capture the control premium paid for acquired corporations. Eyquem Fund LP systematically targets stocks at the largest discount from their full change‐of‐control value with the highest probability of undergoing a near‐term catalytic change‐of‐control event. This document analyzes in detail the factors driving returns in the market for corporate control and the immense size of the opportunity.


Hunting Endangered Species: Investing in the Market for Corporate Control Fall 2012 Strategy Paper

This is the investment strategy I apply in the Eyquem Fund. It is obviously son-of-Greenbackd (deep value, contrarian and activist follow-on) and, although it deviates in several crucial aspects, it is influenced by the 1999 Piper Jaffray research report series, Wall Street’s Endangered Species.

For more of my research, see my white paper “Simple But Not Easy: The Case For Quantitative Value” and the accompanying presentation to the UC Davis MBA value investing class.

As always, I welcome any comments, criticisms, or questions.

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This week I’ve been taking a look at Aswath Damodaran’s paper “Value Investing: Investing for Grown Ups?” in which he asks, “If value investing works, why do value investors underperform?”

Damodaran divides the value world into three groups:

  1. The Passive Screeners,” – “The Graham approach to value investing is a screening approach, where investors adhere to strict screens… and pick stocks that pass those screens.”
  2. The Contrarian Value Investors,” – “In this manifestation of value investing, you begin with the belief that stocks that are beaten down because of the perception that they are poor investments (because of poor investments, default risk or bad management) tend to get punished too much by markets just as stocks that are viewed as good investments get pushed up too much.”
  3. Activist value investors,” – “The strategies used by …[activist value investors] are diverse, and will reflect why the firm is undervalued in the first place. If a business has investments in poor performing assets or businesses, shutting down, divesting or spinning off these assets will create value for its investors. When a firm is being far too conservative in its use of debt, you may push for a recapitalization (where the firm borrows money and buys back stock). Investing in a firm that could be worth more to someone else because of synergy, you may push for it to become the target of an acquisition. When a company’s value is weighed down because it is perceived as having too much cash, you may demand higher dividends or stock buybacks. In each of these scenarios, you may have to confront incumbent managers who are reluctant to make these changes. In fact, if your concerns are broadly about management competence, you may even push for a change in the top management of the firm.”

We looked at Damodaran’s passive screeners Tuesday, the contrarian value investors Wednesday, and today we’ll take a look at the activists.

The Activist Value Investors

Damodaran cites the well-known Brav, Jiang and Kim article that I have discussed here before:

If activist investors hope to generate their returns from changing the way companies are run, they should target poorly managed companies for their campaigns. Institutional and individual activists do seem to focus on poorly managed companies, targeting companies that are less profitable and have delivered lower returns than their peer group. Hedge fund activists seem to focus their attention on a different group. A study of 888 campaigns mounted by activist hedge funds between 2001 and 2005 finds that the typical target companies are small to mid cap companies, have above average market liquidity, trade at low price to book value ratios, are profitable with solid cash flows and pay their CEOs more than other companies in their peer group. Thus, they are more likely to be under valued companies than poorly managed. A paper that examines hedge fund motives behind the targeting provides more backing for this general proposition in figure 15.

As we have seen both undervalued or poorly managed stocks can generate good returns.

Damodaran says that the “market reaction to activist investors, whether they are hedge funds or individuals, is positive.” A study that looked at stock returns in targeted companies in the days around the announcement of activism showed the following results:

Damodaran points out that “the bulk of the excess return (about 5% of the total of 7%) is earned in the twenty days before the announcement and that the post-announcement drift is small.”

There is also a jump in trading volume prior to the announcement, which does interesting (and troubling) questions about trading being done before the announcements. The study also documents that the average returns around activism announcement has been drifting down over time, from 14% in 2001 to less than 4% in 2007.

Can you make money following activist investors?

Damodaran says “sort of,” if you follow:

The right activists: If the median activist hedge fund investor essentially breaks even, as the evidence suggests, a blunderbuss approach of investing in a company targeted by any activist investor is unlikely to generate value. However, if you are selective about the activist investors you follow, targeting only the most effective, and investing only in companies that they target, your odds improve.

Performance cues: To the extent that the excess returns from this strategy come from changes made at the firm to operations, capital structure, dividend policy and/or corporate governance, you should keep an eye on whether and how much change you see on each of these dimesions at the targeted firms. If the managers at these firms are able to stonewall activist investors successfully , the returns are likely to be unimpressive as well.

A hostile acquisition windfall? A study by Greenwood and Schor notes that while a strategy of buying stocks that have been targeted by activist investors generates  excess returns, almost all of those returns can be attributed to the subset of these firms that get taken over in hostile acquisitons.

Follow the right activists, and do ok, or front run them, and potentially do very well:

There is an alternate strategy worth considering, that may offer higher returns, that also draws on activist investing. You can try to identify companies that are poorly managed and run, and thus most likely to be targeted by activist investors. In effect, you are screening firms for low returns on capital, low debt ratios and large cash balances, representing screens for potential value enhancement, and ageing CEOs, corporate scandals and/or shifts in voting rights operating as screens for the management change. If you succeed, you should be able to generate higher returns when some of these firms change, either because of pressure from within (from an insider or an assertive board of directors) or from without (activist investors or a hostile acquisition).

So how do we mess it up?

• This power of activist value investing usually comes from having the capital to buy significant stakes in poorly managed firms and using these large stockholder positions to induce management to change their behavior. Managers are unlikely to listen to small stockholders, no matter how persuasive their case may be.

• In addition to capital, though, activist value investors need to be willing to spend substantial time fighting to make themselves heard and in pushing for change. This investment in time and resources implies that an activist value investor has to pick relatively few fights and be willing to invest substantially in each fight.

• Activist value investing, by its very nature, requires a thorough understanding of target firms, since you have to know where each of these firms is failing and how you would fix these problems. Not surprisingly, activist value investors tend to choose a sector that they know really well and take positions in firms within that sector. It is clearly not a strategy that will lead to a well diversified portfolio.

• Finally, activist value investing is not for the faint hearted. Incumbent managers are unlikely to roll over and give in to your demands, no matter how reasonable you may thing them to be. They will fight, and sometimes fight dirty, to win. You have to be prepared to counter and be the target for abuse. At the same time, you have to be adept at forming coalitions with other investors in the firm since you will need their help to get managers to do your bidding. 

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Michael R. Levin, who runs The Activist Investor website, has produced a white paper, Effective Activism, on the Cheap that identifies 36 undervalued companies that fit his profile for “effective activism, on the cheap.” Michael likens the list to the companies generated in an Endangered Species / Darwin’s Darlings strategy.

Says Michael of the target companies in his white paper:

  • These companies conceal significant potential value relative to their current market cap, with a potential to increase the average investment by about 75%.
  • They have a concentrated investor base (ten largest investors own at least half of the outstanding shares), which allows an activist to influence management in creative and low-cost ways.
  • They are also hardly micro- or small-cap investments, with an average market cap of $375 million (the highest at $1.8 billion), which should provide ample liquidity.

How cheap is “cheap”?

We estimate that an investor that confines its activism to companies with highly concentrated holdings can spend a tenth of the cost of a full proxy contest, and avoid the proxy solicitors, public relations firms, and legions of attorneys. For a fund manager that earns income in the form of fees (management and performance), this savings can make an activist strategy feasible, and even attractive.

Click here for more information on and to obtain a copy of the report.

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In the Spring 1999 Piper Jaffray produced a research report called Wall Street’s Endangered Species by Daniel J. Donoghue, Michael R. Murphy and Mark Buckley, then at Piper Jaffray and now at Discovery Group, a firm founded by Donoghue and Murphy (see also Performance of Darwin’s Darlings). The premise of the report was that undervalued small capitalization stocks (those with a market capitalization between $50M and $250M) lacked a competitive auction for their shares and required the emergence of a catalyst in the form of a merger or buy-out to close the value gap.

In the first follow-up, Endangered species update: The extinct, the survivors, and the new watch list, from Summer 2000, Murphy and Buckley (Donoghue is not listed on the 2000 paper as an author) tested their original thesis and provided the “Darwin’s Darlings Class of 2000,” which was a list of what they viewed as “the most undervalued, yet profitable and growing small cap public companies” in 2000.

In the Fall of 2001, Donoghue, Murphy, Buckley and Danielle C. Kramer produced a further follow-up to the original report called Endangered Species 2001 (.pdf). Their thesis in the further follow up should be of particular interest to we value folk. Putting aside for one moment the purpose of the report (M&A research aimed at boards and management of Darwin’s darlings stocks to generate deal flow for the investment bank), it speaks to the very fertile environment for small capitalization value investing then in existence:

In the last few of years, many small public companies identified this [secular, small capitalization undervaluation] trend and agreed with the implications. Executives responded accordingly, and the number of strategic mergers and going-private transactions for small companies reached all-time highs. Shareholders of these companies were handsomely rewarded. The remaining companies, however, have watched their share prices stagnate.

Since the onset of the recent economic slowdown and the technology market correction, there has been much talk about a return to “value investing.” Many of our clients and industry contacts have even suggested that as investors search for more stable investments, they will uncover previously ignored small cap companies and these shareholders will finally be rewarded. We disagree and the data supports us:

Any recent increase in small-cap indices is misleading. Most of the smallest companies are still experiencing share price weakness and valuations continue to be well below their larger peers. We strongly believe that when the overall market rebounds, small-cap shareholders will experience significant underperformance unless their boards effect a change-of-control transaction.

In this report we review and refresh some of our original analyses from our previous publications. We also follow the actions and performance of companies that we identified over the past two years as some of the most attractive yet undervalued small-cap companies. Our findings confirm that companies that pursued a sale rewarded their shareholders with above-average returns, while the remaining companies continue to be largely ignored by the market. Finally, we conclude with our third annual list of the most attractive small-cap companies: Darwin’s Darlings Class of 2001.

Piper Jaffray’s data in support of their contention is as follows:

Looking back further than just the last 12 months, one finds that small-cap companies have severely lagged larger company indices for most periods. Exhibit II illustrates just how poorly the Russell 2000 compares to the S&P 500 during the longest bull market in history. In fact over the past five, seven and ten years, the Russell 2000 has underperformed the S&P 500. For the five, seven and 10 year periods, the S&P 500 rose 82.6 percent, 175.6 percent and 229.9 percent, respectively, while the Russell 2000 rose 47.9 percent, 113.4 percent, and 206.3 percent for the same periods.

The poor performance turned in by the Russell 2000 can be attributed to the share price performance of the smallest companies in the index. Our previous analysis has shown that the smallest companies in the index have generally underperformed the larger companies (see “Wall Streets Endangered Species,” Spring 1999). To understand the reasons for this differential, one must appreciate the breadth of the index. There is a tremendous gap in the market cap between the top 10 percent of the companies in the index, as ranked by market cap (“the first decile”) and the last 10 percent (“the bottom decile”). The median market capitalization of the first decile is $1.7 billion versus just $201.0 million for the bottom decile. There is almost an 8.0x difference between what can be considered a small cap company.

This distinction in size is important, because it is the smallest companies in the Russell 2000, and in the market as a whole, that have experienced the weakest share price performance and are the most undervalued. Exhibit III illustrates the valuation gap between the S&P 500 and the Russell 2000 indices. Even more noticeable is the discount experienced by the smallest companies. The bottom two deciles of the index are trading at nearly a 25 percent discount to the EBIT multiple of the S&P 500 and at nearly 40 percent below the PIE multiple on a trailing 12-month basis.

This valuation gap has been consistently present for the last several years, and we fully expect it to continue regardless of the direction of the overall market. This differential is being driven by a secular trend that is impacting the entire investing landscape. These changes are the result of:

• The increasing concentration of funds in the hands of institutional investors

• Institutional investors’ demand for companies with greater market capitalization and liquidity

• The shift by investment banks away from small cap-companies with respect to research coverage and trading

The authors concluded that the trends identified were “secular” and would continue, leading small capitalization stocks to face a future of chronic undervaluation:

Removing this discount and reviving shareholder value require a fundamental change in ownership structure. Equity must be transferred out of the hands of an unadoring and disinterested public and into those of either: 1) managers backed by private capital, or 2) larger companies that can capture strategic benefits. Either remedy breathes new life into these companies by providing cheaper sources of equity capital and shifting the focus away from quarterly EPS to long-term growth.

They recognized the implications for secular undervaluation which lead them to make an impressive early identification of the re-emergence of modern shareholder activism:

Unfortunately, many corporate executives continue to believe that if they stick to their business plan they will eventually be discovered by the financial community. Given the recent trends, this outcome is not likely. In fact, there is a growing trend toward shareholder activism to force these companies to seek strategic alternatives to unlock shareholder value. Corporate management is now facing a new peril – the dreaded proxy fight. Bouncing back from their lowest level in more than a decade, proxy fights have increased dramatically thus far in 2001 and are running at nearly twice the pace as they were last year, according to Institutional Shareholder Services. In fact, not since the late 1980s has there been such attention devoted to the shareholder activism movement.

As shown in our Darwin’s Darlings list in Exhibit XX, page 23, management ownership varies widely among the typical undervalued small cap. For those that were IPOs of family-held businesses, management stakes are generally high. In these instances in which a group effectively controls the company, there will be little noise from activist shareholders. However, companies with broad ownership (i.e., a spinoff from a larger parent) are more susceptible to unfriendly actions. In fact, widely held small caps frequently have blocks held by the growing number of small-cap investment funds focused on likely takeover targets.

Regardless of ownership structure, these companies typically have the customary defensive mechanisms in place. They are also protected because they are so thinly traded. In most cases it can take more than six months to accumulate a 5 percent position in the stock without impacting the share price. While we expect most of the successful acquisitions in this sector to be friendly, small-cap companies will have to increasingly worry about these unfriendly suitors.

There are several consistent factors that are driving the increased frustration among shareholders and, consequently, the increased pressure on Management and Boards. These factors include the aforementioned depressed share prices, lack of trading liquidity, and research coverage. But also included are bloated executive compensation packages that are not tied to share price performance and a feeling that corporate boards are staffed with management allies rather than independent-minded executives. Given the continuing malaise in the public markets, we believe this heightened proxy activity will continue into the foreseeable future. Companies with less than $250 million in market capitalization in low growth or cyclical markets are the most vulnerable to a potential proxy battle, particularly those companies whose shares are trading near their 52-week lows.

Here they describe what was a novelty at the time, but has since become the standard operating procedure for activist investors:

Given the growing acceptance of an aggressive strategy, we have noticed an increase in the number of groups willing to pursue a “non-friendly” investment strategy for small caps. Several funds have been formed to specifically identify a takeover target, invest significantly in the company, and force action by its own board. If an undervalued small cap chooses to ignore this possibility, it may soon find itself rushed into a defensive mode. Thwarting an unwanted takeover, answering to shareholders, and facing the distractions of the press may take precedence from the day-to-day actions of running the business.

So how did the companies perform? Here’s the chart:

Almost 90 percent of the 1999 class and about half of the 2000 class pursued some significant strategic alternative during the year. The results for the class of 1999 represent a two-year period so it is not surprising that this list generated significantly more activity than the 2000 list. This would indicate that we should see additional action from the class of 2000 in the coming year.

A significant percentage (23 percent of the total) pursued a sale or going-private transaction to provide immediate value to their shareholders. Others are attempting to “grow out of” their predicament by pursuing acquisitions and many are repurchasing shares. However, many of Darwin’s Darlings have yet to take any significant action. Presumably, these companies are ignoring their current share price and assuming that patient shareholders will eventually be rewarded through a reversal in institutional investing trends, or perhaps, in a liquidity event at some later date.

The actual activity was, in fact, even greater than our data suggests as there were many transactions that were announced but failed to be consummated, particularly in light of the current difficult financing market. Chase Industries, Lodgian, Mesaba Holdings, and Chromcraft Revington all had announced transactions fall through. In addition, a large number of companies announced a decision to evaluate strategic alternatives, including Royal Appliance, Coastcast, and Play by Play ‘Toys.

The authors make an interesting observation about the utility of buy-backs:

For many of Darwin’s Darlings and other small-cap companies, the share repurchase may still have been an astute move. While share price support may not be permanent, the ownership of the company was consolidated as a result of buying in shares. The remaining shareholders were, in effect, “accreted up” in their percentage ownership. When a future event occurs to unlock value, these shareholders will reap the benefits of the repurchase program. Furthermore, the Company may have accommodated sellers desiring to exit their investment, thereby eliminating potentially troublesome, dissenting shareholders. There are circumstances when a repurchase makes good sense, but it should not be considered a mechanism to permanently boost share prices.

Piper Jaffray’s Darwin’s Darlings Class of 2001, the third annual list of the most attractive small-cap companies, makes for compelling reading. Net net investors will recognize several of the names (for example, DITC, DRAM,  PMRY and VOXX) from Greenbackd and general lists of net nets in 2008 and 2009. It’s worth considering that these stocks were, in 2001, the most attractive small-capitalization firms identified by Piper Jaffray.

See the full Endangered Species 2001 (.pdf) report.

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The Official Activist Investing Blog has published its list of activist investments for August:

Ticker Company Investor
ADPT Adaptec Inc. Steel Partners
ANR Alpha Natural Resources Duquesne Capital Management
BARE Bare Escentuals Sandler Capital Management
CAMD California Micro Devices Corp Gamco Investors
CITZ CFS Bancorp Financial Edge Fund
DCS Claymore Dividend & Income Fund Bulldog Investors
FCM First Trust Four Corners Senior Floating Rate Income Fund Bulldog Investors
FPU Florida Public Utilities Co Energy Inc
FRZ Reddy Ice Holdings Inc. Avenir Corp
GBNK Guaranty Bancorp Patriot Financial Partners
GCS DWS Global Commodities Stock Fund, Inc. Western Investment
HBRF.OB Highbury Financial Inc. North Star Investment Management Co
HFFC HF Financial Corp Finacial Edge Fund
KFS Kingsway Financial Services Inc Joseph Stillwell
MRVC.PK MRV Communications Boston Avenue Capital; Spencer Capital
NUF Nuveen Florida Quality Income Municipal Fund Western Investment
PXD Pioneer Natural Resources Southeastern Asset Management
RATE Bankrate Inc. Coatue Management
RUSS.OB Whitney Information Network Inc Kingstown Capital Partners
SBSA Spanish Broadcasting System Inc Attica Capital Partners
SCSS Select Comfort Clinton Group
SNG Canadian Superior Energy Palo Alto Investors
SNS Steak & Shake Co The Lion Fund
SPA Sparton Corp Lawndale Capital Management
TMNG The Management Network Group Mill Road Capital
TXI Texas Industries Inc. Shamrock Activist Value Fund
VXGN.OB VaxGen Inc. Boston Avenue Capital; Spencer Capital
VXGN.OB VaxGen Inc. Steven Bronson; Mark Boyer
XOHO.OB XO Holdings Inc Amalgamated Gadget

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