Greenbackd

Ken Squire argues in a feature article in this week’s Barron’s magazine, A Golden Age for Activist Investing (subscription required), that the “political climate, shareholder sentiment and opportunities available to activists” means that “the sun, the moon and the stars have moved into alignment for activist investing.” Squire believes that the knowledge that investors “can’t rely on the markets to create value, so they will have to create it themselves” will turn many formerly passive investors into “reluctant activists.”

Squire makes some interesting points:

1. We are witnessing “the largest spreads ever between price and value”

While we don’t accept that we are yet witnessing “the largest spreads ever between price and value,” we believe that we are getting close. On long-term measures of value (for example, Graham’s 10-year trailing P/E ratio and corporate profits as a proportion of GDP) market prices are well below average and approaching all time lows (See Future Blind‘s post Market Valuation Charts prepared in October last year when the S&P500 was around 1160). More on this at a later date. (Note that this is not a declaration that we are nearing the bottom. We think there’s a good chance the markets will over-correct to the downside and stocks will be undervalued for an extended period).

2. The “economic and political climate will make it much easier for activist investors to succeed”

Squire argues that the “economic crisis has eroded confidence in boards and corporate leadership” and “[shareholders] have less patience for laggard management, indecisiveness and missteps, and are more likely to support an activist.” We don’t disagree with these points, but we dispute that this necessarily translates into success. Incumbent directors have a huge advantage over alternate slates. See, for example, Carl Icahn’s argument that boards and managements are entrenched by state laws and court decisions that “insulate them from shareholder accountability and allow them to maintain their salary-and-perk-laden sinecures.”

3. The “impaired credit markets will make it difficult to implement financial-engineering solutions”

Squire believes the environment will force activists to “focus on operations, strategy and governance, rather than stock repurchases and special dividends”:

There are many companies whose operations or strategy fell short, and activists will identify them and implement plans to improve operations, cut costs and redirect investment.

This is a particularly interesting point. It’s clearly more difficult for an activist investor to articulate to stockholders the benefits of improvements in operations or a redirection of investment than it is to simply promise a dividend or a buy-back, which should in turn reduce their chance of getting on the board. This might suggest that impaired credit markets actually reduce an activist investor’s chance of success.

4. We will see a “significant increase in corporate/strategic acquisitions”

Squire argues that “corporate acquirers have a low cost of capital” which will “compensate in part for the void in private-equity buyouts”:

Activists not only will be open to discussing potential transactions with strategic acquirers, but often will seek them out. The activist-investor board member will want to be involved in negotiating the transaction to assure that stockholders receive the best value.

5. Companies with net cash will attract activist investors

Squire writes that activists will target exactly the type of investments Greenbackd favors:

Given today’s backdrop, many activists are expected to emphasize net cash as an inducement to invest. Large amounts of cash give a company the financial flexibility to withstand economic stress, and make it a more attractive takeover target. Abundant cash also may be an indication that the stock is mispriced. In many cases, price/earnings ratios have been gravitating toward 10, without regard to cash balances.

Based on the foregoing, it’s hard to disagree with Squire’s conclusion that 2009 will be “a busy and exciting year for shareholder activism.” It’s certainly very good news investors like us. Lest we get a reputation for being blind cheerleaders for activist investment as an end in and of itself, we’d like to emphasize that Greenbackd’s focus is undervalued asset situations with a catalyst and we’re almost agnostic as to the source of the catalyst. Our ideal situation is a management prepared to recognize the discount of price to value and undertake some step to unlock that value or remove the discount. We remain ever optimistic that all directors – including those of smaller companies outside the glare of the analyst coverage and the mainstream media – fully embrace their fiduciary duties to stockholders. Our experience is that this doesn’t often happen in the absence of an agitating stockholder. This is the real reason that formerly passive investors become “reluctant activists.” Not because they “can’t rely on the markets to create value” but because they can’t rely on some boards and managements not to destroy value.