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Travis Dirks has provided a guest post on the voting power of differently sized shareholdings, which has important implications for activist investors seeking to impose their influence on a management. Travis is an expert in Nanotechnology, and received his Ph.D. from the world’s leading institution for the study of condensed matter physics, University of Illinois at Urabana-Champaign. Travis has also taught informal workshops on sustainable competitive advantage, business valuation, and the wider applications of behavioral finance and prospect theory, in addition to running a concentrated deep value/special-situations equity portfolio, which has returned 69.53% since inception in June 2006 relative to the S&P 500’s -6.08%. An entrepreneur at heart, Travis has co-founded one successful local business and one technology startup. He is currently working on a book – Voting Power in Business. Travis can be reached at TravisDirks@gmail.com.

(I would greatly appreciate feedback on whether the information below is new and/or useful to you)

Process over outcome. The watch words of all great investors. By thinking probabilistically in terms of relevant long-term averages, such investors gain control over a field swayed by random events. Yet, it appears that this method of thought has not yet been thoroughly applied to shareholders’ only means of control: the shareholder vote. When probabilistic thinking is applied to the proxy battle the activist investor, and those of us who rely on him to catalyze our deep value investments, gain a counterintuitive and valuable edge! Here, I outline the strategic value of voting power – a measure of a shareholder’s true influence – via two examples: a simplified hypothetical and a real world company.

How does ownership differ from power?

Pop quiz: 1) Does 10% ownership of a company imply 10% influence on the vote? 2) Does buying 1% more of the company imply proportionally more power? 3) Is your influence on the vote impervious to other shareholder’s buying or selling?

Answers: No, no and NO!

Voting power is not related to ownership in a straightforward way – it is a function of the entire ownership structure of the company, i.e., how much everyone else owns. Voting power measures the percentage of all outcomes where a voter gets to decide the result of the vote. In fact, you can gain more or less power depending on who you buy from! The counterintuitive nature of these answers hints at an opportunity for the enterprising investor.

A simple example of voting power analysis

Alice and Bob each owned 50% of a successful rapidly growing small business. Like so many before them, they lost sight of cash flow and needed money fast. With no bank to turn to, they decided to sell 2% of their business to uncle Charlie. So the ownership structure looks like this: Alice –> 49%, Bob –> 49%, Charlie –> 2%. Does Charlie, with only 2% ownership, really have any influence on the company? The astounding fact is that Charlie now has just as much power over the business as Alice and Bob. When matters come to a vote, Alice, Bob, and Charlie are in exactly the same situation: to win the vote they each have to convince one of the other two to agree with them and it doesn’t matter which one.

Not everyone is as fortunate as Charlie – a voter can have drastically less control than his ownership would indicate. In fact, he may even have no control at all!

Let’s rejoin the story a few years later. Charlie now owns a third of the company, as do Alice and Bob. They’d like to raise more capital to buy out a weak competitor so, at Charlie’s suggestion, they do something clever: they sell Dan 20% of the business (new ownership structure: Alice –> 26.66%, Bob –> 26.66%, Charlie –> 26.66%, Dan –> 20%).  Interestingly, though Dan paid for 20% of the business, he received zero voting power! The reason is that there is no possible voting outcome in which Dan could change the result by changing his vote. All possible voting outcomes have a winning majority even without Dan’s vote! Effectively, Dan is wasted conference space. Thus:

Rule 1 of voting power analysis: a voter can have drastically more or less voting power than his ownership would indicate.

Driving strategy via voting power analysis: Breitburn Energy Partners

What strategically valuable information can such statistical analysis reveal for a large public company?  Consider such a company from my (and Seth Klarman’s) portfolio: BreitBurn Energy Partners L.P. (NYSE: BBEP)

BBEP’s is a beautifully intricate story in which the oil crash, the market crash, an angry majority shareholder, a convenient bank loan covenant, 5 years of hedged production, and the fleeing of dividend-loving stock holders combined to create the easiest purchasing decision I’ve ever made! Voting power analysis sheds new light on one part of this story – a dispute between the majority shareholder and the company over voting rights.

In June 2008 the board decided to give the limited partners the right to vote on who would sit on the board of directors—with one caveat. No one share holder could vote more than 20% of the company’s shares. In the event that a shareholder owned more than 20% of the outstanding shares, the final vote would be counted as if the rest of the shareholder’s votes did not exist. This understandably upset Quicksilver Resources Inc., who held 40% of the outstanding shares. Strategically, how should Quicksilver and The Baupost Group (the other large shareholder) react to these unique voting rules?[i]


Figure 1: Percentage ownership (blue), and voting power under two schemes –  standard (red) and BBEP’s 20% cap (green) for Quicksilver Resources Inc. and The Baupost Group, the two largest stakeholders of Breitburn Energy Partners.

In Figure 1 the blue bars show Quicksilver’s and Baupost’s percentage ownership of BBEP as of March 2010. The red bars show each company’s voting power under a standard voting scheme. Notice that under a standard voting scheme  Quicksilver has drastically more voting power than their ownership indicates and Baupost has drastically less. This disparity, with some shareholders having more power and some less, is closer to the rule, than the exception. Under the 20% cap rule (green bars), however, Quicksilver’s voting power is cut in half and Baupost’s tripled, but both have influence that is more in proportion with their ownership – a powerful insight that could have been used in BBEP’s defense in the inevitable lawsuit that followed.

The lawsuit was settled and a voting system in which Quicksilver got to vote all its shares (but others who crossed the 20% threshold did not) was agreed on. The resulting power distribution is now exactly the same as under a standard voting scheme (red bars). Therefore, in the event of a disagreement between Quicksilver and Baupost, Baupost’s chances of success are much worse than their ownership percentage would suggest.

How to use voting power analysis to minimize influence loss?

The settlement also seemed to indicate that Quicksilver would be selling down its majority position. It has already sold nearly a quarter of its holdings, most of which went to a new share holder, M.R.Y. Oil Co. Now, assuming Quicksilver would like to retain some ownership, what strategic insight can voting power analysis lead to? Because voting power is a function of both individual ownership and the overall ownership structure, it is actually possible to minimize your lost voting power (on a per share basis) by strategically selecting low-impact buyers.[ii]

Consider two options open to Quicksilver to drop below the 20% ownership threshold: selling a third of its holdings (10% of the company) to the second largest stakeholder, Baupost, or selling it to small shareholders on the open market.[iii]

Figure 2: The current voting power structure at Breitburn Energy Partners (blue: ownership, red: voting power), as of July 2010, and two hypotheticals in which Quicksilver Resource Inc. sells another 10% of the company. In the first scenario, the shares are distributed among the smallest shareholders (orange bars). In the second, the shares are sold in a lump sum directly to The Baupost Group (pink bars). The inset shows the percentage change in power from the current situation for each hypothetical.

Figure 2 shows each company’s ownership stake (in blue), as of July 2010, along with the associated voting power (in red). First, note that Baupost’s voting power has improved significantly from March (see Figure 1) without buying any shares because the ownership structure has changed. Second, Quicksilver’s voting power changes depending on whether it sells its shares to the smallest shareholders (in orange) or to Baupost (in pink). When Quicksilver sells to the masses, Baupost’s power again increases substantially, even though they have not increased their holdings by a single share! (The same is true for M.R.Y. Oil Co.) Thus:

Rule 2 of voting power analysis:  voting power can be increased by influencing others to buy or sell!

In the inset in Figure 2 we can see that if Quicksilver sells its shares to Baupost, Quicksilver loses nearly 50% of their voting power. Whereas, if they sell to smaller shareholders they lose only 37% of their voting power. Thus, even a simple application of voting power analysis has profound implications – given the choice, Quicksilver can buffer its loss of influence by a whopping 13% by distributing its shares to smaller shareholders, rather than selling a lump sum to Baupost.

Voting power analysis: what else is it good for?

Stakeholders can use voting power (and related) analysis to help guide key strategic decisions like:

  • Who to buy from and who not to buy from to maximize their purchased control
  • Who to sell to and who not to sell to minimize any lost influence
  • When to be greedy by identifying situations where the purchase of a few more shares will result in a large increase in influence
  • When not to be greedy by identifying situations when the sale of just a few shares will result in a large decrease in influence
  • How to increase their influence without buying any more ownership
  • How much of a company can be sold, while giving up ZERO voting power

and more…

In conclusion, control isn’t worth much – until it is. When trying to change the course of a business in crisis, voting power analysis might prove essential. As voters form coalitions, the effective sizes of the voting blocs grow and so can the disparity between voting power and percentage ownership. It is here in the crucible where, I believe, voting power analysis plus intelligence about key voters’ stances can provide a real edge to investors trying to decide whether the proxy battle is worth the expense and, if so, how best to win it.

Again, I would really appreciate feedback – especially on whether such voting power analyses are commonly applied either in the boardroom or by activist investors.

Travis Dirks, Ph.D. (TravisDirks@gmail.com)

I’d like to thank my co-authors, Radhika Rangarajan and Guy Tal for their insightful conversations that both inspired and fleshed out these ideas as well as for their heroic efforts in helping me to (hopefully) make this tricky subject understandable!


[i] I have made two main assumptions for ease of calculation. The first is that all shareholders vote their shares. The second is that the shares held by groups and individuals with small enough position to not file a 13d are held in equally sized small pieces. While a more realistic assumption, such as a power law distribution in shareholder size, will change the values of voting power, it will not change the main results: percentage ownership alone does not equal voting power, allowing for full optimization of voting power. Also, a Shapley-Shubik index is used to measure voting power.

[ii] It is also possible to optimize in other ways. For instance we can  buy shares to maximize our voting power gain or even our voting power gain plus competitors’ voting power loss.

[iii] Here I’ve assumed that Baupost would get to vote all 25% of its shares, as it would in most other companies, after its own lawsuit. Interestingly, if Baupost were to suffer the 20% cap, selling to Baupost or the masses becomes nearly equivalent options for Quicksilver (Q = 28% , B = 22% , M = 7% ).

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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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One of my favorite strategies is the Endangered Species / Darwin’s Darlings strategy I discussed in some detail earlier this year (see Hunting endangered species and Endangered Species 2001). The strategy is based on a Spring 1999 Piper Jaffray 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. 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.

The NYTimes.com has an article, Accretive Uses “Take Private” Tactic In Equities, discussing hedge fund Accretive Capital Partners, which uses a strategy described thus:

Accretive Capital’s strategy is to buy long-only stakes in small- and micro-cap stocks that [founder Rick] Fearon believes would be attractive “take private” companies. The benefits of being public just don’t add up for such companies, he said.

Years ago when Fearon was a principal at private equity firm Allied Capital, he was struck by the wide gap in value the public and private equity markets assigned companies.

In private equity, companies were valued at six to seven times their cash flow, while public companies, especially the smallest businesses, were valued at almost half that, he said.

Fearon believes that market inefficiency, where prices often fail to reflect a company’s intrinsic value, and the $400 billion or so that pension funds and endowments currently have committed to private equity, will help spur returns.

Fearon is fishing in waters where, because the market capitalization of the smallest companies is less than $100 million, Wall Street research fails to adequately cover their operations. In addition to helping create an inefficient market, it has eroded the benefits of being a public company.

With an undervalued stock, stock options are never in the money, erasing the use of stock as a motivator for management and employees; cash becomes preferable to stock for acquisitions, and management holds on to undervalued shares.

“Management teams that have a strategy of A, B, C and D for creating shareholder value may in the back of their minds be thinking, ‘Well, maybe strategy E is the take private transaction, or we sell the company to a strategic buyer, because we’re not recognizing any of the benefits of being public,'” Fearon said.

In essence, the strategy is Endangered Species / Darwin’s Darlings. How has Accretive Capital performed?

Accretive Capital has been involved in 19 take-private transactions, or about one-third of the positions it has closed over the past decade.

Fearon has managed to take the $2 million in capital he started with from mostly high-net worth friends and family to about $20 million on his own. His fund plunged in 2008, but returned 132 percent last year and is up about 20 percent as of July.

Assuming no additional outside capital, turning $2M into $20M in ten years is a compound return of around 25%, which is impressive. [Update: As Charles points out in the comments, the article clearly says he’s returned 4x, not 10x, which is a compound return of around 15%, which is still impressive in a flat market, but not as amazing as 25%.]

Says Fearon of the investment landscape right now:

“We’re not lacking investment ideas or opportunities, our primary restraint is capital right now.”

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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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In March I highlighted an investment strategy I first read about in a Spring 1999 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, simply stated, is to identify undervalued small capitalization stocks lacking a competitive auction for their shares where a catalyst in the form of a merger or buy-out might emerge to close the value gap. I believe the strategy is a natural extension for Greenbackd, and so I’ve been exploring it over the last month.

Donoghue, Murphy and Buckley followed up their initial Wall Street’s Endangered Species research report with two updates, which I recalled were each called “Endangered Species Update” and discussed the returns from the strategy. While I initially believed that those follow-up reports were lost to the sands of time, I’ve been excavating my hard-copy files and found them, yellowed, and printed on papyrus with a dot matrix 9-pin stylus. I’ve now resurrected both, and I’ll be running them today and tomorrow.

In the first follow-up, Endangered species update: The extinct, the survivors, and the new watch list (.pdf), 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.

As for the original class of 1999, the authors concluded:

About half of the Darwin’s Darlings pursued some significant strategic alternative during the year. A significant percentage (19 of the companies) 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, about half of the 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, more likely, a liquidity event at some later date. The path chosen clearly had a significant impact on shareholder value.

Here’s the summary table:

There are several fascinating aspects to their analysis. First, they looked at the outstanding performance of the sellers:

The 19 companies that pursued a sale easily outperformed the Russell 2000 and achieved an average premium of 51.4% to their 4-week prior share price. The vast majority of transactions were sales to strategic buyers who were able to pay a handsome premium to the selling shareholders. In general, the acquirers were large cap public companies. By simply valuing the profits of a Darwin’s Darling at their own market multiple, these buyers delivered a valuation to selling shareholders that far exceeded any share price the company might have independently achieved. Note in the summary statistics below that the average deal was at an EBIT multiple greater than 10x.

Here’s the table:

Second, they considered the low proportion of sellers who went private, rather than sold out to a strategic acquirer, and likely causes:

Only three of the Darwin’s Darlings announced a going-private transaction. At first glance, this is a surprisingly small number given the group’s low trading multiples and ample debt capacity. With private equity firms expressing a very high level of interest in these transactions, one might have expected more activity.

Why isn’t the percentage higher? In our opinion, it is a mix of economic reality and an ironic impact of corporate governance requirements. The financial sponsors typically involved in taking a company private are constrained with respect to the price they can pay for a company. With limits on prudent debt levels and minimum hurdle rates for equity investments, the typical financial engineer quickly reaches a limit on the price he can pay for a company. As a result, several factors come into play:

• A Board will typically assume that if a “financial” buyer is willing to pay a certain price, a “strategic” buyer must exist that can pay more.

• Corporate governance rules are usually interpreted to mean that a Board must pursue the highest price possible if a transaction is being evaluated.

• Management is reluctant to initiate a going-private opportunity for fear of putting the Company “in play.”

• Financial buyers and management worry that an unwanted, strategic “interloper” can steal a transaction away from them when the Board fulfills its fiduciary duty.

In light of the final two considerations, which benefit only management, it’s not difficult to understand why activists considered this sector of the market ripe for picking, but I digress.

Third, they analyzed the performance of companies repurchasing shares:

To many of the Darwin’s Darlings, their undervaluation was perceived as a buying opportunity. Twenty companies announced a share repurchase, either through the open market, or through more formalized programs such as Dutch Auction tender offers (see our M&A Insights: “What About a Dutch Auction?” April 2000).

As we expected, these repurchases had little to no impact on the companies’ share prices. The signaling impact of their announcement was minimal, since few analysts or investors were listening, and the buying support to the share price was typically insignificant. Furthermore, the decrease in shares outstanding served only to exacerbate trading liquidity challenges. From announcement date to present, these 20 companies as a group have underperformed the Russell 2000 by 17.5%.

For many of the Darlings and other small cap companies the share repurchase may still have been an astute move. While share prices may not have increased, 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 should reap the benefit of the repurchase program. Furthermore, the Company may have accommodated sellers desiring to exit their investment, thereby eliminating potentially troublesome, dissenting shareholders.

One such company repurchasing shares will be familiar to anyone who has followed Greenbackd for a while: Chromcraft Revington, Inc., (CRC:AMEX), which I entered as a sickly net net and exited right before it went up five-fold. (It’s worth noting that Jon Heller of Cheap Stocks got CRC right, buying just after I sold and making out like a bandit. I guess you can’t win ’em all.) Murphy and Buckley cite CRC as an abject lesson in why buy-backs don’t work for Darwin’s Darlings:

I’m not entirely sure that the broader conclusion is a fair one. Companies shouldn’t repurchase shares to goose share prices, but to enhance underlying intrinsic value in the hands of the remaining shareholders. That said, in CRC’s case, the fact that it went on to raise capital at a share price of ~$0.50 in 2009 probably means that their conclusion in CRC’s case was the correct one.

And what of the remainder:

About half of the Darwin’s Darlings stayed the course and did not announce any significant event over the past year. Another 18 sought and consummated an acquisition of some significant size. While surely these acquisitions had several strategic reasons, they were presumably pursued in part to help these companies grow out of their small cap valuation problems. Larger firms will, in theory, gain more recognition, additional liquidity, and higher valuations. However, for both the acquirers and the firms without any deal activity, the result was largely the same: little benefit for shareholders was provided.

Management teams and directors of many small cap companies have viewed the last few years as an aberration in the markets. “Interest in small caps will return” is a common refrain. We disagree, and our statistics prove us right thus far. Without a major change, we believe the shares of these companies will continue to meander. For the 53 Darwin’s Darlings that did not pursue any major activity in the last year, 80% are still below their 1998 high and 60% have underperformed the Russell 2000 over the last year. These are results, keep in mind, for some of the most attractive small cap firms.

This is the fabled “two-tier” market beloved by value investors. While everyone else was chasing dot coms and large caps, small cap companies with excellent fundamentals were lying around waiting to be snapped up. The authors concluded:

The public markets continue to ignore companies with a market capitalization below $250 million. Most institutional investors have large amounts of capital to invest and manage, and small caps have become problematic due to their lack of analyst coverage and minimal public float. As a result, these “orphans” of the public markets are valued at a significant discount to the remainder of the market. We do not see this trend reversing, and therefore recommend an active approach to the directors and management teams at most small cap companies. Without serious consideration of a sale to a strategic or financial buyer, we believe these companies, despite their sound operating performance, will not be able to deliver value to their shareholders.

Tomorrow, the 2001 Endangered species update.

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Back in the spring of 1999, when the world was enamored of dot coms and not much else, three guys at Piper Jaffray, Daniel J. Donoghue, Michael R. Murphy and Mark Buckley*, produced a superb research report called Wall Street’s Endangered Species. The thesis of the paper was that there were a large number of undervalued companies with strong fundamentals and solid growth prospects in the small cap sector (defined as stocks with a market capitalization between $50M and $250M) lacking a competitive auction for their shares. Donoghue, Murphy and Buckley argued that the phenomenon was secular, and only mergers or buy-outs would “close their value gap:”

Management buy-outs can provide shareholders with the attractive control premiums currently experienced in the private M&A market. Alternatively, strategic mergers can immediately deliver large cap multiples to the small cap shareholder.

I believe that this phenomenon led to the emergence of activist investors in the small cap sector over the last decade. More on this in a moment.

Endangered species report

The document is drafted from the perspective of a M&A team selling corporate advisory services. Here’s the pitch:

Many well-run and profitable public companies in the $50-250 million market capitalization range are now trading at a significant discount to the rest of the stock market. Is this a temporary, cyclical weakness in small stocks that is likely to reverse soon? No, these stocks have been permanently impaired by a shift in the economics of small cap investing. This persistent under-valuation is sure to be followed by a rise in M&A activity in the sector. We have already seen an uptick in the number of “going private” transactions and strategic mergers involving these companies. Management teams that identify this trend, and respond to it, will thrive. The inactive face extinction.

Donoghue, Murphy and Buckley’s thesis was based on the then relative underperformance of the Russell 2000 to the S&P 500:

The accompanying graph, labeled Exhibit I, illustrates just how miserably the Russell 2000 lagged the S&P 500 not only last year but in 1996 and 1997 as well. Granted, small cap returns have tended to run in cycles. Since the Depression, there have been five periods during which small cap stocks have outperformed the S&P 500 (1932-37, 1940-45, 1963-68, 1975-83, and 1991-94). It is reasonable to believe that small caps, in general, will once again have their day in the sun.

They argued that the foregoing graph was a little misleading because the entirety of the Russell 2000 universe wasn’t underperforming, just the smallest members of the index:

However, a closer look at the smallest companies within the Russell 2000 reveals a secular decline in valuations that is not likely to be reversed. The table in Exhibit II divides the Russell 2000 into deciles according to market capitalization. Immediately noticeable is the disparity between the top decile, with a median market capitalization of $1.5 billion, and the tenth decile at less than $125 million. Even more striking is the comparison of compounded annual returns for the past ten years. The data clearly demonstrates that it is not the commonly tracked small cap universe as a whole that is plagued by poor stock performance but rather the smallest of the small: companies less than about $250 million in value.

Stocks trading at a discount to private company valuations

The underperformance led to these sub-$250M market cap companies trading at a discount to private company valuations:

Obscurity in the stock market translates into sub-par valuations. As shown in Exhibit IV, the smaller of the Russell 2000 companies significantly lag the S&P 500 in earnings and EBIT multiples. It is startling to find that with an average EBIT multiple of 9.0 times, many of these firms are valued below the acquisition prices of private companies.

And the punchline:

Reviving shareholder value requires a fundamental change in ownership structure. Equity must be transferred out of the hands of an unadoring public, and into those of either: 1) management 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 capital, and by shifting the focus away from quarterly EPS to long-term growth.

Increasing M&A activity

The market had not entirely missed the value proposition. M&A in the small cap sector was increasing in terms of price and number of transactions:

Darwin’s Darlings

Donoghue, Murphy and Buckley argued that the value proposition presented by these good-but-orphaned companies, which they called “Darwin’s darlings,” presented an attractive opportunity, described as follows:

Despite the acceleration of orphaned public company acquisitions in 1997 and 1998, there remains a very large universe of attractive public small cap firms. We sifted through the public markets, focusing on the $50-250 million market capitalization range, to construct a list of the most appealing companies. We narrowed our search by eliminating certain non-industrial sectors and ended up with over 1500 companies.

We analyzed their valuations relative to the S&P 500. The disparity is so wide that the typical S&P 500 company could pay a 50% premium to acquire the average small cap in this group without incurring earnings dilution. Those dynamics appear to be exactly what is driving small cap takeover values. The median EBIT multiple paid for small caps in 1998 was roughly equal to where the typical S&P 500 trades.

We honed in on those companies with multiples that are positive, but even more deeply discounted at less than 50% of the S&P 500. Finally, we selected only those with compounded annual EBIT growth of over 10% for the past five years. As shown in Exhibit VII, these 110 companies,“Darwin’s Darlings,” have a median valuation of only 5.8 times EBIT despite a compounded annual growth rate in EBIT of over 30% for the past five years.

The emergence of activists

Donoghue, Murphy and Buckley identified the holders of many of these so-called “Darwin’s darlings” as “small cap investment funds focused on likely take-over targets:”

As detailed in the description of our “Darwin’s Darlings” in Exhibit VIII, management ownership varies widely among these companies. For recent IPOs of family-held businesses, management stakes are generally high. For those that were corporate spin-offs, management ownership tends to be low. We frequently find large blocks of these stocks held by small cap investment funds focused on likely take-over targets, leading to a surprisingly high percentage of total insider ownership (management plus holders of more than 5%).

Regardless of ownership structure, these companies typically have the customary defensive mechanisms in place. They are also protected by the fact that they are so thinly traded. In most cases it takes more than six months to accumulate a 5% position in the stock without moving the market. Hence, we expect virtually all acquisitions in this sector to be friendly. There is no question that some very attractive targets cannot be acquired on a friendly basis. However, coercing these companies into a change of control means being prepared to launch a full proxy fight and tender offer.

In When Wall Street Scorns Good Companies, a Fortune magazine article from October 2000, writer Geoffrey Colvin asked of Darwin’s darlings, “So why are all these firms still independent?”

The answer may lie in another fact about them: On average, insiders own half their shares. When the proportion is that high, the insiders are most likely founders; they have enough stock to fend off any hostile approach, and they haven’t sold because they aren’t ready to give up control. Not many outside investors want to go along for that ride. Thus, low prices.

But there’s still a logical problem. Since the companies are so cheap, why don’t managers buy the shares they don’t already own– take the company private at today’s crummy multiple, then sell the whole shebang at an almost guaranteed higher price? Going private has in fact become more popular than ever, but what seems most striking is how rare it remains. Of Piper Jaffray’s 1999 Darwin’s Darlings– 110 companies–only three went private in the following 12 months. That makes perfect sense if you figure that many of the outfits are run by owner-managers whose top priority is keeping control. Announce a going-private transaction and you put the company in play, and even a chummy board may feel obliged to honor its fiduciary duty if a higher bid comes along.

Thus we reach the somewhat ugly truth about Wall Street’s orphaned stars: Many of them (not all) like things the way they are–that is, they like staying in control. The outsider owners are typically a diffuse bunch in no position to put heat on the controlling insiders. The stock price may be lousy, but when the owner-managers decide to sell–that is, to get out of the way–it will almost certainly rise handsomely, as it did for the 19 of last year’s Darwin’s Darlings that have since sold.

So shed no tears for these scorned companies, and don’t buy their shares without a deep understanding of what the majority owners have in mind. In theory the spreading corporate governance movement ought to protect you; in practice the shareholder activists have bigger fish to fry. Such circumstances may keep share prices down, but that’s the owner-managers’ problem. At least, in this case, the market isn’t so mysterious after all.

I believe that the third paragraph above best describes the reason for the emergence of the activists in the small cap sector. Observing that stock prices rose dramatically when owner-managers of “Wall Street’s orphaned stars” decided to sell, and outside investors were “typically a diffuse bunch in no position to put heat on the controlling insiders,” activist investors saw the obvious value proposition and path to a catalyst and entered the fray. This led to a golden decade for activist investing in the small cap sector, one that I think is unlikely to be repeated in the next decade. Regardless, it’s an interesting strategy, and an obvious extension for an investor focussed on small capitalization stocks and activist targets.

*Donoghue, Murphy and Buckley in 2002 founded Discovery Group, a fund manager and M&A advisory that takes significant ownership stakes (up to 20%) in companies trading at a discount to “fundamental economic value.”

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We’ll be in San Diego next week for the Hedge Fund Activism and Shareholder Value Summit. If you’re going too, and you’d like to catch up, we’d love to hear from you. You can reach us at greenbackd [at] gmail [dot] com.

We’ll be posting intermittently next week, but we’ll be back to our regular schedule starting from Monday, 28 September. Hopefully we’ll have some new insights to share.

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We’ve received some great investment ideas on this blog from our readers, and it seems a shame that they remain hidden in the comments of other posts (See, for example, Shake&Bake’s take on LDIS or Sop81_1’s analysis of EDCI). To that end, we’re extending an open invitation to anyone who wishes to submit a post for publication. The only requirement is that it be within the remit of Greenbackd, which is say that it is an undervalued asset situation with a catalyst. Email your idea to greenbackd [at] gmail [dot] com.

We have our first guest post for Friday from Wes Gray. We hope it’s the first of many.

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Catalyst Investment Research, the collaboration between Damien J. Park of Hedge Fund Solutions and The Official Activist Investing Blog, and Jonathan Heller, CFA, of Cheap Stocks, has a new Special Report on the Steel Partners II Investment Portfolio (.pdf).

In the Special Report, Damien and Jonathan analyze the Steel Partners II portfolio companies to determine which have been “unfairly impacted by the recent selloff” following Steel Partners II’s announcement that it will restructure as a publicly-traded holding company.

Damien and Jonathan describe the opportunity as follows:

Following months of litigation with several investors seeking to block the restructuring, Steel was granted Court approval to move forward with the plan on June 19. As a result, on July 15, Steel Partners distributed approximately half of the economic value of their fund via cash and a pro rata in-kind distribution of securities to those investors seeking to exit the fund immediately. Following the distribution, a number of smaller, illiquid securities observed enormous selloffs – causing a massive imbalance in supply and demand, and resulting in a precipitous decline in the market value of certain companies. We believe the dramatic reduction in value at a few of these companies is a short-term phenomenon and not correlated with the fundamental value intrinsic to the company.

Read the rest of the Special Report by clicking here (.pdf).

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Northstar Neuroscience Inc (NASDAQ:NSTR) has paid an initial distribution of $2.06 per share.

We’ve been following NSTR (see our post archive here) because it was a net cash stock that had announced a plan to liquidate. We estimated that the final pay out figure in the liquidation would be around $59M or $2.26 per share, which presented an upside of around 18% from our initial $1.91 position. The company had estimated a slightly lower pay out figure of between $1.90 and $2.10 “assuming we are unable to sell our non-cash assets” and expected the initial distribution to be approximately $1.80 per share. The $2.06 distribution returns our initial capital and makes our profit since inception 7.9%, with further distributions to come.

From the relevant report:

As previously disclosed, on June 12, 2009 Northstar Neuroscience, Inc. (the “Company”) filed Articles of Dissolution (the “Articles of Dissolution”) with the Secretary of State of the State of Washington in accordance with the Company’s Plan of Complete Liquidation and Dissolution (the “Plan of Dissolution”). The Articles of Dissolution became effective, and the Company became a dissolved corporation under Washington law, on July 2, 2009 (the “Effective Date”) at 5:00 p.m. Pacific Time.

In addition, the Company’s common stock (the “Common Stock”) was officially delisted from the NASDAQ Global Market at the opening of trading on the Effective Date, pursuant to the previously filed Form 25, which the Company filed with the Securities and Exchange Commission and The NASDAQ Stock Market, Inc. on June 22, 2009. The Company has instructed its transfer agent to close the Company’s stock transfer records as of the close of business on the Effective Date and no longer to recognize or record any transfers of shares of the Common Stock after such date except by will, intestate succession or operation of law.

On July 13, 2009, pursuant to the Plan of Dissolution, the board of directors of the Company approved an initial liquidating distribution of $2.06 per share to the shareholders of record of the Common Stock as of the Effective Date. The Company expects to pay this initial liquidating distribution in cash on or about July 15, 2009.

Pursuant to the requirements of Washington law, the Company intends to retain certain of the remaining assets of the Company to satisfy and make reasonable provision for the satisfaction of any current, contingent or conditional claims and liabilities of the Company until such time as the Company’s board of directors determines that it is appropriate to distribute some or all of such remaining assets. The amount and timing of any subsequent and final distributions will be at the discretion of the Company’s board of directors.

(emphasis added)

[Full Disclosure:  We do not have a holding in NSTR. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

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