Posts Tagged ‘Activism’

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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Update: Icahn drops the hammer

From the press release:




CONTACT: SUSAN GORDON (212) 702-4309

NEW YORK, NEW YORK, DECEMBER 6, 2011 – Carl C. Icahn today announced that Icahn Enterprises Holdings LP (a subsidiary of Icahn Enterprises LP (NYSE: IEP)), intends to initiate a tender offer for all of the outstanding shares of common stock of Commercial Metals Company (the “Company”) at $15 per share.

Closing of the tender offer will not be subject to any due diligence or financing conditions, but will be subject to the redemption by the Company’s Board of Directors of the recently adopted “poison pill” and waiver by the Board of Directors of Section 203 of the Delaware General Corporation Law, as well as other customary conditions. The tender offer will be subject to there being validly tendered and not withdrawn at least 40.1% of the issued and outstanding shares of the Company. That number of shares, when added to the shares already owned by the offeror and its affiliates, represents a majority of the issued and outstanding shares of the Company on a fully diluted basis. The tender offer will include withdrawal rights so that a tendering shareholder can freely withdraw any shares prior to the acceptance of such shares for payment under the tender offer.

Mr. Icahn stated that: “It is disappointing that this Board and management team rejected our all cash offer to buy Commercial Metals at $15 per share. I believe it was incumbent on the Board, and that the Board’s fiduciary duties required it, to allow shareholders to decide whether they wished to sell their Company.

Our tender offer will be directed to shareholders and will require shareholder action. After attempting to work with the Board, we are launching this tender offer so that shareholders can decide for themselves what they wish to do with their company.

We urge you to tender your shares. We have tried and failed to reason with the Board and management, and now it is incumbent upon you to voice your view and urge the Board to respond to shareholder demands. A strong tender offer response will send an unmistakable message to the Board that they need to redeem the poison pill and waive Section 203 so that the tender offer can close and shareholders can be paid immediately. All tendered shares will have withdrawal rights so that a tendering shareholder can freely withdraw any shares previously tendered prior to the acceptance of such shares for payment under the tender offer.

The tender offer price represents a premium of 31% over the stock’s closing price on November 25, 2011 (the trading day immediately prior to our previously announced offer to acquire the Company), which was $11.45, and a premium of 72.6% from its low this year on October 3, 2011, which was $8.60. If a majority of shareholders accept our tender offer (including shares already owned by the offeror and its affiliates), we do not believe that even this Board will stand in the way of allowing a majority of its shareholders from accepting this premium if they wish to do so. However, if the Board, even after hearing from a majority of shareholders, fails to lift the poison pill and waive Section 203, we will leave the tender offer open and seek a court order compelling the Board to redeem the poison pill and waive Section 203 so that the shareholders can receive their money.

We hope that even this Board will not decide to waste time and money fighting the will of shareholders in a courtroom battle. But, if they choose to do so, please know that we will fight this case all the way to the Delaware Supreme Court, and it is our belief, that we will prevail on the merits and that the court would order the Board to redeem the pill and waive Section 203 so that the shareholders can be paid. Obviously, the greater the amount tendered, the stronger our case will be.

Commercial Metals has consistently been at odds with good corporate governance standards. Examples of the lack of good corporate governance that are blatantly hostile to shareholders abound and include: (i) the retention of a staggered board, (ii) the adoption of a poison pill without shareholder approval and at the extremely low trigger of 10%, and (iii) the refusal by the Board to allow shareholders to vote on whether our offer was sufficient.

In addition, the 2011 ISS Proxy Advisory Services Report for Commercial Metals highlights numerous other areas of “High Concern”. ISS also noted that Commercial Metals sustained poor total shareholder return performance as determined by ISS’ standards. As a result of the Company’s poor performance, it is extremely important to send a clear message to the Board and management by tendering your shares.

Carl Icahn submitted a bid  for Commercial Metals Company (NYSE:CMC) last week that prompted an odd response from the company. Icahn sent a follow-up letter that was vintage Icahn. It seems management continued to ignore him, so late last week he sent a further letter to the company demanding action by yesterday at 9am. Icahn’s letter:


December 2, 2011

Board of Directors
Commercial Metals Company
6565 North MacArthur Boulevard, Suite 800
Irving, Texas 75039

Ladies and Gentlemen:

On Monday, we informed you and publicly announced that Icahn Enterprises LP would purchase Commercial Metals Company at $15 per share, in cash, without any financing or due diligence conditions. Disappointingly, it is Friday afternoon, the week is over, and we have still not heard from you.

We are sure that you are keenly aware that since our announcement, over 22 million of the Company’s shares have traded. This represents over 19% of the Company’s outstanding shares, and is 200% higher than the average weekly trading volume over the past 52 weeks. To allow your shareholders to trade such heavy volumes without responding to our offer is completely irresponsible – but wholly consistent with the pattern of irresponsibility demonstrated by the Company over the years.

Icahn Enterprises (which currently has, on a consolidated basis, $22.4 billion of assets, including in excess of $13 billion in liquid assets, which are cash and marketable securities) made a legitimate offer to acquire your Company, and to be clear, we continue to be immediately ready to meet with you to document the transaction. We are not asking for any due diligence or financing conditions. All that we are asking is that you allow your shareholders to decide if they wish to sell their company.

We have received a number of inquiries from shareholders this week, as we are sure you have too. Shareholders deserve an answer; it is incumbent on this Board to respond to our offer. To that end, if you continue to disregard your duties and have not contacted us by 9:00 a.m., New York City time, on Monday, December 5, 2011, to schedule a meeting to discuss our offer, please be forewarned that we intend to take matters into our own hands.

Carl C. Icahn

No position.

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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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Carl Icahn has plowed $1 billion into energy stocks over the last 6 months according to his latest SEC filing. Says The NYTimes Dealbook column:

Yet speculation is rife given the activist investor’s history with energy companies and his reputation for focusing on companies that he believes are undervalued and ripe for a shake-up in some way — with a restructuring or a sale among the possibilities.

One company that may have attracted his interest is one he already knows:  Anadarko Petroleum. Shares of Anadarko, a Texas-based Independent oil company, tumbled in the spring after the explosion and spill at a BP-operated well in the Gulf of Mexico. Anadarko owns a 25 percent stake in the well.

Anadarko’s stock price fell below $35, wiping $19 billion off its market capitalization. (The stock has since recovered, closing at $56.35 on Monday.)

Mr. Icahn goes back several years with Anadarko.  In 2005, Mr. Icahn and a fellow activist investor, Jana Partners, accumulated a 7 percent stake in Kerr-McGee, an Oklahoma-based energy exploration and production company. The Icahn group demanded the company sell off certain units and commence a big stock buyback.  Kerr-McGee did, and then sold itself to Anadarko for $16.4 billion, representing a rich premium of 40 percent.

Mr. Icahn built his stake in the combined company, and by the beginning of 2008 he had 14.8 million Anadarko shares worth around $971 million.

“Investors who bought Kerr McGee stock on the same date I invested and profited from the acquisition by Anadarko realized an approximate 234 percent return,” Mr. Icahn wrote on his blog, the Icahn Report, in 2008.

He rode Anadarko up to its high price of around $80 a share in May of 2008 as oil prices  headed to $147 a barrel.  But Mr. Icahn appeared to be focusing more of his attention and money on his campaign against Yahoo. Oil prices slid to under $35 a barrel as the financial crisis took hold.  Mr. Icahn began selling off his stake and was completely out of Anadarko by May 2009.

Read the article.

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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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Central to the discussion of sub-liquidation value investing in Japan is the ability or willingness of shareholders to influence management, and management’s willingness to listen. As Ben Graham noted in the 1934 edition of Security Analysis, in the US:

The whole issue may be summarized in the form of a basic principle, viz:

When a common stocks sells persistently below its liquidating value, then either the price is too low, or the company should be liquidated. Two corollaries may be deduced from this principle:

Corollary I. Such a price should impel the stockholders to raise the question whether it is in their interest to continue the business.

Corollary II. Such a price should impel the management to take all proper steps to correct the obvious disparity between market quotation and intrinsic value, including a reconsideration of its own policies and a frank justification to the stockholders of its decision to continue the business.

The perception is that, in Japan, these two corollaries do not flow from that basic principle. As The Economist notes in a February 2008 article, Samurai v shareholders: Japan’s establishment continues to rebuff foreign activist investors (subscription required):

Japanese businessmen and politicians fear that the activists are short-term investors keen to strip firms of their cash. The conflict highlights a fundamental divide: companies in Japan are social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.

And therein lies the rub. Companies in Japan are social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.

Can foreign investors not subject to the cultural expectation that companies consider the needs of employees and the community at large succeed?

According to a 2009 Knowledge@Wharton article, How the Environment for Foreign Direct Investment in Japan Is Changing — for the Better, the environment for foreign investors in Japan is improving, but continues to be more bureaucratic than in the US:

Despite the support shown by elected officials for increasing [foreign direct investment] in Japan, foreign investors still face a substantial amount of bureaucratic red tape, particularly with respect to protected industries. [Direct investment] is principally governed by the Foreign Exchange and Foreign Trade Control Law, which specifically prevents foreign investors from acquiring a majority stake in Japanese companies within industry sectors classified as closely related to national security and public safety. This includes industries as diverse as aeronautics, defense, nuclear power generation, energy, telecom, broadcasting, railways, tourist transportation, petroleum and leather processing.

Foreign investors intending to make direct investments in certain industries must file with the Japanese Ministry of Finance as well as the respective ministry governing the specific industry of the investment target. If issues are found in relation to the investment, either the Ministry of Finance or the industry-specific ministry has the authority to issue an official recommendation to revise the investment plan or to put a complete stop to the acquisition. Industry-specific regulations that, for example, limit foreign ownership to one-third for airline and telecom companies, further constrain foreign investors.

It’s worth considering the experience of two notable activist campaigns in Japan. The first, Steel Partners’ campaign for Sapporo, the brewer, is described in the Knowledge@Wharton article:

Steel Partners has imported its U.S. activist investment model to Japan and has shown a willingness to question publicly the strategy of current management at its investment targets and to litigate disagreements.

As a result of Steel Partners’ posture, the firm’s take-over bid for household-brand Bulldog Sauce met with resistance from the media and Japan’s legal system. The court to which Steel Partners appealed a failed injunction to prevent Bulldog’s poison-pill strategy stated: “[Steel Partners] pursues its own interests exclusively and seeks only to secure profits by selling companies’ shares back to the company or to third parties in the short term, in some cases with an eye to disposing of company assets…. As such, it is proper to consider the plaintiff an abusive acquirer.”

The Economist article discusses the The Children’s Investment Fund’s (TCI) battle for the Japanese power provider J-Power:

The biggest showdown between the activists and the establishment is at J-Power, the former state-run energy firm, which was privatised in 2004. [TCI] a British fund, which owns 9.9% of the firm, has been politely but firmly lobbying J-Power to appoint two TCI representatives to its board, improve margins and unwind cross-shareholdings with other firms. Having been rebuffed, TCI now wants to double its bet. In January it asked for permission to increase its stake to 20% (any holding above 10% requires government approval). John Ho, the head of TCI’s Asian operations, says the deal is a test of the integrity of Japan’s reform agenda. And it would be, except that Mr Ho has chosen a remarkably hard case. Japan, lacking natural resources, is worried about energy security and is reluctant to hand more control over its power infrastructure to foreign investors.

The Knowledge@Wharton article concludes:

After applying for approval to increase shareholdings to 20%, TCI met a wall of resistance: J-Power management cautioned that TCI could cut maintenance and investment costs in nuclear plants, and the Japanese media relayed sensationalist warnings about the potential for “blackouts.” The result: The Japanese government blocked the investment.

These are not encouraging outcomes. The final word is best left to Takao Kitabata, the vice-minister of Japan’s powerful Ministry of Economy, Trade and Industry (METI):

To be blunt, shareholders in general do not have the ability to run a company. They are fickle and irresponsible. They only take on a limited responsibility, but they greedily demand high dividend payments.

High dividend payments? We’re a long way from liquidation as a matter of course.

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Farukh Farooqi, a long-time supporter of Greenbackd and the founder of Marquis Research, a special situations research and advisory firm (for more on Farukh and his methodology, see The Deal in the article “Scavenger Hunter”) provided a guest post on Silicon Storage Technology, Inc (NASDAQ:SSTI) a few weeks back. Farukh wrote:

Activist-Driven Situation Summary: Silicon Storage Tech. (SSTI; $2.78) dated January 6, 2010

SST is a fabless, designer and supplier of NOR flash memory chips which are used in thousands of consumer electronic products. It has two businesses – Products sales of $240 mm with 20% gross margin and licensing revenues of $40 mm with near 100% margin.

As of September 30, 2009, SST had cash and investments of $2.14 per share, net non-cash working capital of $0.41 per share and zero debt. This implies that the market is valuing its business at $0.23 per share or $22 mm. This is a Company which annually spends $50 mm on R&D alone!

Judging from last 10 years of SST’s history, valuation has suffered from (1) dismal bottom line performance and (2) Corporate governance issues.

After bottoming in Q109, Company revenues and margins have rebounded sharply. The Board has decided to take this opportune time to create “value” for shareholders by selling it to a private equity fund for … $2.10 per share. As part of the deal, the current CEO and COO are going to keep their equity interest in the private Company.

In response, an activist shareholder (Riley Invesment Management) resigned from the Board when the Go-Private deal was announced. Last week, he and certain other large shareholders formed SST Full Value Committee and have asked the Board to reconsider the transaction.

Given the governance issues (which could improve as a proxy fight to add independent members is underway), a discount to the peer group is warranted. However, whether you value it on EV/Revenue, EV/EBITDA or Price/Tangible Book Value, the stock has 50% to 200% upside potential.

Farukh has left a comment that I want to draw to your attention:

SSTI being acquired by MCHP for $2.85 per share.

Does this price make sense?

SSTI has $2.55 per share in cash, investments and net working capital. Which means, MCHP is really offering $0.35 per share in value or approximately $35 mm for a semiconductor business which generates $280 mm in sales and almost $50 mm per anum in gross profit and another $40 mm per year in license fees.

The license fees alone can be worth $200 mm using a 20% yield.

SST story reminds me of the Road Runners cartoon with management being the Wile E. Coyote, trying to sabotage shareholders every which way….. Beep Beep.

[Full Disclosure: I do not hold SSTI. 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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The Official Activist Investing Blog published its list of activist investments for November (My apologies. I’m a little tardy with it):

Ticker Company Investor
ADPT Adaptec. Inc. Steel Partners
AEPI AEP Industries KSA Capital
AGYS Agilysys Inc MAK Capital One
BKS Barnes & Noble Inc Ronald Burkle
CITZ CFS Bancorp Inc. Financial Edge Fund LP
CLCT Collectors Universe Marlin Sams Fund
CNO Conseco Inc. Paulson & Co
COBR Cobra Electronics Corp Timothy Stabosz
CWLZ Cowlitz Bancorporation Crescent Capital
DEST Destination Maternity Corporation Crescendo Partners
DGTC.OB Del Global Technologies Steel Partners
DVD Dover Motorsports Marathon Partners
EDAC Edac Technologies Corp Resilience Capital
EQS Equus Total Return, Inc. Sam Douglass
FCM First Trust/Four Corners Senior

Floating Rate Income Fund

Bulldog Investors
FFHS First Franklin Corp Lenox Wealth Management
FGF SunAmerica Focused Alpha Growth Inc Bulldog Investors
FGF SunAmerica Focused Alpha Growth Fund, Inc. Bulldog Investors
FGI SunAmerica Focused Alpha Large-Cap Fund, Inc. Bulldog Investors
GLA Clark Holdings, Inc. Cherokee Capital Management
GRNB Green Bankshares, Inc. Scott Niswonger
GSIG.PK GSI Group Stephen Bershad
GSIG.PK GSI Group JEC II Associates LLC
IMMR Immersion Corp Ramius Capital
IPCS iPCS, Inc. Greywolf Capital Management
JTX Jackson Hewitt Tax Service Inc. Discovery Capital
KONA Kona Grill Inc BBS Capital Management
LEGC Legacy Bancorp Inc. Sandler O’Neill Asset Management
LNY Landry’s Restaurants Inc. Pershing Square Capital
MACE Mace Security International Inc Lawndale Capital
MEG Media General Inc GAMCO Investors
MGYR Magyar Bancorp Inc. Financial Edge Fund
MYE Myers Industries Inc GAMCO Investors
OMPI Obagi Medical Products Discovery Group
ORCC Online Resources Corp Tennenbaum Capital Partners
OSTE Osteotech Inc. Kairos Partners
PLFE Presidential Life Corp Herbert Kurz
PTEC Phoenix Technologies Ramius Capital
PTFC.PK Penn Traffic Co Foxhill Opportunity Fund
SONA Southern National Bancorp of Virginia Inc Patriot Financial Partners
SRO DWS Rreef Real Estate Fund, Inc Susan Ciciora Trust
SSTI Silicon Storage Technology Inc Lloyd Miller
TICC TICC Capital Corp Raging Capital Management
TRA Terra Industries Inc CF Industries Holdings
TXCC Transwitch Corp Brener International Group
UAHC United American Healthcare Corp. Strategic Turnaround Equity Partners
UAHC United American Healthcare Corp John Fife
USAT USA Technologies Inc. Brad Tirpak; Craig Thomas
WWVY Warwick Valley Telephone Co Santa Monica Partners

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