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Posts Tagged ‘Shareholder activist’

There are good reasons for tracking activists. For one, research supports the view that stocks the subject of activist campaigns can generate significant above market returns, on the filing and, importantly, in the subsequent year. Recent industry research by Ken Squire, manager of the 13D Activist mutual fund (DDDAX), finds an average outperformance of 16% over the subsequent 15 months for companies larger than $1 billion in market cap:

Ken Squire is founder and principal of 13D Monitor, a research service that tracks activist investing and has data on Icahn-led activist situations since 1994, when the investor targeted Samsonite Corp. The average return of the 85 positions since then was 18.7% (measured until he closed the position, if at all), compared to 12.7% for the Standard & Poor’s 500 over comparable time frames.

Yet this impressive-seeming average outperformance should be viewed in the context of a general tendency of stocks to outperform once they have attracted the intense interest of known activist investors. In other words, this doesn’t apply to Icahn alone.

Squire calculates that, following a 13D filing, the shares of companies larger than $1 billion in market value have historically outperformed the S&P 500 by an average of 16 percentage points over the subsequent 15 months. A separate study of nearly 300 activist actions by hedge funds between April 2006 and September 2012 found a similarly strong record of success. Squire runs the relatively new (and so-far small) 13D Activist mutual fund (DDDAX), which chooses stocks from among ongoing activist situations and beat the S&P 500 by 5.27% in 2012, after fees.

Squire takes into account the past record of specific activist investors when considering fund holdings. Hedge fund JANA Partners, for example, has a strong success rate in its arm-twisting maneuvers on corporate executives it deems lacking. One of its prominent targets currently is Canadian fertilizer giant Agrium Inc. (AGU).

Squire’s research accords with earlier studies on this site, most notably these two:

  1. In Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors, April Klein and Emanuel Zur examined recent “confrontational activism campaigns” by “entrepreneurial shareholder activists” and concluded that such strategies generate “significantly positive market reaction for the target firm around the initial Schedule 13D filing date” and “significantly positive returns over the subsequent year.” The authors find that the filing of a 13D notice by an activist hedge fund is a catalytic event for a firm that heralds substantial positive returns in the stock. Klien and Zur found that “hedge fund targets earn 10.2% average abnormal stock returns during the period surrounding the initial Schedule 13D. Other activist targets experience a significantly positive average abnormal return of 5.1% around the SEC filing window. These findings suggest that, on average, the market believes activism creates shareholder value. … Furthermore, our target abnormal returns do not dissipate in the 1-year period following the initial Schedule 13D. Instead, hedge fund targets earn an additional 11.4% abnormal return during the subsequent year, and other activist targets realize a 17.8% abnormal return over the year following the activists’ interventions.”
  2. In Hedge Fund Activism, Corporate Governance, and Firm Performance, authors Brav, Jiang, Thomas and Partnoy found that the “market reacts favorably to hedge fund activism, as the abnormal return upon announcement of potential activism is in the range of [7%] seven percent, with no return reversal during the subsequent year.” Further, the paper “provides important new evidence on the mechanisms and effects of informed shareholder monitoring.”

h/t @reformedbroker

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Kinnaras Capital Management has sent a follow up letter to Media General Inc (NYSE:MEG) requesting the board “selloff MEG in its entirety and divorce this company from the inept management team currently at the helm.”

In its earlier letter Kinnaras expressed frustration with the performance of MEG, and urged the Board to “take advantage of the robust M&A market for both newspaper and broadcast television and to sell all operating units of MEG in order to retire existing corporate and pension debt and achieve a share price shareholders have rarely seen in recent years.”

MEG is a provider of local news in small and mid-size communities throughout the Southeastern United States. It owns three metropolitan and 20 community newspapers and 18 network-affiliated broadcast television stations Virginia/Tennessee, Florida, Mid-South, North Carolina, and Ohio/Rhode Island.

The initial letter included Kinnaras’s sum-of-the-parts valuation, which Kinnaras Managing Member Amit Chokshi sees at $9.75 per share against a prevailing price of around $4.60.

Here’s the follow up letter:

Kinnaras also has on its website its recommendations to MEG shareholders ahead of the proxy vote.

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

Says Michael of the target companies in his white paper:

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

How cheap is “cheap”?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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