Thought for the Week (301):
Activist Investors Play An Important Role
· Value investors look for opportunities in assets that are undervalued and take on a “passive” or “active” role depending on the level of interaction they seek with a company’s leadership.
· Activist investors will often fight company management and the Board of Directors in a very public and aggressive manner to get their way.
· Although the Investment Committee remains passive, we believe that activist investors can play an important role in equity markets by keeping management teams focused on value creation.
Active vs. Passive
Warren Buffett is one of the world’s most famous and successful “value investors” who coined a rather famous line many years ago:
“Price is what you pay, and value is what you get”
Although this statement may seem overly simplistic for someone whose net worth exceeds several billion dollars, the Investment Committee would highly recommend that every investor memorize this sentence (perhaps even print out a copy and hang it on a wall).
For example, let’s say that we were to find an Armani sweater hidden in the racks at a discount retailer for 75% off the retail price, simply because there is a small hole in the fabric. We could purchase the sweater, fix the small hole, and then have a very nice sweater for a fraction of the price.
Similar opportunities exist in equity markets, and value investing is predicated upon the idea that these markets overreact to negative information. In our example above, the Armani retail store overreacted to a small hole in a sweater and chose to dump it at an assumingly low price. Our savvy discount shopper realized the opportunity and bought an asset that was unfairly punished.
Stock prices often overreact in the same manner and value investors who can see the opportunity and are patient enough to wait for a thesis to play out can realize substantial returns. The trick, however, is to pay attention to the value instead of the price.
Value investors who make the mistake of focusing on price alone often end up buying “value traps”. These are stocks that screen cheap but are cheap for a reason. Let’s say that the hole in the Armani sweater was swapped for a large discoloration on the back of a sleeve. Had our shopper not thoroughly examined the sweater, he would have purchased something that would likely never be seen out in public.
Simply put, value investors do not buy stocks because they are cheap, but rather for the reason that they represent a good value. Furthermore, their level of involvement will classify them into one of two types:
Passive investing is relatively straightforward because it’s not much more than a “buy and hold” strategy. On the other hand, active investing can be quite complex and even highly aggressive at times. Here’s how it works:
The activist investor screens for undervalued companies and identifies the reason why a specific company is undervalued. If actions by management can make that value realized, they will acquire the stock. Some examples of potential management actions that can create value include spinning off subsidiaries or underperforming divisions, using cash to buy back stock or paying a larger dividend, sell the company, etc.
NOTE: Most activist investors need large amounts of capital because they must purchase enough stock to be taken seriously. In most cases, an activist investor needs 5% or more of the shares outstanding to have the “muscle” necessary to fight with management.
Typically, the activist investor will meet with the management team of the company to make their case to unlock value within the enterprise. These conversations often go nowhere given an aversion towards change from management (think about how many CEOs would welcome criticism from an outside party) or due to a fundamental disagreement on just how much value can be unlocked.
If conversations with management are not constructive, then the activist investor will often publicly lobby the Board of Directors to adopt their proposed changes. The Board oversees company management and is established to serve in the best interest of shareholders. Therefore, they have the power to replace managers and force some level of change when necessary.
If both the management team and Board resist an activist investor’s idea(s), a “proxy fight” can emerge. Basically, the activist will lobby other large stockholders in an attempt to get enough shareholder votes to force the Board to make change. All in, the whole process can take years and require a tremendous amount of time, effort, and most of all patience.
Simply put, the main difference between an active and passive investor is that although both strive to identify hidden value in a stock, an active investor will take part in unlocking that value whereas a passive investor leaves that job to the current management.
The Good, The Bad, & The Ugly
Activists are tenacious and will publicly fight with management for years when necessary. In fact, many will lobby government officials and even get litigious with Boards. Although many of their tactics may appear hostile, they serve a very important purpose in markets because managers realize that when they destroy shareholder value, activists will likely be there to step in and demand change.
For example, the management team at Apple had been criticized for years over their exorbitantly large cash balance, which exceeded $150 billion at one point. Such a large cash balance sitting in the bank earns no interest, and financial theory states that if a company has no credible growth prospects then they should give cash back to shareholders so they can redeploy that cash into better investments.
Despite shareholder frustrations, Apple was never the target of an activist until their stock fell from close to $800 down to $500 in a matter of months. The pressure on management continued to escalate to the point where two very well known activists, Carl Icahn and David Einhorn, got involved. Both investors are quite powerful on Wall Street and are savvy enough to know how to apply pressure to corporate management and Boards.
The end result has been a much more shareholder friendly Apple, where they now pay a strong dividend and have been buying back shares. The Investment Committee strongly agreed with the activists involved in Apple because the company was not acting in the best interest of shareholders who did not have as strong of a voice as Mr. Icahn.
Although this example with Apple shows the good in activists, there have been several scenarios where the bad, and even the ugly, has emerged. At the end of the day, activists are trying to make money and often their incentives are not aligned with the long-term health of a target company.
Activists have been known to fight to achieve short-term results that will cause only a temporary pop in the stock. The activist will then book a healthy profit by selling the stock with little regard to the long-term fundamental health of the company. Furthermore, activists tend to force managers to spend time and energy fighting them instead of dedicating their focus to running the business.
Implications for Investors
One of the most basic economic principles is that individuals are “self-interested”. Meaning, our primary goal is to better our lives over the long run. Activists have clients that are paying them to grow their investment just as any investor would expect. Therefore, it’s important to remember that these activists may make decisions that benefit their investors but hurt the shareholders of the companies they target.
Although activists may not always have their incentives aligned with their targets, they serve an important role in markets because they create a form of “checks and balances” with shareholders that are too small to have a voice. Managers who make repeated mistakes and destroy shareholder value should be held accountable, and if a Board is not acting in the best interest of its shareholders, then activists step in because they recognize value and will fight to unlock it.
The bottom line is that the Investment Committee applauds activists only when their efforts are intended to enhance the long-term benefit for the company and its shareholders.
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