institutional investors vs. “activists”

As I see it, today’s activist investors are the successors to the corporate raiders/ “greenmailers” of the 1980s.  In some cases–Carl Icahn is an example–they’re the same person.

Greenmailers (a takeoff on blackmailers) would typically attack small cash-rich companies by buying a 5% – 10% equity position and threatening to launch a hostile bid to take over the firm unless they were bought out at a high price.  That price would typically be all the cash in the corporate treasury.

The tactic often worked.  A CEO who had spent thirty years clawing to the top of the heap  so that he could exercise power and reap large cash/stock rewards during a five-year tenure as chief executive, knew he would be out the door if a change of control took place.  So he might be all for acquiescing to the greenmailer.  Sometimes, too, a company might have questionable accounting or other dirty secrets that could scarcely stand to see the light of day.

The issue for other shareholders:  while the greenmailer would make a financial killing, he would leave behind a firm drained of cash and typically worth considerably less than before the greenmailer showed up at the door.

Activists play a slightly different game.  They attack large companies (perhaps because smaller prey has long since been devoured).  They typically invest millions of dollars in buying a company’s shares, but because of the size of the target, may only hold 1% – 3% of the outstanding equity.  Activists typically demand seats on the board of directors and offer “advice,” which may be sound (or may not), and which usually consists in actions like dividend increases, stock buybacks and/or spinoffs of business lines.  These are all levers designed to get the stock price up quickly–so the activist can sell and be on his way.

The threat is the same:  the sitting CEO has run a grueling thirty-year corporate marathon only to see the prize snatched away as he’s crossing the finish line if the activist decides that he’s part of the problem.

The issue for other shareholders:  none of the actions activists recommend may be good for the long-term health of the company (look at what happened to J C Penney).  And unlike the greenmail case, where the attacker’s threat is to take over the firm–meaning a profit for other holders and resolution to the issue–the activist may well tie up management time and energy with proxy fights or other distractions that go on for years.

Tomorrow:  what to do.

 

 

analyzing sales rather than earnings (ii)

The answer the Bloomberg Radio reporter gave to the question, “Why sales, not earnings?” was that sales are harder for a less-than-honest company to manipulate.  In some highly abstract and technical way this might be true, but in any practical sense the reply is ridiculous.  Stuffing the channel is a time-honored, easy to do way of inflating sales.

Still, there are instances where an investor will want to look at sales rather than earnings.

1.  Value investors looking for turnaround situations will seek out companies with lots of sales but little in the way of earnings.  They’ll benchmark the poorly performing firm against a healthy rival in the same industry.  They figure that if the two firms have comparable plant, equipment and intellectual property, then a change of management should enable the weaker firm to achieve results that are at least close to what the stronger one is posting now.

As I see it, this mindset is what separates value investors from their growth counterparts.  The latter, myself included, begin to salivate when they see a strong bottom line; the former are magnetically attracted to big sales/no profits firms instead.

2.  Especially in the tech world, companies often go public before they become profitable.  AMZN, which didn’t report black ink for eight years after its IPO, is the poster child for this phenomenon.

Potential investors routinely look at the size of the market a given firm is addressing and the rate of its sales growth as a way of gauging its potential value.  This is a tricky thing to do, since it requires us to decide how much of the money the company is now spending is akin to capital spending–one-time foundation laying that won’t recur–and how much is spending that’s needed to generate each new sale.  Put a different way, it’s a decision on what is SG&A and what is cost of goods.  As AMZN illustrated, there’s huge scope for error here.

(An aside:  I attended an AMZN IPO roadshow presentation.  Management mostly said that during the PC era investors could have bought then-obscure companies like MSFT and CSCO and made a fortune.  The internet age was dawning and AMZN offered a similar chance.  Nothing but concept.)

3.  A simpler variation on #1  + #2, which is currently being worked vigorously by activist investors at the present time, is to find companies that may not break out results by line of business but which in fact operate in two different areas.  In the most favorable case for activists, the target firm will look like nothing special but have one high-growth, high-profit area whose strong performance is being obscured by a low-growth low/no-profit sibling.  The activist forces a separation, after which growth investors bid up the price of one area, value investors the other.

 

Obviously, no one uses just one metric.  But the way I look at it, the only persuasive case for using sales as the keystone to analysis is the value investor use I outlines in #1.

 

can activists pay their nominees to target company boards? should they?

Today’s Financial Times points out that 33 major American publicly traded companies have changed their bylaws to forbid board members from taking incentive payments keyed to the firm’s performance from third parties.

What is this all about?

In a sense, this is an aspect of the question of who really owns a company.  In theory, the owners are the shareholders and the company is run for their benefit.  As a matter of practice, most often the top management of the firm is in control.  It is usually happy with the status quo, and doesn’t typically stint on corporate jets, country club memberships and the like for themselves.

That’s where the board of directors comes in.  The board is elected by the shareholders to run the company.  It does so by appointing professional management to actually do the job, while it supervises, sets compensation and approves major decisions.  Control the board and you control the company.

A time-tested way for activist investors (a term which covers a whole raft of characters, from greenmailers and corporate raiders to more respectable operators who simply want to replace incompetent management) to influence the running of a company is through its board.  Activists often wage proxy battles to get their own nominees elected to the board by shareholder vote.  What better way, activists argue, to motivate such nominees to press for improved corporate performance than to pay them bonuses for achieving it?

The idea of activist investors compensating compliant directors potentially strengthens the activists’ hands in the three-way battle for company influence among:  management (which is virtually always backed 100% by individual shareholders, regardless of performance), institutional investors (who want strong stock performance but who suspect activists) and the activists themselves.

Personally, I think suspicion of activists is often warranted.  After all, look at what Bill Ackman did to JCP.  He erased a third of that firm’s revenues and all of its profits, and then sold his stock quickly–with board approval–at much more favorable prices than ordinary shareholders were able to achieve.  Thanks a lot.

So far, activists haven’t had much success with their pay-for-performance strategy, mainly because the incentivized nominees have lost in their board elections. But managements apparently see this tactic as enough of a threat to be quietly closing the door to it.

To me, the most interesting question is why activists feel the need to motivate their hand-picked board nominees with sizable amounts of cash.  From their rhetoric, it appears the answer is that their successful nominees quickly get used to receiving  hundreds of thousands of dollars for attending a few meetings a year, plus free use of the company’s jet fleet, free lunch   …and find the prospect of living the good life up much less appealing than they did when they were standing outside with their noses pressed up against the glass.