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Activist investors—fund managers that hope to drive up share prices by actively changing their target company’s strategy—often produce attractive returns for their clients. If you’re not one of the fortunate few to be a client, you can still use their influence to help with your turnaround investing.
As a turnaround investor, you can harness activists in two ways: buy a position in a stock with the expectation that an activist will soon follow, or buy after an activist takes a stake.
While one of the many dozens of activist funds might find their way to selecting your particular stock, this approach is likely to be frustrating and unrewarding. Activists choose where and when to strike, while you are left guessing and waiting with a stock that might never get the call (and may continue to be a laggard). You have to wait for a catalyst, but activists are their own catalyst. If you find a stock with all the other turnaround traits you want, the potential for later activist involvement can bring an added appeal but it should not be the primary motivation for buying a stock.
A better approach is to buy after the activist makes their move. You will probably have to pay a bit more for your shares, but the outcome is more likely to be positive. Once an activist takes a stake in a company, how do you evaluate whether it is worthwhile to follow on? This is a bit of an art, but the primary criteria include the following:
1. Stock is a laggard and/or undervalued. How badly has the stock lagged the market and its peers? How undervalued is the stock relative to its peers and its own history? The weaker and cheaper the shares, the strong the activist’s case that something needs to change and the greater the potential upside if their campaign is successful.
2. Operating margins have decayed and lag peers. How weak are its operating margins compared to its past and to its peers? How long have margins been a problem? Chronically weakening margins can indicate weak management and provide more opportunity for improvement.
3. Assets and cash flows are poorly utilized. Does the company have excess cash or overly-conservative amounts of debt? To what extent is cash being re-invested in low-return businesses? Are there mis-fit operations or clearly lagging divisions that should be sold or spun-off? All of these offer opportunities for activists to make improvements.
These first three criteria can be measured in hard numbers. Two softer criteria that can be just as important include the following:
4. Undercurrent of grumbling among the shareholder base. To what degree has there been grumbling among shareholders about entrenched, weak or overpaid management? Company leadership is supposed to work for the shareholders, not reward themselves, so a combination of weak stock returns and weak accountability can grate on investors nerves. Similarly, a poorly articulated strategy, or one that sounds good but isn’t delivering, as well as a bloated cost structure, can imply a lazy or out-of-touch management team. All of these strengthen the activist’s case that meaningful change is needed and would boost the shares if implemented.
5. Company leadership’s credibility relative to the activists’. The weaker the company’s share and operating performance, the weaker its leadership’s credibility. Spiffy anti-activist marketing blitzes, legal defenses like poison pills, and pure bluster have increasingly limited impact and can actually reduce management’s credibility. Similarly, activists gain credibility through the quality and detail of their research on the target, the merits of their arguments, their track record of successes in previous campaigns, their overall fund performance and their amount of assets under management. When the activist asks for support from mutual funds, pension funds and even ETFs, credibility is critical. As an extreme illustration of credibility: a shareholder gadfly at the annual meeting won’t get far, but if Warren Buffett shows up, his words are likely to be heeded.
What you are looking for is an activist campaign targeting a weak stock with a sound plan for large and obvious improvements that has a solid chance of being implemented. With these, the stock has the ingredients for meaningful gains.
In our next note on activists, we’ll evaluate two currently-running activist campaigns with these criteria.