Investing alongside activist investors can be a tantalizing proposition. There are few outright bargains in the market now and a company that is trading cheaply with a definite catalyst in an activist investor gaining control can be very appealing. We have invested alongside activists several times over the years. We have had our successes and failures, so we want to share three rules we have developed over time that we believe increase the odds of an investment alongside an activist being a success.
1. Try to buy at a similar price as the activist
This is probably our most important rule. If you are going to depend on a third party (the activist) for your investment thesis to work out, you need to ensure that your interests are aligned with those of the activist. The easiest way to do that is buy shares at a similar price (or lower) as the activist investor. If you do that, you will be in the same boat as them.
Take the hypothetical example of XYZ Company. It is trading at $20 per share and an activist investor announces they have bought shares and are pushing for a sale of the company. They say they believe they can get it sold for $40 per share. Over a short period of time, the stock price goes up to $32 on anticipation of a quick sale and you decide the activist investor's case is compelling. You buy in alongside them albeit at the higher price of $32. Months go by and the company has a hard time finding buyers and the stock price falls back to $25. Finally after many months, the company announces it found a PE consortium to buy it out at $30 a share. It is a decent premium to the current trading price and the activist is happy because they paid $20 a share, so they readily agree to the deal. Unfortunately, the deal leaves you with a $2 per share loss.
While this example may be extreme, it shows the pitfalls of not having your interests aligned with an activist. A deal that may be good for them might not be good for you.
2. Focus on businesses that are underperforming their peer group
The second rule we have is to try to limit or investments to situations where companies are underperforming their peer group. When it is clear that the issue with a company is with its management, it is much easier to fix. All the activist investor needs to do is bring in new management that is competent and can run things the same way the company’s peers are being run.
Take the example of Darden Restaurants (DRI, Financial) and Starboard Value. Darden’s profit margins and restaurant traffic numbers were far below peers. All (and we say this semi-facetiously as turning around a company is no small task) the new management team hired by Starboard needed to do was do what Brinker International (EAT, Financial) had done to improve their business.
When a company can copy another company’s existing playbook for success, it greatly improves the odds of an investment working out in everyone’s favor.
3. Avoid situations where business fundamentals are unfavorable
Many activist campaigns focus on unlocking “hidden” assets at an often times troubled company or turning around a business in a challenged industry. We prefer to avoid these situations.
Take Starboard’s campaign at Macy’s (M, Financial) for example. It focuses on unlocking Macy’s hidden real estate value by selling off a substantial portion of the company's retail locations. The problem is that the entire department store sector is challenged. While several of the prime real estate locations likely have a lot of value, I am skeptical that a vast majority of the company's mall locations have substantial value given current mall traffic trends. More importantly, the value of the core business may be declining faster than the value of the real estate holding can be realized.
Or take Bill Ackman (Trades, Portfolio)’s infamous JCPenney’s (JCP, Financial) activist campaign. It should serve as ample warning about how hard it is to turn around a struggling business. JCPenney’s faced numerous challenges that even an executive as talented as Ron Johnson could not overcome.
Instead, our advice is to stick to companies operating in markets that are doing well. Avoid companies that need massive turnarounds and are operating in markets that are being disrupted.
We hope you can learn from our experiences investing alongside activists and that this checklist can help you determine which potential activist investments have the best chances of success.
Disclosure: Long DRI.
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