Modern Value Investing: Activist Involvement as a Margin of Safety

An overlooked source, but one that must be approached carefully

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Jan 25, 2019
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In rounding out chapter seven of “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” Sven Carlin offered an important, but often overlooked, source for a margin of safety.

Tool 15: Potential activist involvement

Carlin observed that business troubles can depress share prices, reflecting lower revenues or earnings. That situation, combined with a lack of “shareholder coherence,” can make the company attractive to shareholder activists. These are deep-pocketed individuals or funds that see opportunities to make above-average gains by turning a company around—with or without buy-in from the board of directors. To turn around the targeted company, activists buy a significant stake in it, then set out to change management, improve certain practices or take other remedial steps.

For example, the author turned to Jana Partners (Trades, Portfolio) and Whole Foods (WFM, Financial). Jana describes itself this way: “JANA Partners LLC is an investment manager specializing in event-driven investing founded in 2001 by Barry Rosenstein, JANA’s Managing Partner and Co-Portfolio Manager. JANA typically applies a fundamental value discipline to identify undervalued companies that have one or more specific catalysts to unlock value.” Catalysts are the fixable problems activists see in targeted firms.

The firm disclosed, in April 2017, that it had accumulated a 9% stake in Whole Foods; that made it the company’s second-largest shareholder. It saw an opportunity to realize greater value in the company by selling it, a move with which Whole Foods' CEO bitterly disagreed.

Several months later, in August 2017, the company was sold to Amazon (AMZN, Financial) at a 27% premium. That, wrote Carlin, “provided an excellent margin of safety for Whole Foods investors.”

Going beyond Carlin’s coverage, activist intervention is normally more complex and drawn out than in the Whole Foods case. Typically, an activist buys a significant stake in the company and then petitions for one or more seats on the board of directors. Once on the board, the activist directors aim to convince other directors and officers that shareholders would benefit from the changes they are proposing.

If unsuccessful in gaining a board seat—and entrenched boards and officers quite often try to keep activists out—the activist firm can try to convince other major shareholders to support it. This normally means working with other institutional investors (mostly pension funds and mutual funds) to vote out existing directors at an annual meeting. In an interesting twist, activists now try to gain institutional supporters before launching their bids.

Relating all this to margin of safety begins with the reason the company attracted one or more activists in the first place. A once strong company has been lagging for several years because of internal rather than external factors; in other words, activists are not looking for companies that are suffering because of macroeconomic issues such as recessions or business cycles.

Instead, they see something management has done to depress the fundamentals, leading to a low stock price. For example, many would-be conglomerates used to think they could build empires with their management counsel. Yet, the opposite was often the case and activist investors would force them to sell off underperforming or outperforming subsidiaries. It was generally believed the management of subsidiaries would do better if freed from the strictures imposed by a conglomerate.

The difference in share price, between the existing lows and potential highs from having, for example, new management, would be the margin of safety. Bold value investors might buy on news that an activist investor might get involved or is already involved and wait for improvements. I used the word “bold” for a reason; activist investing doesn’t always turn out to be profitable.

The following two slides, from the Lazard 2017 Activism Year in Review, illustrate some of the players and actions. The first slide shows the major activist firms:

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The second slide shows the most prominent campaigns undertaken by the activists that year:

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As noted, institutional investors are becoming dominant activist shareholders. In a 2018 year-end review of shareholder activism, academic Yuliya Ponomareva wrote in Forbes, “In a manner vaguely reminiscent of the corporate raiders of the 1980s, a new generation of activist shareholders is on the rise. And these players are big fish. Some of the biggest institutional activists include BlackRock (BLK, Financial), with more than $6 billion in assets under management, followed by the Vanguard Group, with $5 billion.” [She means trillions rather than billions.]

Also among the big activist players is the California Public Employees' Retirement System (CalPERS); according to the writer, the returns from its activism have been positive, averaging some 7% per year for the past 20 years. Its results have prompted other big funds to become activists as well.

However, investors should know research indicates activists can both increase and destroy value. Ponomareva concluded, “Corporate shake-outs can make firms leaner and are powerful tools for increasing managerial efficiency. However, they should not be a tool for squeezing out short-term financial gains at the expense of long-term development and profit. Thus, shareholders must carefully examine the value enhancement potential of a firm targeted by activists.”

To get back to our starting point, activist interventions can offer a margin of safety, but strong fundamental and qualitative research is still required to ensure “the value enhancement potential”.

(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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