When an Activist Investor Limits Your Upside

In some cases, an activist investor could be looking for a short-term exit, while you're hoping for long-term gains. As a result, you could be stuck with a higher cost basis than the activist investor.

In this clip from Industry Focus: Tech, Motley Fool analyst Dylan Lewis and contributor Evan Niu, CFA, discuss how these scenarios could present themselves.

A full transcript follows the video.

This podcast was recorded on Oct. 21, 2016.

Dylan Lewis: Mentor (MENT) is not a company that either of us cover all that much. In some ways, it's kind of a niche within a niche, as a semiconductor supplier. So, as we talked about this company, we're going to be looking more broad stroke at their situation, and less specific to their financials. Standard caveats here that this is not personalized financial advice for Mark. But, because they're shopping around, and it's really at the behest of activist investors, I don't see that as a huge problem. It's not the same way that Twitter is shopping itself around, kind of desperate for dancing partner. This is something that we see, and it's fairly common with activist investors.

Looking at what's been going on with Mentor over the past couple years, their valuation right now is a $3 billion company. That puts them pretty much at the height of where they've been over the last five years. You think about these new shareholders with a huge stake in the company, and people who may have owned shares for quite some time, their interests are going to be fairly aligned when it comes to a valuation if there is a sale. I think the worry with these types of situations is, maybe you bought at highs a year and a half ago, and due to whatever, poor guidance -- which did happen in Mentor Graphics' case -- there was a big sell-off in late 2015, but they have since recovered. But, these activists getting in at a much lower valuation and then being willing to take, say, a 30% premium that undercuts your cost basis and doesn't let your thesis play out on the stock.

Evan Niu: You never get to break even.

Lewis: Yeah, you never hit that point where, maybe you have something that's more of a three- to five-year horizon on whatever you're looking to see from the business, and activist investors, on the flip side, might say --

Niu: "We want to cash out."

Lewis: "We want to cash out in six months, or a year." And then, you might not get to see that come to fruition. So that's something to be mindful of. I do think, because that's the case here with Mentor, as an investor, and my advice to Mark as something to watch would be, be less mindful of what's going on on the sale side, and pay closer attention to anything management might push in terms of capital allocation, or what to do with specific business units. If they're looking to hold this, that's the thing that's going to be most disruptive to the thesis and the business that you originally had when you bought shares.

Niu: Yeah. I think, certainly, if an activist investor is pushing for sale of a company, it's really hard to say, "That's not in line with my interests," because obviously, the stock will go up. But it depends on what the activist investor wants. There's lots of different things they could want, their goal could be a wide range of things. But, in this case, if it's just pushing for an outright sale, given that the stock is at five-year highs, I don't think many investors are going to be upset about it, having someone on their side that can get more value out of it.

Lewis: Yeah. The gains might be less than what they would have been had you let the company play out over that five-year horizon, but I don't think there are going to be a lot of people who wind up getting kneecapped on their position because of that.