Activist, Heal Thy Company

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In the 1990 movie Pretty Woman, Richard Gere plays a corporate raider - a sort of business pirate who seeks to take control of companies and shake their valuable assets loose, leaving them with nothing. If the movie were filmed today, Gere would most likely play an activist investor instead.

In contrast to their draconian predecessors, activist investors don't seek total control of the companies they target. Instead, they seek a lower-risk route, taking sizable positions and urging other investors to join them in making demands of company management, whether that amounts to a dividend increase, a share buyback, or the sale of real estate or assets of over- or underperforming divisions.

In the public markets, management's motives are too often separated from shareholder value. In the Little Book that Beats the Market, Joel Greenblatt spends a good deal of time urging stock market investors to think of themselves as owners of a piece of a business -- sound advice indeed. Activists operate in this spirit.

This "ownership" mentality has been boosted amid a hailstorm of $15,000 umbrella stands, corporate-jet joyrides, and more-money-than-you-will-make-in-a-lifetime severance packages. The luster has worn off of the American executive, and now that investors are closer to eye level with once-titanic CEOs, the staring matches have begun in earnest. Especially given the numerous hedge fund strategies that have gone bust or become overused, you can begin to see why knowing more about activism is worth your time.

Some of the more successful recent activist-investing situations have involved some very notable brands. H.J. Heinz (NYSE: HNZ), best known for getting ketchup on your tie, was targeted by Nelson Peltz. By all accounts, Mr. Peltz's plan to fix Heinz was notably one of the highest-profile fights in years. And while management attempted to make Peltz look like a threat to shareholders, they ultimately adopted his plan. The previously falling stock turned around and rose 23%. Peltz is also the current force behind a bid for Wendy's (NYSE: WEN), which ironically spun off its crown jewel Tim Hortons (NYSE: THI) after some fulminating by activist Bill Ackman.

Activist investors in 2005 pushed McDonald's (NYSE: MCD) to IPO its Chipotle Mexican Grill (NYSE: CMG) (NYSE: CMG-B) unit. Investors holding McDonald's stock got a very tasty deal: Chipotle surged more than 50% in its first few days of trading, seemingly proving activist theories that it was more valuable apart from McDonald's than as part of it.

If you're interested, but don't happen to run a hedge fund, how can you participate before everyone shows up at the party?

Although activism can be successful when owners with a small stake in a company lead the push, the more shares an investor owns, the stronger their hand in any deal. More often than not, activists acquire a large stake in a target company, which triggers an SEC filing. By watching for these "Regulation 13-d" filings, required once an investor has gathered more than 5% of outstanding shares, you can sometimes get in on the action before the market catches on. You can search for new filings and track the progress of current activist situations using the SEC's EDGAR online system.

Proceed with caution
Time to throw some cold water on any optimism you may have kindled. There's no magic rainbow to quick investing returns. While activism can be lucrative, it's not without pitfalls. If you don't believe in the underlying fundamentals of a business, you shouldn't follow activist actions; remember, you can be left holding the bag if things don't go as planned. Companies at which activist investing have failed include Celebrate Express (Nasdaq: BDAY) and BKF Capital Group.

In the case of Celebrate, a pre-packaged party favors company, many investors followed activists in acquiring shares near $12-$14. Since that time, they've had anything but a party, with supply chain issues and logistical nightmares dogging the stock during its plummet to $9.

In 2005, two hedge funds teamed up to force BKF Capital to use its extra cash for a dividend increase and share buyback. The funds were successful in gaining board seats, but in less than a year's time, the stock went from almost $40 to just south of $13. It now sells in the $2 range. In the end, the only people happy with the BKF deal were the management team, who left with a mint in severance loot.

Current events
One of the most interesting activist battles at present involves hedge fund manager Bill Ackman of Pershing Square squaring off against Target (NYSE: TGT). Ackman's tapped his war chest of cash to purchase nearly $5 billion worth of Target stock and options, a stake representing roughly 9.6% of total shares outstanding. Ackman is known for his interest in deteriorating companies, which doesn't describe Target, so why would he want this large a stake? Many investors don't believe there's much Target can do to enhance its financial performance, but Ackman apparently feels differently. He already plans to persuade management to cut its credit card business.

Although it's less high-profile than Target, the battle over Borders Group (NYSE: BGP) should be equally entertaining. It's currently trading around $15, but activists feel that the company could be worth $36 per share in less than two years. Accordingly, many funds have taken a position in the national book retailer.

As a Foolish investor, fundamentals are always most important to evaluate. But evaluating the prospects of activist situations can certainly provide extra value to your due diligence. If you purchase a company that really has untapped underlying value, activist investors may just be the key to unlocking the hidden value in the company and turning around its performance.

Chipotle's gotten the nod from both Motley Fool Hidden Gems and Motley Fool Rule Breakers. Try either market-beating newsletter absolutely free for 30 days.

Fool contributor Rimmy Malhotra is a New York City-based money manager. He owns shares of Target, McDonalds, Citigroup, Sears, and Borders. He welcomes your feedback. Borders is a Motley Fool Inside Value pick. Heinz is a Motley Fool Income Investor selection. The Fool's disclosure policy is neither a corporate raider, an Oakland Raider, nor a raider of the lost ark.