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A Common-Sense Guide to Shareholder Activism

By Michael Olsen, CFA - Apr 19, 2013 at 3:32PM

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Activists shake things up. Make sure it’s the right way.

For any problem, you can find good and bad solutions. A Band-Aid on a broken leg isn't the most effective remedy. Likewise, Elaine's Seinfeldian answer to NYC's sometimes inhospitable citizenry -- name tags for everyone -- falls short. In shareholder activism, and for smaller investors looking to ride activist investors' coattails, the same standard holds. There are best practices, less effective means, and those that eviscerate shareholders' hard-earned dollars.

All of which raises the question: For individual investors trying to maximize their long-term returns, what's the best way to draft activists -- the investors whose outsize stakes and, often, influence give them the power to steer the company behind the stock? Let's look at some of the more common activist agendas, the qualitative merits and potential pitfalls, and how to put yourself on the right side of things. I expect this topic, among others, to receive airtime at IMN's 4th Annual Active-Passive Investor Summit, which I'll be attending next week.

Dress for success: A common-sense checklist
Most value hogs are familiar with the qualitative case for activism, as I've mentioned before. Managers, being human, mess up. They make poor capital-allocation decisions, build empires, willfully and greedily abuse their power, and in rare cases treat companies like their piggy banks -- the consequence of overconfidence, groupthink, or heuristic-driven decision methods. The sales pitch goes that activists provide accountability, independent perspective, and ideas on how to create value.

That's great on paper, but some activists are no different than the managers they criticize -- they're susceptible to short-termism, decision-making folly, and worst of all, greed. Some are outright self-dealers, verging on nefarious. Like whiskey's purportedly curative properties for colds and swine flu, there are effective ways to treat a patient -- and those less so. Aligning yourself with the right activists and situations is critical to successful long-term investments. Choose situations that stack the odds in your favor. Here's how.

1. Soft activism: Calling your significant other insufferably vapid doesn't elicit a positive reaction -- or a meaningful shift in behavior, for that matter. Telling managers they've got it wrong in bellicose, derisive language isn't the most effective tactic, either. Instead, you're more likely to encounter a defensive audience. Activists with a history of constructive engagement are received with open arms, as a partner with common goals. Follow them before the cage-rattlers.

2. The right jockey: Some folks have it, others don't. Aligning yourself with activists who have a record of success, who've consistently undertaken measures benefiting shareholders on a long-term basis, is critical. A few I like: Jeff Ubben's ValueAct, Alex Roepers' Atlantic Investment Management, David Nierenberg's D3 Family Funds, Nelson Peltz's Trian Partners, Barry Rosenstein's JANA Partners, and Jeff Smith's Starboard Value (some of whom will speak at the conference). Never forget: What's good for one activist investor may not be right for you.

3. Incentives and governance: In the end, all business is about capital allocation. An otherwise good business can wither under an ineffective, incompetent, or self-dealing capital allocator. Many varieties of activism apply a Band-Aid without regard to the long-term effects. Activism that encourages effective capital allocation -- and installs the appropriate checks and balances -- addresses the root cause and best positions shareholders for long-term value creation. Follow activists with a history of the latter. Specific measures to look for: creating independent boards, developing pay/incentives that align shareholders' interests with management's, and installing the right leaders. A recent example, and for long-suffering shareholders, hopeful beneficiary: Chesapeake Energy (CHKA.Q). A natural gas explorer endowed with legion resources, its share price has been dragooned by a governance nightmare, and former CEO McClendon's brand of cowboy capital allocation.

4. Spinoffs: In the sleeve of activism tricks, agitating for spinoffs or splitting companies is a favorite strategy. And the empirical evidence supports it. The Bloomberg Spin-Off Index has generated annualized returns of 15%, versus 6% for the S&P, since its 2003 inception. Managers at spinoffs have a way of finding so-called efficiencies -- but choose your spinoffs carefully. 

Sometimes, the spinoff comes loaded with debt. Still other times, a strategic asset is decoupled from a parent, weakening its long-term prospects. Seek spinoffs of unrelated businesses, where a conglomerate discount is most likely, and appropriately leveraged balance sheets. One that succeeded: Fortune Brands Home and Security -- a cash-rich spinoff of great brands, previously obscured by a conglomerate discount. One designed to fail: Orchard Supply Hardware, a debt-laden home improvement retailer, formerly part of the Sears Holdings family.

5. Corporate reorgs: Two acronyms found their way into activist vocabulary and stuck: REIT (real estate investment trust) and MLP (master limited partnership). The attraction of these structures is obvious: Shares typically command higher valuations, cash flow increases thanks to tax-advantaged status, investors collect a nice yield, and capital efficiency (arguably) improves. But as with spinoffs, not all reorgs are created equal. 

Because REITs and MLPs retain limited earnings, they're forced to tap capital markets pretty often. That can be good, because it forces discipline, but cyclical, capital-intensive, and/or debt-laden companies aren't particularly suited for the structure. Transocean (RIG -0.48%) as an MLP, Carl Icahn? No, thank you. A deepwater driller, subject to the drilling cycle's wax and wane, capital intensivity, and relatively continuous reinvestment needs doesn't fit the mold.

6. Capital structure, repurchases, and dividends: Another favorite is paying dividends, repurchasing shares, or taking on debt. Sometimes activists advise taking on debt to pay a dividend or repurchase shares. For overcapitalized companies, like Apple -- the fortunate possessor of $100 billion in cash, and positively enormous margins -- it's not such a bad idea. Yet again, context is in order. A natural-gas-focused E&P shouldn't lever up to repurchase shares, and it shouldn't pay a whopping dividend, either. Once again, short-term gains can be the enemy of long-term appreciation. But Apple can and probably should do all of these. 

The Foolish bottom line
Activists serve an important role and offer significant checks-and-balances advantages. But tagalong investors should choose their partners wisely. If you wouldn't join the activists' demonstration on the streets, you shouldn't pony up your cash to support their cause, either.

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Stocks Mentioned

Chesapeake Energy Corporation Stock Quote
Chesapeake Energy Corporation
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Transocean Ltd. Stock Quote
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