Activist Investors Cannot Generate Significant, Long-Term Gains

by: Jeremy Josse

Originally posted in TheStreet on May 18, 2016.

Can activist investors deliver the outsized returns that their actions and rhetoric seem to promise?

TheStreet recently published an interesting article about the potential impact of activist hedge fund managers and the failure of mega mergers - sometimes potentially good deals.

But the article only touches on part of the dilemma of the whole activist strategy and mania. While activism becomes popular at specific times, particularly in bull markets, the strategy probably cannot generate long term alpha or outperformance.

The central problem is that an activist has to have a large position in a stock to have an impact. This is fine in a bull market as stock prices rise. Indeed, it is probable that a large amount of the stock uplift in a position held by an activist has nothing to do with the activism; rather, it stems from buying into a rising market. Naturally, an activist's buying helps with demand for the stock.

But if the wider market declines, the activists' 'activism' tends to become increasingly irrelevant to the direction of the stock (if it ever really was in the first place). In a sudden bear market, activists tend to find they have large concentrated positions that often become highly illiquid - or at least can only be sold down at a significant discount to their then market price.

This phenomena wiped out various activists with limited experience in the last credit crisis. They included Aticus Capital, the fund of Timothy Barakett and Nathan Rothschild.

Curiously enough, these types of financial models are not uncommon. There are numerous industries that make a significant ROIC during good times, only systematically to wipe out years of historic retained profits in bad times.

It is true, for example, of many aviation lessors. These companies are betting not just on aircraft lease rentals, but more importantly on the residual value of aircraft at the end of say a typical 5-year lease. If aircraft values have gone up during that lease period (usually because of benign economic conditions) the lessors make out like bandits.

However in an economic downturn, there are fewer passengers, aircraft sit in deserts unused, their rentals collapse, and critically, so do their values. The result is aircraft lessors usually make a nice ROE for a few years and then wipe out most of the last few years' retained earnings in downturns. For many such companies their long term ROE may even be negative.

An honest aircraft leasing executive in presenting his budget would show gradually rising returns for a few years and then suddenly profits falling off a cliff during an expected market downfall. Unsurprisingly, you rarely see such budgets in the industry, as the leasing executive would be unlikely to keep his job for long.

Other industries have similar features, including the investment banking industry. Significantly, it seems activist hedge fund managers fit into the same category. They experience a solid and easy run as the equity markets rise and then often a wipe-out of numerous years of return when the market collapses.

Large, illiquid positions make orderly disposals, and avoiding such losses, in a downturn extremely difficult. Like the leasing executive, I've yet to see an activist investment prospectus that says: "we forecast to make solid returns for a number of years, and then in the next market downturn can be expected to lose our shirt...." There are also now so many managers dabbling in activism that like many hedge fund strategies it has just become ubiquitous.

There is the odd activist like Carl Icahn who seems to make it always work, but then in reality he has unique market influence and uses other methods, aside from pure activism to influence management decisions and share price. There are also maneuvers (e.g., taking profits when a merger is announced even if it doesn't happen, partial hedging of long positions before it's too late, etc.) that good activists regularly use to mitigate downside risk. But the central long-term flaw in the strategy remains.

Approach activism with great caution and do your research. Consider what costs it is worth paying for this type of strategy? The activist may be just a heavily concentrated, long only bull market investor. Probe how he will manage the inevitable downturns?

Jeremy Josse is the author of Dinosaur Derivatives and Other Trades, an alternative take on financial philosophy and theory (published by Wiley & Co). He is also a Managing Director and Head of the Financial Institutions Group at Sterne Agee CRT in New York. Josse is a visiting researcher in finance at Sy Syms business school in New York.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of CRT Capital Group LLC, its affiliates, or its employees. Josse has no position in the stocks mentioned in this article.