If you are reading this, presumably you are seeking alpha, that is, you are looking for the premium an investment portfolio earns above a benchmark like the Standard & Poor's 500. Positive alpha for a stock means it is undervalued relative to other stocks with similar systematic risk, and the better a portfolio manager like you is at that job, the more positive your portfolio’s alpha. Alas, obtaining positive alpha for flesh and blood stock pickers like you has become considerably more difficult as the structure of the stock market has changed.
Some market analysts believe you are also facing extinction. In June, JPMorgan analysts estimated that discretionary stock traders now account for a mere 10% of trading volume and that most traders no longer buy or sell stocks based on specific fundamental valuations. Passive and quantitative investing accounts for 60% of daily trading volume, more than double the figure from a decade ago. In August, Bloomberg reported that, for the first time, the $28 billion average daily value of transactions in the three main ETFs tracking the S&P 500 Index is about to exceed the average turnover for all of the separate stocks within the benchmark itself.
The graph below compares the summation of the traded value (price multiplied by number of shares) of S&P 500 index members versus the traded value of the S&P 500 ETF (SPY).
As the graph indicates, investors have been moving sharply toward ETFs that mimic benchmark returns since 2007. The financial crisis created a spike in volatility that also increased correlations between different asset classes. Although that movement has decelerated, pessimists think ETFs will eventually remove all research-driven value investors. They believe the stock pickers will ultimately all fall victim to automated, day-trading, computer-driven strategies. Optimists argue that stock picking isn’t dead, it’s just that the nearly 1,400 different types of ETFs provide the lowest cost means for gaining exposure to equities:
Bad or good as they may be for the markets, stock prices swayed by algorithms whipping around a sea of passive ETFs will continue to make life difficult for fundamental investors. Investment professionals in particular will be challenged to justify higher fees. And, in general, anyone using research to make investment decisions faces that most existential question: "Why bother?" After all, if the only thing that matters is figuring out what the guy (or computer) next door will do next, then fundamental research is a waste of time.
The impact of this one-two punch on active management can be seen anecdotally in the number of active funds closing, merging or switching their investment focus toward private equity or other less liquid markets in which fundamental research remains more meaningful in terms of generating returns.
Despite these depressing trends, investors still hope to beat the market. In fact, you would not be reading this or other research if you already knew it was pointless to do so. While it is possible that all of us are fools, there are still reasons for pursuing active management and using research for stock selection. To start, lumping all discretionary fundamental traders under the single label “active investors” - and all ETFs under the single label “passive investing” - doesn’t really account for the very different strategies they employ and doesn't make much of a distinction between the risk-adjusted success of those strategies. Second, with respect to the use of fundamental research as an investment tool, it seems fairly obvious that one cannot outperform a market if all one does is own a proxy for the market.
Still, the only realistic way for active investors to outperform is by finding and exploiting valuation mistakes made by the other, institutional experts that dominate the market, all of whom receive the same information simultaneously via the internet, use similar IT, and are led by similarly motivated professionals. Achieving and sustaining significant outperformance using price discovery therefore only increases over time. However, one of the best proven, research-driven methods for obtaining above average returns at below benchmark risk is activist investing. In part, this is because activists can take advantage of the unequal distribution of information they create. Hence, much like high frequency trading, this strategy can be deployed without its practitioners risking time in solitary confinement (at least, so far).
An activist investor purchases an equity position in a company and then uses it to publicly press corporate management to increase the value of that position via changes in policy, financing structure, cost cutting, dispositions, or other actions. Of course, only the activist investor knows beforehand that he or she will be collecting a significant position in a particular public company and only he or she knows what type of changes will be pressed upon a target management.
The distribution of information is inherently unequal. The activist gives no advance notice to other shareholders. In most cases, however, existing shareholders cheer when the announcement comes across the tape. The stratagem is relatively cheap - a less than 10% stake in the outstanding equity of a company is often enough to begin a campaign to effect change. Proxy contests and shareholder resolutions are typically much less expensive than hostile acquisitions. And activist investing has been shown to be successful. For example, one study showed that it was the best-performing strategy among hedge funds in 2013. The activist funds returned 16.6% on average that year versus 9.5% at other hedge funds.
How has it been doing lately...? Let’s compare the returns on different types of hedge fund strategies and the S&P 500 for a multi-year period through the present. Per the graph below, over the past five years, quarterly returns to activist hedge funds (the HFRXACT Index ticker) exceeded returns on other event-driven hedge fund strategies, including credit arbitrage, distressed restructuring, merger arbitrage, multi-strategy, special situation, and European event driven approaches. Still, none of these actively-managed event driven strategies beat a passive investment in the S&P 500 index over the full five-year period. The five-year annualized equivalent return on the S&P 500 for the period is 13.9% while activist hedge funds clocked in at 9.5%. In fact, the only hedge fund strategy that beat the S&P 500 for the past five years was focused investing in India – the HFR India Index generated a 16.6% return:
What’s missing from that graph is the relative risk of owning the market via an S&P 500 passive ETF versus owning an activist fund or a fund which pursues another of the active hedge fund strategies. You can compare return per unit of risk using either a Sharpe Ratio or, more simply, by dividing the return by a measure of volatility. As it turns out, despite the well-reported decline in S&P 500 volatility, the hedge fund strategies persistently ran at still lower volatilities throughout the last five years.
The most recent quarterly volatility of the S&P 500 is 7.2%. By comparison, the index for activist strategies ran 2.2%; distressed restructuring 1.9%; merger arbitrage 1.6%; special situation investing 3.0%; and European event driven strategies 2.3%. If you compare the S&P 500’s 17.2% normalized return per 7.2% unit of quarterly volatility against the activist strategy’s 15.3% normalized return per 2.2% unit of quarterly volatility, the result is 2.4 versus 7.0 in favor of the activist strategy. If you could wait the entire five-year period, you received a higher return via the S&P 500 but, if you needed to pull out funds along the way, you would have had a tough time picking the right quarter in which to withdraw those funds betting on the more volatile stock index.
To provide some perspective of who the most prominent activist investors are, what resources they have at their disposal and the types of companies they engage with, I’ve listed below the largest activists, their firms, the assets those firms have under management and their largest corporate targets by market capitalization:
Activists today are more popular than their predecessors, the corporate raiders of the 1980s with reputations assisted in the media by shareholders voicing their own frustrations with overpaid executives, large unused cash balances, and nonperforming or unnecessary assets housed within public corporations. Demands for more rational executive compensation, changes in board oversight, greater cash distributions, divestitures of questionable businesses, and more shareholder engagement all work in their favor.
The success activist investors have had in generating above-average returns per unit of risk usually means that news of their involvement in a particular company is greeted with cheers from that company’s stockholders. In most cases there is at least a one-day increase in the price per share. The typical shareholder, however, may know very little about what a particular activist plans to do with his shares and have few details about the activist’s track record with other companies. They might want to hold their applause.
To get a handle on it, I tracked the annualized percentage change in 395 target companies which remain public. The list excludes target companies which were privatized or whose valuations could not otherwise be compared from the start of an activist campaign through the present. Also excluded are situations less than six months old, which is my attempt to separate the initial improvement in target stock prices on news of activist participation from the impact of activist campaigns to change target policies. I compared the stock prices and market capitalizations at the start date of each activist investment through to yesterday’s close. I then annualized the percentage changes using spreadsheet IRR functionality for the different time periods. There are other possible methodologies one might employ, but that is the approach I used for illustrative purposes here.
Size. The table below shows the annualized percentage change through yesterday’s close in market capitalization for the 10 largest market cap activist target companies. U.S. companies account for most of the target companies but I’ve adjusted stock prices and market capitalizations for currency differences in the case of foreign companies whose shares are not US dollar denominated. While the market cap annualized changes are largely positive, note that there has been a full range of outcomes, running from negative to positive results. In addition, technology companies account for half of the top 10:
Carl Icahn tops this list because of his position in Apple (NASDAQ:AAPL), the world’s largest public company by market capitalization. To remind you, after positioning in AAPL in August 2013, Icahn pressed AAPL to increase the size of its share repurchase program and AAPL management did subsequently state that it would be looking to buy back more of its common. Icahn’s activism, however, was still limited. Worried about AAPL’s prospects in China, by April 2016, Icahn exited his AAPL position with what he said was a $2 billion profit. Still, the annualized change in market cap for AAPL from the date of Icahn’s involvement through yesterday’s close is 15.2%. That puts it above average. By comparison, the S&P 500 saw an annual equivalent rate of return of 12.2% for the period post Icahn's investment.
For that matter, Icahn's position in Netflix (NFLX) does not appear on the list because, at the time of his investment it was a significantly smaller market cap entity. NFLX shareholders actually enjoyed the highest percentage change in the company’s market capitalization post Icahn’s involvement and, in any event, Icahn’s NFLX strategy was far more opportunistic than activists. In October 2012, when Icahn began buying shares, NFLX CEO Reed Hastings was in the midst of reversing some major strategic errors - the September 2015 decision to separate DVD and streaming services from each other while raising prices. NFLX shares had lost 80% of its value by that point. Icahn exited NFLX in June 2015 over the objections of Brett Icahn, his son and the person he credits with seeing the opportunity. Icahn had made no demands from NFLX management and actually missed out on the subsequent upside. Technically, however, the annualized change in market cap for NFLX from the date of Icahn’s investment through yesterday’s close is 79.8%. The S&P 500 saw an annual equivalent rate of return of 14.7% for the period.
Using market capitalization on the date of activist entry clearly has its drawbacks. A second takeaway from the Icahn anecdotes is that with respect to target companies, market capitalization size matters, but not necessarily in the way you would think. A more rigorous statistical analysis helps make the point clearer. Regressing the pre-activist, starting market capitalizations against the annualized percentage change to date, produces a bit more insight. It turns out that, if there is any relationship between the target’s market cap size and the activist’s level of success, it is almost nil (1.5% correlation coefficient for the group). In other words, an activist showing up as an investor in a smaller market cap company may be better for market cap improvement than an activist showing up with a stake in a larger market cap company.
Success. In the study above, I used the annualized change in market capitalization. The directional changes in stock price and percentage changes in stock price were largely in line with the directional and percentage changes in market capitalization. However, market capitalization changes can be a misguided measure of success if a target company simply increases its capitalization by issuing more shares (e.g., to fund either an acquisition or for other purposes). Hence, focusing on annualized percentage share price gains post entry of an activist is a better measurement of success. The table below orders the target companies by annualized change in stock price from the time an activist took a position through the present date:
Note the preponderance of smaller companies (save NFLX) and the wide range of sectors on the success list. Also, despite the exclusion of activist stakes initiated within the past six months, half of the top returns are from positions initiated at the start of this year. There is, however, overall only a mild relationship between success in terms of stock price improvement and timing. Regressing the age of the initial position against the annualized percentage change in stock price results in just a slightly positive correlation (1.5% correlation coefficient for the entire group). On balance, while there may be a bigger improvement, the more recent the activist has become involved, it looks like the news effect dissipates and what matters over time are the changes put into effect. I can’t statistically prove that point with just these metrics, but looking at the results of this study, I wouldn’t suggest shareholders simply rely on the clock for an activist to produce higher returns.
As usual, there’s a bit more to the story behind each of these situations. OptimizeRx Corporation (OPRX) operates an Internet website through which it offers advice to consumers on how to save money on branded prescription and over-the-counter healthcare products. Wolverine Asset Management’s top return on OPRX is a fluke. It shows up as being scarcely six months old but the Wolverine Flagship Fund, an offshore affiliate of same, initiated a 9.0% position in OPRX common back in March 2014, and if you use that as your starting point, returns to shareholders during the longer period go to negative 8.9% on an annualized basis.
Not that Wolverine hasn't acted like an activist. The fund did send OPRX management a letter earlier this year requesting strategic changes to address raising the company’s equity valuation, but there’s hardly a sense that this amounted to much. In a March earnings conference call, when OPRX CEO Will Febbo was asked about the Wolverine letter, he said: “It took me a while to drill down to even find out what they were talking about but it sounded - it sounds - very positive.” Wolverine may not be getting much assistance from other holders. OPRX’s largest investor, WPP Luxembourg Gamma Three, owns 20.6% of the common as a passive investment according to filings. That’s probably not going to help Wolverine's campaign.
More potentially effective is the NRG Energy (NRG) situation. NRG is an independent power producer which, like other IPPs, has faced years of weak electricity demand and low electricity prices, a consequence of cheap natural gas. Paul Singer at Elliott Management and turnaround specialist C. John Wilder at Bluescape Resources partnered up to buy a 9.4% stake and began pressing NRG to cut costs.
On January 17th, NRG stock rose 5.1% once the position became public knowledge. Negotiations with Elliott led NRG to add two board seats and begin an operational review. Management then moved to restructure bankrupt subsidiary GenOn Energy Inc. by transferring ownership in the reorganized company to creditors.
Elliott Management generally has a good track record in its activist campaigns. The median return on the 22 situations in which Elliott has taken a position is 11.8%.
Failure. The trope that one learns a great deal more from failure than one does from success is true. In this case, looking at the targets which have dropped the most on an annual percentage basis subsequent to an activist taking a stake, one of the key lessons is that shareholders would be wise to hold their applause when certain activists appear.
Per the table below, Raging Capital was involved in three of the worst percentage returns to stockholders who held on to their position after Raging Capital’s entry date through Wednesday. Not that Raging Capital hasn’t been involved in a few success stories, notably, Ashford, Inc. (AINC) and Crestwood Equity Partners (CEQP). Both of those have yielded returns in the mid-20s post Raging Capital’s participation. However, the median return on the activist positions I can track that Raging Capital has entered into is a negative 12.0%:
Raging Capital isn't alone on the multiple flop list. Clinton Group's attempt to assist First NBC Bank from turning into a zero didn't succeed despite urging management to opportunistically reduce its balance sheet, sell ethanol receivables, divest Florida assets, and develop a strategic plan for use of its deferred tax assets. The median return on the targets Clinton Group has pursued to date is minus 8.5%.
Credit. I also took a look at the impact of activist investment campaigns on the credit spreads of the largest target companies (using the market capitalization at the initiation date). I used only the five largest targets since most of the smaller targets on the full list do not have tradeable CDS. The narrowing or widening of CDS spreads post initiation of an activist position can be seen as a proxy for credit improvement or decline, respectively. The study isn’t particularly rigorous, but what I see are large targets whose credit spreads went in both directions post news of activist involvement: AAPL five-year CDS widened 11.7%, GE (NYSE:GE) CDS narrowed 22.0%, Microsoft (NASDAQ:MSFT) CDS narrowed 5.8%, Samsung (OTC:SSNLF) CDS widened 33.3%, and Procter & Gamble (NYSE:PG) CDS narrowed 56.8%. I wouldn’t read too much into this mini-study. The impact an activist has on a target’s credit profile can be miniscule – especially a large cap target - and the type of strategic, management, policy, or financial changes an activist seeks are likely too particular to the target to draw any credit conclusions.
Alpha. It’s helpful to take a step back and look at exactly what market you are trying to beat in order to know whether you’ve outperformed by adopting one strategy or another. A market is any process used to set the prices of goods or services. Its purpose is to permit trading, distribution and allocation of resources by letting participants evaluate and price items for exchange. Certain types of computer-driven momentum trading can temporarily separate prices from rational longer-term valuations. Under such circumstances trading volume may increase but in the short term, the allocation of resources looks briefly questionable. This seems unfair to investors whose trading costs are higher or whose computers (or thinking) is slower.
It’s also helpful to consider what we mean when we talk about free and fair markets since those are the key attributes investors rely on for a shot at outperformance. A free market is unfettered by government intervention, price controls, or monopolists. It’s considered fair if there are many small participants trading comparable products with equal and timely access to all relevant information. Without those attributes, markets fail because their participants conclude it would be better to trade ownership rights elsewhere. Some of this is hypocrisy. Investors need to believe that markets are free and fair with respect to regulation of individual behavior. On the other hand, each investor is motivated by greed to try to take advantage of everyone else. Unregulated, greedy investors would more naturally seek to corner a piece of the market and drive up or down prices like a monopolist, use predatory pricing, exploit information other traders don’t have, and price gouge. Greedy traders have every reason to act in a most unfree and unfair manner. Take away regulated morality and it is only the threat of lawsuits, fines, disgorgement of profits, and imprisonment that stops traders from behaving in a way that all but guarantees market collapse. Should fundamental discretionary investors conclude that the securities markets are unfair because pricing power is too concentrated with algorithmic trading programs or too manipulated via spoofing or high frequency trading, they will leave the public markets. What would be left is a small group of program traders all too familiar with each other’s signaling patterns. A complete replacement hasn’t happened so far and probably won’t. Over time, the returns on algorithmic trading – like every other financial innovation – have declined the more broadly the stratagem is used.
Unless you are invested in an activist hedge fund – and paying the fees for that service – mimicking their results by investing alongside their targets requires careful due diligence on both the activist and the target. Yes, there are one or two public activist funds that are available to retail investors but it’s hard to recommend them. For example, 180 Degree Capital Corp. (TURN) is an internally managed closed-end fund which focuses on investing in and providing value-added assistance through constructive activism. However, TURN’s fund assets under management are just $75 million. The fund is unlikely to have much impact even if it concentrates more than 10% of its assets in a single company’s shares. In TURN’s case, that target is Adesto Technologies Corp. (IOTS).
Active management hasn’t been good enough on average to create alpha for fund investors, but activist management, at least on a risk-adjusted basis, appears to be on much better footing. The alternative of investing alongside target companies can be helpful to your own returns as long as you understand how that activist is positioned, when that position was initiated, what changes the activist is attempting to impose, what that activist's time horizon looks like, and what kind of results that activist typically produces.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.