RealMoney Silver - Riding Activist Investors to Profits

Riding Activist Investors to Profits
By Tim Melvin
RealMoney.com Contributor
4/3/2008 12:55 PM EDT

In recent years, one of the most talked about investing styles has been activist investing, as investors like William Ackerman of Pershing Square have staked out large positions in various companies. It makes for great headlines, but can average investors piggyback their way to profits off of this news? I confess to being a bit of a geek, so I went to the numbers and the academic reviews of the subject.

As it turns out, piggybacking does work, and in fact, extraordinarily well. One of the first studies I found was from the Harvard Business School by Robin Greenwood and Michael Schor. It had some interesting conclusions about the success of the activist investor.

In situations where activists were able to force a transaction, such as the sale or merger of a company, the stock outperformed the market by about 7%. In situations where no transaction was completed, the target companies matched the market. The study also concluded that a transaction was much more likely once an activist investor took a position. In fact, about 25% of the time, some sort of transaction was concluded.

If a quarter of your portfolio gave you a 7% edge and the rest matched the market, that would give you a substantial 1.75% long-term edge on the market. In his book, "Investment Philosophies" (if you have not read it, you should), Ashworth Damodaran also concludes that activists have a positive influence. He found that there was positive outperformance not just for takeovers, but for corporate management changes and asset spinoffs as well.

One study examined the impact of being placed on the Council of Institutional Investors focus list. The council is a group of large investors who release a list of poorly performing companies for coordinated institutional activist activity. The companies targeted end up outperforming the market by over 11%, as the funds coordinate to pressure management to make positive changes.

Most of the studies found that the funds acted like value investors buying companies that had valuation ratios and poor stock performance. In fact, Damodaran states that activist investing does not really work on companies whose recent stock price performance has been positive.

Now that we have a little backup for following the activists, how can this make us money?

Paying attention to the various Securities and Exchange Commission (SEC) filings by the biggest and most successful funds can give us a storehouse of ideas to investigate and possibly add to our long-term portfolios. The company-search function at sec.gov is not only a wonderful tool that is easy to use, it's free. Making a list of successful activists and searching the filings is actually quick and easy thanks to one of the few useful government services I have run across.

iPass

One of the funds with an incredible long term record I follow is Shamrock Holding in Burbank, Calif. They have been in business since 1984 and have a long-term track record of somewhere right around 25% annualized returns according to several articles and interviews I found on the web.

The company was founded by Roy Disney and has been very active lately, as the market and prices of potential targets have fallen substantially since the first of the year. On March 3, the company wrote a letter to the management of iPass (IPAS) , a maker of software for remote and mobile workers to communicate with their offices, demanding the immediate sale of the company.

The company has seen its stock price fall almost 40% over the past year and has resisted the idea of a sale, but it did recently announce a $30 million share buyback to attempt to boost the stock price. The shares are cheap, trading right around book value with over $1 a share in cash, and no dent at all. If they, as management has estimated, return to profitability this year and buy back stock over the year, the price could work higher without a sale.

If Shamrock, which owns around 14% of the outstanding shares, can force a sale, then the stock could easily double from the current level. And with other activist and value managers owning close to another 10%, a sale could be a foregone conclusion. Either way, the stock falls into the too cheap not own category regardless of market conditions.

Pep Boys

Another recent target of the activist funds is beleaguered Pep Boys (PBY) . Between them, Barrington Capital and Pirate Capital own over 22% of the shares. The auto parts and services company had a rough fourth quarter. Between a generally sluggish retail environment and restructuring costs to exit low-profit lines, the company fell to a loss in the quarter.

Both Barrington and Pirate were buyers in the quarter, adding to their already large positions. Both have held the stock for some time and have previously suggested the company be sold to unlock the value of not just the brand, but the real estate and leases held by the company. Trading at book and at just $.25 on the dollar of sales, Pep Boys shares do appear cheap at these levels. I am not ready to buy this one just yet, but will look to sell $7.50 puts should the price slide continue.

Bottom Line

Activist investing works. Although many of the funds got hit last year when deal financing fell apart in the second half of the year, they are accumulating positions in many companies that are out of favor in the current environment in hopes to agitate transactions when the credit markets loosen up and business conditions improve.

For a long-term strategy, it's not a bad idea to pay close attention to what they are buying now. It is no secret that I am bearish on the market right now, but following this group of investors can help you build your watchlist for later and find that occasional stock that's too cheap not to own, no matter what the market does.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider iPass to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.