CSX Stands Ground Against Activists

For his part, Hohn fought fire with fire and has, in turn, counter-sued CSX and accused the board of insider trading. TCI has announced its own slate of directors to be elected to the board, and a proxy battle appears set for June.

It's not clear whether Hohn will win the support of other institutional investors.

Although CSX's stock is up 29% since TCI first announced its complaints, investors need to weigh who will do the best job of overseeing CSX's activities beyond the annual meeting. Will other shareholders see TCI as a short-term opportunist or a long-term steward of CSX's best interests? CSX has effectively portrayed TCI as having inconsistent and poor ideas for how the company should be managed.

The battle is reminiscent of the first proxy battle Carl Icahn ran against Motorola(MOT - Cramer's Take - Stockpickr) last year. The handset maker was able to convince shareholders to trust them over Icahn due to the activist initially calling for increasing its debt-load and doing a buyback just as the company was about to see its sales fall sharply, causing it to need every dollar on its balance sheet.

Hohn's been successful with a "rough edges" and aggressive style of activism. For his 2006 Christmas card, his family trumpeted to friends that "Chris has had an exceptionally exciting year overthrowing German CEOs and expanding his investment conquests to China and Brazil."

CEOs have long bristled at TCI's demands for change and recently some investors have too. Yale's pension fund, which was one of the original investors in TCI when it started in 2004, pulled its $500 investment in 2006 after TCI retroactively raised its fees to existing investors presumably because of the hedge fund's success.

Hohn's initial successes as an investor were all event-driven. He became the loudest voice of shareholders in favor of or against a merger or buyout happening. When he started to broaden his approach to go after targets in an activist way (with a long-term time horizon for improving a company absent any specific "event"), he's run into problems. CSX has stiff-armed him to date in the U.S. and he's hit another brick wall in Japan with his investment in the utility J-Power.

Chris Hohn and TCI are still very successful, as their Barron's hedge fund ranking shows. However, they've made several mistakes in the CSX battle which they -- and other activist investors -- should learn from for future campaigns:

1. A battering ram approach that is publicly critical of targets can be very successful in an event-driven context but does not always work in activist situations. Negotiation, diplomacy, cajoling, humor and tact are just as important when meeting with an activist target as the threat of "going negative" in a public battle. TCI's successes in the activist realm will increase as they demonstrate their abilities in these softer skills.
2. Avoid inconsistencies. This applies to politicians and activist investors alike. Your words can be easily used against you by your opponents in a debate, so don't give them any ammunition. Activist investing requires a lot of up-front work in selecting targets and the kinds of actions you think would create value if implemented. If you advocate changes that come across as potentially weakening the company in the long-term (such as taking on significant debt), expect a tough time convincing your fellow institutional and pension fund investors to go along with your prescriptions.
3. CSX didn't exploit this, but TCI initially disclosed in October that it held "shares in other US railroads but has not had to launch similar campaigns there because managements have been more co-operative." If I was a CSX shareholder without holdings in CSX's competitors, this would be a red-flag. It says to me that the company has mixed motives -- even if it doesn't. Activist investors need to avoid any perceived conflict of interest and should therefore avoid investing in competitors.

I would bet that CSX will likely prevail in the June proxy battle for the same reason that Motorola's investors refused to embrace Carl Icahn in his first attempt at a board seat last year. On top of that, CSX's relative performance to its peers and the market has been good in recent years. It's tougher to rally the troops in opposition to management when that investment is one of your better performers.

If his proxy fight fails at CSX, Chris Hohn will then have to decide whether to stay on as an investor and look to fight another day or cash in his winnings and move on. Activist investing is still a place which allows the "loser" to walk away with a 30% gain. That should help nurse TCI's wounds.