1 February, 2017
Alex Gavrish explains the guiding principle behind activist investments. Good investments are just like good stories or movies: with three part structure, important turning points, intrigue, drama, and surprises
Over past few years we have witnessed tremendous growth of shareholder activism. US is the leader in this field. Not a day passes without reports in financial media about new activist investor campaigns or updates on companies in which activists already invested.
It is expected that activism is here to stay and will only continue to grow. Activist investors themselves are positive and optimistic. According to a 2016 edition of Shareholder Activism Insight report and survey published by Schulte Roth & Zabel law firm, most investors expect activism campaigns to continue at the same pace or even increase.
A recent article in Financial Times asked the question if it is possible to predict which companies will be targeted by activist investors. The motivation to do this is understandable. First, once activists are onboard, they will actively influence company and will do all in their power to make sure business value is reflected in the share price.
In addition, disclosure of share ownership by activist investors and large hedge funds is moving the shares of company up. Identifying future targets can give investors an extra edge and improve returns. As British economist John Maynard Keynes said:
“Successful investing is anticipating the anticipations of others”
Can this be done with activists? And if yes, how?
The possible solution suggested by research firm Activist Insights is a correct step in the right direction. Researchers from Activist Insights found few significant factors that might help investors predict future targets of activists. Among these factors are recent share price performance, company’s return on equity, institutional ownership and presence of hedge funds that are known for activist campaigns.
However, I believe this is not enough for intelligent investors. The reason being that reverse engineering the features of companies activists target is an exercise in “retroactive” data mining. These factors and features certainly point one in the right direction overall. But it is not these factors and characteristics themselves that attract activists or hedge funds.
It is the other way around: activists and hedge funds are attracted to a company, and it happens that it possess certain characteristics. Without going into the definition of what is value, activists are still investors, and mostly value investors.
So it is not surprising that shares of the companies they target do not perform well. Return on equity factor is more problematic: who would pick companies based a low return of equity factor? If investor has to use this factor at all, then one should pick companies with high return on equity, not low return on equity.
So to make a long story short, even if you decide to use these factors in your decision making process, actual implementation is very problematic.
The question then is what really attracts activist investors? How is it possible that despite all of market efficiency, a small pack of activist investors and hedge fund managers continue to come up with great investment ideas? Why these opportunities do not disappear?
I think that great investment managers are also good storytellers. Many investors believe that making good investments requires excellent skills in the analysis of financial accounting statements, building complex and detailed valuation models, forecasting future profitability of companies and otherwise analyzing numbers “to death”.
In my book Story Investing I argue that best investments are just like good stories or movies: with three part structure, important turning points, intrigue, drama, and surprises. One of the highlights of the approach is the proposal to develop both a historical as well as future narrative for the company and its share price. It is not only a question of providing verbal and common sense explanation of the numbers.
Daniel Loeb, a well-known activist investor and manager of hedge fund management firm Third Point told me that he agrees with story thesis.
I think activists are especially good at identifying this three part story structure of complication, development and resolution. It allows them to develop a sound investment thesis for the company. And of course they aim to jump aboard the train at the beginning of the resolution part.
Of course, such approach is highly dependent on one’s personal interpretation of company’s story. This storytelling should be supported by standard analytics and fundamental valuation. But it is this art of narrative thinking and story composition that will ultimately make a difference.