25 July, 2017
Alex Gavrish discusses the possible story behind activist investors’ large investment into Nestle
During my last trip to London I went to Courtald Gallery located in Somerset House. At the gallery there is currently a temporary exhibition with a collection of works by artists from the Bloomsbury Group. One picture struck me immediately as I entered the room – “A Conversation” by Vanessa Bell. It is so alive that you are immediately overwhelmed by a sense that some emotional or dramatic conversation is taking place. Even without knowing the name of the painting it is very easy to guess it. The picture just tells you the story “behind it”. The author Virginia Woolf wrote in a letter to her sister, Vanessa Bell: “I think you are a most remarkable painter…a short story writer of great wit…I wonder if I could write the Three Women in prose”.
Over past few years we have witnessed tremendous growth of shareholder activism. Not a day passes without reports in financial media about new activist investor campaigns. Many investments by activists, when disclosed, are so easy to understand that there is no need for in-depth analytic reports. The ideas are so expressive, and just like Vanessa Bell’s picture – they themselves tell you a whole story.
So what story does activist investor Daniel Loeb and his firm Third Point see in shares of Nestle? What prompted him to make such a large investment into a large consumer goods company well known to everybody? What potential upside he was able to foresee? After all, there should be a reason why investors agree to pay significant fees for this.
Everybody would probably agree that markets are efficient to a large degree. What is amazing is that despite this, a small pack of activist investors and hedge fund managers continue to come up with great investment ideas. How is it possible? 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 or otherwise analyzing numbers “to death”. But according to one of the best investment managers of the 20th century, Peter Lynch of Fidelity Investment’s Magellan Fund – which achieved a 29% annual return over thirteen years period between 1977 and 1990, good investing is about something else: “Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage”.
Strictly analytical approach to investment management does not provide us tools for dealing with uncertainty. The closed and fixed form of analytics leaves no place for imagination. And without imagination, we are just not capable of fathoming uncertainty, fathoming the future.
Isaac Bashevis Singer, Nobel Prize laureate in literature said: “A story to me means a plot where there is some surprise. Because that is how life is – full of surprises”. The same holds true for investing, because companies, markets and economy by their very nature are social processes. And when there are humans involved, there will always be surprises.
Albert Einstein once said that: “Everything should be as simple as it can be, but not simpler”. So in case of Nestle, what exactly is this simplicity? Or is it too simple?
Before I answer this question, let me first propose what this investment is not about.
The end of activism
Firstly, it is not about activism. Although one can argue that Nestle underperformed relative to some benchmarks or other companies in the sector, one cannot say outright that it is an underperforming, badly managed company. Over past nine years shares of Nestle returned approximately 9% annually including dividends. A reasonable and attractive long-term return for a blue chip consumer goods company.
Anton Chekhov, Russian playwright and short story writer said: “Don’t tell me the moon is shining; show me the glint of light on broken glass”. So far, there does not seem to exist broken glass in Nestle’s house. Activist investors usually target companies which obviously underperform or are badly managed. It is hardly the case with Nestle. Yes, there is room for improvements – but it is probably true of any large and complex company of Nestle’s size and scope.
The best proof that it is not about activism are similar investments by other hedge funds and activists into shares of large cap, blue chip companies. Bill Ackman’s stake in Mondelez International and Nelson Peltz’s position in both Mondelez and Procter & Gamble. Even recent investment by David Einhorn in General Motors seems to fall into the same conceptual “category”. Seemingly a coincidence, one cannot help but to recognize a certain pattern here.
Secondly, it is not about valuation. Daniel Loeb certainly deserves a huge credit for his talent of finding investments with excellent “built-in” risk-reward profiles. For example, he often applies sum-of-parts principle of valuing companies. He made a few quite impressive investments in the past which reflected this sum-of-parts idea. Investment in Yahoo was centered on sum-of-parts valuation: Yahoo’s ownership of large stakes in Yahoo Japan and Alibaba Group, which was subsequently IPOed. More recent investment in Baxter was greatly “structured” as well – after spin-off of Baxalta which was immediately acquired by Shire, Baxter retained a 20% percent stake for some time and later disposed of it. Existence of this “sum-of-parts” structure improves the share’s risk-reward profile. And whatever the outcome of activist campaign, there is a good chance that value of these parts will be realized, in one way or another. When these parts exist and are undervalued, management has much less room to mess thing up. The approach is so good, in fact, that even if the ungifted or corrupt management deliberately destroys value, there is still a good chance of coming out on top and making money.
In case of Nestle, “sum-of-parts” is reflected in their 23.2% stake in L’Oreal and possibilities for selling certain brands or businesses. For example, they recently announced a possible sale of their US confectionary business. Nestle’s stake in L’Oreal is currently valued at $27 billion and represents 10% of company’s current market capitalization.
The stake in L’Oreal does not seem to be a cornerstone of the investment case as it represents a small proportion of Nestle’s market cap. So despite the existence of sum-of-parts “structure”, it is hard to say it will make a big difference.
So what is going on here? Why all these activist investors and cut-throat hedge fund managers suddenly trying to become “Warren Buffett” saints of sorts?
Shrinking opportunity set
I think that significant investments by these investors into shares of large cap, blue-chip companies reflect the shrinking investment opportunity set in the market. We came a long way since 2008 credit crisis. Many companies (or the market in general, if you will) changed a lot. Corporations were forced to improve and optimize their business. A huge wave of shareholder activism gained more and more momentum during these years. It was accompanied by low interest rates and rising general stock market.
In addition to this, the data shows that US public equity markets are shrinking overall (in terms of the amount of companies). Recent research “The U.S. listing gap” published in the Journal of Financial Economics shows that the number of publicly listed companies in the U.S. declined by about 50% percent since its peak in 1996.
All these circumstances make good investment opportunities harder to come by at present. Activist investors enjoyed a great period, their appetites grew while the opportunity set shrank. So now they find themselves with nothing else to invest but in a kind of “safety bets”.
Free macro optionality
But I think there is more to it. I think that activist investors just see many additional potential sources of upside in shares of these companies.
First, as the US public equity markets are shrinking, there could be a meaningful mismatch between capital looking to be allocated/invested and available investment opportunities. This would put an extra pressure on stocks and push their prices higher without having anything to do with profitability or valuation. And who would be the first ones to enjoy this “dumb” inflow of capital? Of course the safest segment of the market – large, multinational consumer goods companies.
Second, the great availability of credit, low interest rates, and almost ten years (since 2008) of expansive monetary government policy should lead to increasing inflation and might position the markets for an abrupt or smooth – but a depreciation of the major currencies. This depreciation, of course, will be relative to the real purchasing power of money and prices of real assets such as stocks or real estate or food and basic necessities.
Third, at some point these first two trends can lead to a self-reinforcing process which will result in sudden conceptual shift in the minds of individuals regarding the value of cash, currencies and debt. This shift, in turn, might position the stock market for a sudden rise and currencies or debt for a more abrupt depreciation.
Jerome Bruner, a famous cognitive psychologist, explains that narrative mode of thinking leads to conclusions not about certain absolute truths, but about varying perspectives that can be constructed to make experience comprehensible. By telling stories, we formulate these different perspectives.
By making those investments, activists essentially receive all of these macro options for free. So the risk-reward is great: in worst case – these multinational consumer goods companies will do fine and the downside is probably very limited, especially if you have a long-term (five years or more) investing horizon. But in case some of these macro possibilities do materialize, the upside can be very attractive.