Monday, 3 March 2008

Macro-Level Trends – Activist Investors – Looking for Value & Growth Opportunities

Throughout the latter half of the 20th century shareholder activism was for many years a low-key affair, only prominent when a quoted or private company appeared to be heading off the rails. Given the general consistent growth pattern of the period, and only a few comparatively short-lived down-turns through the 70s and 80s and 90s, the dominant shareholder mentality was akin to that of a supervisory role in what were comparatively stable business waters. However, increasingly a new dimension came to light, primarily the US, in the 80s and 90s; the beginnings of which we now recognise as “aggressive activism” with the re-emergence of private equity power.

It is a powerful financial force the size of which had not seen since the days of the great industrialist families, this time instead of procuring industrial value chains to aid efficiencies instead was directed as purist ‘reward funds’ targeting distressed, under-valued organisations that had much ‘unlockable’ potential within their organisational, real estate, plant and intellectual asset-bases. “Strip and flip” became the negatively tainted short-hand jargon for what were often large and risk-laden deals, critics charging the protagonists as blatant opportunists, when in reality the complexity of the challenge dissuaded more risk-averse public and institutional funding and importantly future strategy plotting

Today, the term ‘activism’ itself has evolved and is open to many semantic interpretations; ultimately none right or wrong, simply dependent upon the core agenda of a specific stakeholder – whether to maximise returns in the ‘aggressive’ mould, improve risk adversity in the ‘traditional’ mould or highlight the need for new policy (ie good corporate citizenship) in the ‘alternative’ mould.

However, though ‘activism’ per se has broader ideological coverage than before, the truth is that the pursuit of maximised financial return causes the greatest stir, both internally within a company, and externally amongst press and observers. ‘Aggression’ cognitively equalling a vulture-like “strip & flip” or “balance sheet leverage to raise immediate returns” - Boards and management see it as PE’s modus operandi But even an aggressive shareholder’s own investment strategy will obviously take into account the dynamics of the company set within its respective sector, itself set against the developments of PESTEL forces, and can often highlight the stark realities of a companies position without the temptation to stick one’s head in the sand in what are diminishing prospects. Conversely, if continued growth prospects are good, the activist investor will endeavour to ensure that the company improves beyond the possible ‘rising tide’ of a buoyant environment, applying pressure and assistance to beat the sector average growth trend-line and demonstrate the company as a sector benchmark.

It may sound patronising, but the acute, demanding investor (whether individual or group) will very probably undertake a broader and deeper appreciation about the company than the ‘supervisory’ shareholder or ‘conscientious’ campaigner. And it is this pertinent difference that makes for, to our minds, the much needed ‘catalyst activism’ that we’ve seen periodically in the auto-industry from the likes of Kerkorian’s and Icahn’s rapid shake-up attempts to Cerberus’ more involved approach. Even when not successful in obtaining Board presence such activism (or political threats) do evolve strategic questioning and thinking and can awaken the management to (maybe encompass) alternative options.

Of course central to the issue of corporate strategising is the prime business driver of: Profitability Level vs Time-Scale.

Given the usual myriad of strategic choices, tension will always be evident given the argument for short-term opportunism vs perhaps a hard fought (not guaranteed) longer visions for a larger pot of “jam tomorrow”. Much is dependent upon the cultural context a company operates within, the dynamics of US vs European vs Japanese vs BRIC+ business and financing climates evidently different given their respective micro and macro challenges and investment, corporate and critically cultural (introvert/extrovert) responses.

However, financial commentary from the likes of the FT and Reuters highlight the probable upturn in activism efforts in western markets, moving from smaller-scale targets into larger corporate battles across many sectors including:

- ABM Amro (the deal prompted by The Children’s Investment Fund)
- HSBC (being pressured by Knight Vinke)
- Deutsche Borse (recognising exchange markets consolidation)
- Vodaphone (targeted by Efficient Capital Structures)
- Cadbury Schweppes (being pushed for improved margins by Trian)
Oil –
Royal Dutch Shell
Entertainment & Media
– Time Warner

The recent trend for stock market volatility should continue the trend as fund managers seek to beat what is a poor performing index. Even cautious investors are demanding more for their risk premium given the uncertainty of markets in general, they will expect much of their investment managers when a tempting option is to buy safer fixed income products or look at FX markets.

Moreover, corporate governance imperatives are demanding that fund managers become more involved with their investment choices to assist in the safe-guarding of client monies, naturally leading into the realm of greater questioning and prompting of company management and seeking best routes forward for their own client investment protection and of course maximisation.

And as for the operational success of what are often ill-described ‘short-termist’ activists, the general perspective is that if reputedly longer-term investors (such as pension & insurance funds) don’t like the activist agenda and goal, then often as larger shareholders in mid and large caps the efforts of overtly radical and selfish activists won’t be supported. To quote Peter Montagnon, investment director of the Association of British Insurers, “It is when the two combine that they become a powerful force for change” [FT 07.01.08]. And this perhaps is where external influence upon a company board, beyond executive directors’ remits, can be advantageous.

So what of the auto-industry’s past experience and future possibilities for activist investment?

Though there have been rebounds, the late 2007 stock-drops that many auto-makers and parts suppliers faced due to the expected fall-out from the credit crunch were noticeable indeed, often between 6-9% for VMs and more so for dependent and often more cashflow fragile Tier 1s and 2s.

Besides Chrysler’s history and last year’s transference into private hands, automakers themselves have historically been relatively untouched by activist investors, probably because the role (theoretically cheaper) debt plays an important part in many automakers cyclical and very capital intensive business models, underpinning new growth paths for new futures. Furthermore, when approaching, at, or near the juncture of a tipping point - as we’ve recently seen with Fiat EoY results and GM’s ‘nearly there’ EoY pre-tax operating profits – there may be a tendency for previous fixed income lenders to actualise what are often debt-for-equity stakes and for a company itself to start share-buybacks raising the effectual net worth of shares and negating the usual step by step share accrual process.

However, opposing notional business economics, as real-world events periodically do, the fact that there has been such share-price volatility within US Autos recently, means that even those corporations that are on the road to successful turnaround could be seen as undervalued given that previous headwinds such as legacy costs have been taken off the books thanks to successful recent UAW and Pensions Trust arrangements. Thus GM, Ford and even Daimler’s 19.9% of Chrysler, may be seen as Value Opportunities, but we suspect Daimler recognises the fact and wishes to remain allied for investment reasons aswell as operational ones.

As for US suppliers, hedge funds and PE will have been circling Chapter 11 and distressed debt opportunities for some time, recognising that they could act as short-term arbitrageurs, passing full companies or sub-divisions to $US cash rich Asian foreign trade buyers, eager to gain a geographic foothold in the US, Canadian, Mexican and other foreign shores, the trade buyers themselves eager to improve technical ability and seek horizontal and vertical integration aswell as access to current and potential order-books including Detroit’s big 3. Failing an arbitrage play, activists could push for an operational hike in export sales of relatively advanced items to Asian VM producers, exploiting the seemingly ever declining $US.

It may be the same story for those suppliers to the recently favoured Euro Autos that have been spotlighted (ie PSA, Renault & Daimler), the market polarization - or dum-bell effect - between eco-friendly and well positioned premium producers set to assist their present modules and components suppliers. Equally those suppliers that have the ability to rapidly change their technological and production focus to exploit ‘eco’ and ‘premium’ - and so gain the ability to charge higher prices as a result - will also attract the hostile or welcome attentions of fund managers eager to be part of the trend.

But competition will be tough as the many variations of funds emerging – from event driven to sector specific -demonstrate the high level of liquidity being accrued from the myriad of investor types keen to take advantage of the economic trough. Ironically it is that high liquidity amassing and the need to perhaps be seen to be using it that could drive hedge-funds, PE and SWFs to possibly over-pay.

However, compared to the more dynamic recent few years in general smaller deal activism, we think that the stark reality of such a competitive, complex and capital intensive auto-industry, set against a cautious investment attitude, will force activist investors to take more care and time in formulating their idealised plans and, thanks to their own client questioning and regulatory needs, perhaps be more politically subtle when approaching and convincing company boards of their propositions, and critically be open to improved dialogue and adaptable schemes to ensure their acceptance.