The challenge of predicting where activist investors will pounce
Study suggests that a stock’s short-term underperformance makes a company vulnerable
Is it possible to identify the next target for activist hedge funds before they swoop in?
There is certainly money to be made if you can. The news that veteran rail industry executive Hunter Harrison was teaming up with Paul Hilal, a former partner of Bill Ackman, to demand a shake-up at CSX, the largest railroad in the eastern US, sent CSX shares up 23 per cent last week.
That was a particularly large gain, but most new activist campaigns elicit a share price bump of some kind. Elliott, the combative fund run by Paul Singer, revealed two new campaigns in the past fortnight, each time getting a nice little increase in the value of the stakes it had built: NRG Energy, a power company where Elliott hopes to install an ally on the board, jumped 5 per cent; The Advisory Board Co, a healthcare consultancy, surged 16 per cent when Elliott suggested it should be put up for sale.
These companies are a heterogeneous trio, and different activists tend to pounce on different kinds of businesses. Some funds seek the low-hanging fruit of a large cash pile that can be returned to shareholders, others are offering to help with slow-grinding work of improving a company’s lagging operational performance.
None the less, the quick riches on offer have encouraged many investors and advisors to try to work out who will be the next target.
The latest attempt is by Activist Insight, a research firm that has been tracking activism for years and reckons it has been able to reverse-engineer the characteristics that attract a new hedge fund campaign.
Two of the four factors it found to be significant relate to performance. A company whose total shareholder return over a 12-month period is much weaker than most of its peers is vulnerable to an activist in the following nine months, it found. A group whose return on equity is below average in a sector is also open to a challenge.
The other two factors that are predictive of an activist assault in the coming months are a high level of institutional ownership and the existence on the shareholder register of hedge funds that have run activist campaigns in the past.
These all make sense. Underperforming companies are likely to have unhappy shareholders who, ultimately, are the people an activist needs to win over if their demands are to gain traction. And a campaign is more winnable if the activist only has to win over a small number of big institutions and likeminded hedgies rather than a dispersed retail shareholder base or insiders who are probably supportive of, if not actually on, the board.
Activist Insight’s findings, published last month, largely chime with previous studies, the main difference being that they suggest a short-term period of underperformance is enough to make an activist pounce, and long-term underperformance is not necessarily a predictor.
Previous academic dives into the conditions for activism have additionally suggested that weak corporate governance and other evidence of shareholder dissatisfaction, such as rebellions at annual meetings, also hint at an activist challenge to come.
The Activist Insight Vulnerability model is throwing up a preponderance of healthcare names that look open to an activist campaign, as well as a few consumer-facing companies. AutoZone, which sells car accessories, and AutoNation, the largest car dealer in the US, are the two most vulnerable S&P 500 companies, according to its most recent screen. We will see.
A wider question is how active activists are going to be in 2017. After years in which it has been one of the most sought after sectors of the hedge fund world, money flowed out of such funds last year. That came after several debacles, including the collapse of shares in Valeant Pharmaceuticals, an activist favourite.
The sector’s performance perked up in the second half of last year and, in fact, activism ended as one of 2016’s most lucrative hedge fund strategies, with returns of 10.5 per cent according to HFR. The trouble is that return still lagged the S&P 500, against which activists are supposed to be adding value. Meanwhile, US companies continue to become more receptive to shareholder concerns, meaning fewer cases where activism is needed.
Reflecting that shrinking opportunity set, investors continued to withdraw money from activist funds in the fourth quarter, HFR reported on Friday. Finding the next activist target remains as lucrative as ever, but with potentially fewer out there, it is becoming a harder pursuit.