- Updated 9/13/2019 and may contain affiliate links
Today might be the day that Mr. Shirts gets banned from the financial independence community. There’s occasionally rumblings about how Index Investing is a bubble, but I say “so what?” Index investing is a great path to wealth and the trend towards index investing allows you to potentially capitalize on it with an occasional individual stock purchase. How so? Index investing pushes capital towards companies based solely on a public stock’s total value and nothing else. I disclose our portfolio quarterly and we own mostly index funds with a few individual stocks.
Who are a company’s owners?
If you look at the major owners of public companies in their filings, specifically those that are no longer founder led, the top owners are usually the big four players in Index Funds
State Street (SPDR ETFs)
Blackrock (iShares ETFs)
FMR (Fidelity Group)
After those big four, there is a hodgepodge of secondary fund companies such as:
Capital Research Global (American Funds)
T. Rowe Price
Dodge & Cox Asset Management
So where does the opportunity lie?
Passive investing creates a challenge within corporate governance. Who is the boss? In a public company, the chain of governance goes:
The Shareholders Elect the Board of Directors
The Board of Directors Hires the CEO (and has a say in the rest of the management team.)
The Board of Directors approve various actions, such as the annual audit, high level compensation, and overall strategic plans of the company.
The CEO reports to the Board of Directors.
In a perfect world, the shareholders are actively involved in electing the board of directors and the largest shareholders serve on the board of directors.
What is reality?
The members of the Board of Directors are usually hand selected by the company’s management and the existing board of directors. This creates an environment where the CEO works for the board and the Board is chosen by the CEO. In most companies, the board of directors own very little stock, often less than the CEO. This creates a lack of accountability between upper management and the shareholders.
Mutual Funds vote on behalf of their owners and these mutual funds use Proxy Advisory Firms to provide a third party recommendation on how to vote. (This is paying to shift the liability for more independence). I lived through this poor governance through the last five years of my corporate career.
Now that I’ve bored you with that, lets get to the good stuff:
Introducing the Activist Investor
Gordon Gekko is vilified in the movie Wall Street, but his points about the evolution of corporate America written from 1987 are still accurate today. Pay attention to what Gekko is doing here: Activist investors serve an evolutionary purpose of eliminating poorly performing management and/or poorly performing companies. He points out how many executives are living off the company yet how little of the company they actually own.
The activist investor / fund takes a position in a company, then begins pushing for change. That change could be enhanced improvement, more capital returns to the shareholders, or an outright liquidation of the company. It is the resolution process for mediocrity. In the era of the movie, a buyout firm would just raise billions to do a hostile purchase of a company and reap the rewards for themselves. This peaked in the late 1980s and the buying spree is best chronicled in Barbarians At the Gate, which follows the buyout of the woefully managed RJR Nabisco.
Companies have now created all sorts of defenses for an outright takeover offer. Today an activist investor must lobby proxy advisory firms, mutual fund holders, and individual shareholders for their point of view, while the company fights it with the shareholder’s money. Nice deal huh? The activist has to use their own money, but the company’s management fights with the company’s money, not their personal money. This causes these activist battles to get public quickly since management has nearly unlimited resources and not much to lose.
Index Investing makes activism tough: Vanguard, Blackrock, State Street, and Fidelity rarely take stances on corporate governance and often only ill only side with an activist in a proxy vote under the most egregious circumstances. So what is the opportunity to profit? Activists are out to make their own money, they usually only go into proxy battles with millions of dollars of their own money when they believe the offenses a company’s management are egregious. Management will fight because they often have the upper hand and extending the fight equals more months/years collecting a high salary. Management’s fight is both the public battle, but often also the intense focus behind the scenes to improve the company’s performance. If you’re interested in investing in some individual stocks, following an activist’s position is an attractive proposition.
Recent Activist Examples: (Updated Disclosure: As of 9/13/2019, I currently have positions in $CBRL, $T, and $ARMK, all of which have activist investors in discussions with the company. Q2 2019 Portfolio Update)
Example 1: Cracker Barrel
Cracker Barrel. Cracker Barrel operates 600+ stores across the Southeast. This company was founder led until the early 2000s, then subsequent leadership came in with a massive expansion plan. The company doubled its store count, but failed to make any additional income. In fact, the performance was so poor the income per store fell exactly in half while the store count doubled. Shareholders suffered from all the money spent expanding vs returning money to shareholders via dividends or share buybacks. Cracker Barrel is rare in the restaurant business, it owns its real estate. his has some long term advantages, but is a very expensive model. Instead of returning cash to shareholders or focusing on same store sales, the company kept purchasing real estate and building locations .
On August 23rd, 2011, activist investor Sardar Bilargi published his first letter to management after taking a 9.3% ownership stake in the company. The stock was trading at roughly $40 per share and paying $1/share in dividends to the shareholders. Mr. Bilargi had already developed a reputation as a shrewd investor in his takeover of Steak and Shake, so he immediately had management’s attention. Management fought Mr. Bilargi hard and attacked him personally for his prior takeover, but behind the scenes almost every member of executive management retired and and a former Boarder’s Books executive, Sandra Cochran, emerged as the new CEO.
Mrs. Cochran and the board of directors fought Mr. Bilargi publicly, but behind the scenes was implementing almost all of his recommendations. New store openings were slowed down, capital returns to the shareholders increased, carryout and licencing agreements were reached, and the company became more transparent in its reporting of retail and restaurant sales. The company slowed its growth down and focused on existing operations. The results have been outstanding!
In 2011, Earnings Per Share were $3.81 and in 2017, EPS was $8.37 per share. The stock price moved from $40 per share to $164 per share as of this writing, which triples the S&P 500 return over the same period. Additionally, the company is returning almost 100% of its annual earnings in dividends, between a quarterly dividend and a special dividend that has been paid annually for each of the last three years. In 2017, the company paid $8.25 in total dividends. Mr. Bilargi never obtained a board seat, but his initial $40/share investment is now returning over 20% per year in just its dividend payment six years later. I was a 2012 and 2013 investor in the company and while I sold some shares with my home purchase and diversification, I thank both Mr. Bilargi and Ms. Cochran for their efforts in turning around this company and scoring one of my best investment wins!
Example 2: Darden Restaurants
Darden Restaurants was known for its two flagship stores, Olive Garden and Red Lobster. The company underwent a buying binge of concepts, including Longhorn Steakhouse, The Yard House, and Capital Grille, all while ignoring operational performance. In 2013, the company’s executives were enjoying private jets, constructing a massive corporate office in Orlando, and ignoring the performance of the company. It lagged most of its competitors and the S&P 500 in 2013. Multiple activist investors set in, then the company’s management made the critical error of selling Red Lobster over the objections of the largest shareholders.
Once the executive and old board were ousted, the stock moved out of its range of $40-$50 in 2014 to $65/share, which netted me a 20% gain in a short period of time. If I would have held on to my shares, it would have resulted in a 100% gain over three years and is sitting at $96/share and has increased its dividend which was at risk. Investopedia published this more detailed case study. This was a quick win for me, but long-term Darden Restaurant investors have won with a stock that’s almost doubled the S&P 500’s return.
Current Example: ADP
The only current activist battle I’m invested in is ADP (update – Exited in mid 2018 w/30% gain). Automated Data Products pioneered outsourced payroll. They are #1 in most of the markets they work in and everyone probably knows someone who’s worked there briefly as a sales rep.
Bill Ackman with Pershing Square Capital acquired up to 8% of the company’s outstanding stock and put together a Gordon Gekko style investor presentation after being rebuffed by management. (You can view this here at ADP Ascending) This was a three hour presentation outlining ADPs declining market share, bloated management, and lack of focus. He also included the great zinger of “I’ve found companies that historically under perform have management very skilled at explaining away their under performance”.
ADP has many of the hallmarks of an activist target, very low insider ownership, management team built entirely of internal employees, and a bloated corporate structure. They are also #1 in their industry and slowly having market share whittled away by more nimble competitors. I personally experienced an arrogant, bloated structure inside ADP when I was partnering with ADP on a transaction and their sales leaders spend more time fighting over who got credit for something than actually selling an on-boarding the client. This lack of focus ultimately resulted in the client going elsewhere as each division couldn’t figure out what product to pitch/sell to the client.
After Pershing Square released a presentation outlining all the opportunities they see as long term investors and requested three of the twelve board seats at 8.6% owners, ADP’s CEO Carlos Rodriguez vehemently attacked Bill Ackman. These attacks were personal instead of defending ADP’s performance and talking about the future of the company. The company only has nine independent board members plus the CEO, which is relatively small for a Fortune 500 company and combined they own less than one half of one percent of the company. (Sounds like Teldar Paper!). In fact, almost the entire holdings of the board of directors comes from stock issued by ADP as compensation for being a board meeting.
I am sold and believe Mr. Ackman has a winner. My favorite statistic is the 6.1% revenue growth but 31% compensation growth of their CEO. The entire management team now has their job security threatened. Mr Ackman was not successful in lobbying the proxy advisers to obtain a board seat, but future performance of the company will be closely monitored and I expect ADP will become intensely focused on shareholder returns. As I write this today, the investment is currently up slightly against my total stock market ETF and I am optimistic it will soundly beat the market over the next five years.
What can you do?
First, do you homework. Individual stock investing poses more risk than investing in a diversified mutual fund. Pickup a copy of Barbarians at the Gate and enjoy the history lesson. Not all activist battles work out. Surprisingly enough, many activist’s funds themselves struggle because the good activists attract a bunch of capital and start investing in good deals instead of just great deals. Look for the great deals! I specifically avoid any short activist battles, primarily because of a phase I heard from Michael Lewis’s The Big Short: The market can stay irrational for longer than you can stay liquid.
Bill Ackman is one of the brashest investors out there. He went on a personal mission against Herbalife, which sells overpriced supplements and is involved in multi layer marketing. Mr. Ackman underestimated the margin in the supplements business and the sales machine he was facing, then the company continued to produce enormous amounts of cash to publicly fight his criticism while buying back stock to prop up the share price and set the company up to go private. This bet has set his fund back for half a decade.
If you believe there is a long-term trend towards passive index mutual funds, then there will be opportunities. These passive index funds are unlikely to pressure management and it will take a compelling case plus deep pockets to force change within a company. When an activist decides to do this, they have often picked a winner and can freely participate in the upside. Proceed with caution, but enjoy the ride.
Have you ever followed an activist investor? Are there other market trends you see from investors transitioning into passive mutual funds? Please tell us what you think!