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Apr 19, 2015

The attuned ears of activist investors

A hedge fund manager shares some tips for catching companies' top management at lazy thinking on optimizing shareholder value

Move over, Janet Yellen. It's no longer just the oracular policy pronouncements by the Fed chief that anxious investors are parsing for meaning. They are now also listening for certain phrases from senior executives or board chairs at US companies that may suggest a need for some instruction on how to optimize shareholder value.

Actually, it’s not anxious investors we’re talking about here so much as agitated ones. At 13D Monitor’s Active-Passive Investor Summit held last Monday in New York, the CEO and portfolio manager of one hedge fund sponsor spoke about four key phrases that, when used by senior management, should serve as red flags to activist investors, who are demanding an increased role in what’s done at the companies where their money is parked.

1) ’We have a balanced approach’
Most commonly used to describe the company’s capital allocation strategy. The hedge fund manager offered two things that are wrong with this statement. First, it asks shareholders to assume the current state of affairs is already in balance when in reality a capital allocation strategy is usually being questioned because it’s perceived not to be in balance. For example, there may be excess capital on the balance sheet that an activist investor would like to see returned to shareholders to redeploy as they see fit. Second, he said the term is sometimes being used to denote a mix of activities rather than a balance, and that isn’t necessarily better than a focused approach to capital allocation. Rather than balanced, it would be better to describe a preferred approach as smart or opportunistic. The driving question should be: where can I earn the most attractive return on capital? That might be a well-priced acquisition rather than repurchasing shares, he said.

2) How a company describes its share repurchase authorization
Authorization in and of itself does nothing to create value for shareholders, the hedge fund manager pointed out. A pledge by three different companies to complete a share repurchase program over one year, two years or five years ignores the fact that there is still an excessive amount of cash on each company’s balance sheet that isn’t being put to good use for an extended period of time. The failure to use that cash to capture an investment opportunity that exists today is the point that isn’t being mentioned. It makes no sense to repurchase shares over time if the price at which it’s most attractive to repurchase them exists today. An extended repurchase time frame may indicate that management or the board doesn’t feel equipped to determine when the share price is most attractive for a buyback. If that’s the case, it calls for a different lead director or board of directors that does feel equipped to make that determination.

3) Comparing a company’s share performance with that of a broad market index

Making such a comparison sheds no light on things that really matter, such as the company’s business strategy or its capital allocation plan, the hedge fund manager noted. An appropriate question to ask isn’t whether this company’s share performance has outpaced that of the S&P 500 but, rather, is this company reaching its full potential? Comparisons with market indexes are blunt instruments, fundamentally flawed, and take away from a focus on intrinsic attributes of the company’s strategy.

4) ’We’re focusing on the long term’

This is a statement that ignores the fact that current performance may be hampered by poor practices, such as a bloated expense base, and often signals an attempt to delay or avoid cleaning up a financial mess, he said. To articulate the long-term return expectations of investments the company is undertaking doesn’t address concerns investors have about what management is doing right now to get its business strategy back on track.

There were plenty of other tips from activist investors at the Investor Summit for companies intent on warding off activists, which I’ll get around to sharing one day soon. But it’s clear companies would be well served by efforts to help senior managers avoid putting their foot in their mouth when they’re not prepared to meaningfully discuss their business strategies.

David Bogoslaw

Associate Editor and Online features producer for Corporate Secretary