What Are Activist Investors Looking For?
While shareholder activism has historically been an American phenomenon, it is starting to spread to other developed equity markets around the world.
Activist investors have been living up to their name in recent years, waging campaigns against an array of companies of all shapes and sizes. The number of activist campaigns more than quadrupled from 104 in 2000 to 487 in 2015 and, according to the Financial Times, more than 40 percent of the 500 largest public companies in the United States attracted activist attention between 2009 and 2015. Assets under activist management have been growing at nearly 20 percent a year for more than a decade and the category now collectively controls more than 123 billion dollars.
Choosing a Tasty Treat
What do activists look for when choosing their quarry? The answer isn't obvious, as campaigns have targeted companies that are very different from one another across a broad swath of industries. But after analyzing more than 3,000 campaigns, the paper's authors, Chris Young (Contested Situations within M&A) and Rick Faery (HOLT Corporate Advisory), found that three factors have a statistically significant relationship with activist intervention: valuation, operating performance, and excess cash.
What Is on the Menu
Low valuations have always set activist mouths watering. In short, companies become vulnerable to an activist campaign when valuations become depressed relative to their peers. According to the Credit Suisse paper, discounts on two metrics in particular seem to anticipate activist attention – price-to-book ratios and a measure of enterprise value to operating cash flow. For example, activist investor Elliott Management set its sights on Hess Corp. in 2013 when the company's price-to-book ratio was 40 percent below the median of its peers. The same year, Talisman Energy attracted activist attention when its enterprise value-to-cash flow measure dipped to 40 percent below the median of other companies in the industry.
Credit Suisse also found two measures of operating performance that seem to be reliable predictors of activist intervention – returns on capital and operating expenses as a percentage of sales. Returns on capital capture both the cash flow generating prowess of the business as well as the asset efficiency thereof, whereas operating expenses are straightforward and can point to low-hanging fruit for activist cost-cutting. Not surprisingly, disconnects on either metric can produce a statistically significant increase in the likelihood of activist interest. In 2013, medical device company Hologic attracted Carl Icahn's attention after several years of significant declines in return on capital. That same year, Starboard Value went after Smithfield Foods at a time when operating expenses relative to sales were nearly 10 percentage points higher than its peers.
Three factors have a statistically significant relationship with activist intervention: valuation, operating performance, and excess cash.
Finally, there's the undeniable appeal of a company overflowing with cash, a tasty target for a campaign to initiate share buybacks or increase dividend payments. Which metric works best in identifying balance sheets that are attractive to activists? The ratio of a company's total cash relative to its market capitalization. The higher that ratio relative to one's peers, the more likely a company is to garner unwanted attention. When ValueAct Capital scored a seat on Microsoft's board of directors in 2013, the company's 77 billion dollars cash balance gave it a cash-to-market cap ratio more than double that of the industry median.
A Satisfying Meal
Taken together, all three factors – valuation, operational performance, and cash on the balance sheet – serve well to anticipate activist attention. The factors this paper identifies as important to activists are 76 percent more likely to identify a target of activists than random chance. Coming at it from the other direction, companies with strong operating performance, healthy valuations, and disciplined capital employment are less likely to become activist targets than those without them. "Like most disruptions in the marketplace," concludes the paper, "it all comes back to value creation in the end."