Assessing a Company's Potential for Activism

There are known knowns; there are things we know that we know.
There are known unknowns; that is to say, there are things that we now know we don't know.
But there are also unknown unknowns – there are things we do not know we don't know.
— United States Secretary of Defense, Donald Rumsfeld

The famous observation above misses an important category. There are also unknown knowns; there are things you don't know you know. Until recently, I had a pocket of knowledge in the last category:  what leads an activist to a particular company. 

Two Minute Version:

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There are three pieces to a successful activist campaign. First is some perceived hidden value. Second, the ability to buy in and own it. And finally there is the activist's ability to uncover that value, either by convincing management to take some action or forcing them to through the shareholder voting process. A company must have all three to be interesting to a (sane) activist.

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Below I've unpacked it and given some common factors that lead to activism, but the beauty is that once you've grasped it, you can apply it to your own situation and find the relevant factors yourself. Its a framework that will allow you to access a company's chances of being attacked. It is also quite useful for a company, which wishes to reduce their chances of such an encounter, as well as, for an activist seeking to maximize returns.  

Ten Minute Version:

There are three pieces to a successful activist campaign. First is some perceived hidden value, which could take the form of:

• Traditional Deep Value Metrics - At heart, activists are deep value investors in the tradition of Ben Graham and Warren Buffett (back in his hedge-fund days). Only they work to uncover the value they see actively  rather than wait for "Mr. Market" to recognize it.
• Lower than industry payout ratio or balance sheet leverage, all of which can be increased to yield cash. 
• Higher than industry CEO pay, cash reserves, spending on low ROI growth, all of which can be lowered to yield cash. 
• Separable high growth and low growth business lines, which when separated are valued more apart than they were together. Suddenly an average looking business looks like a high growth business, which is forgiven for burning money, and a low growth cash cow with an attractive dividend. (It is a testament to market in inefficiencies that this strategy produces reliable returns.)

Second, the ability to buy in and own it.

• First a stock must be public and purchasable. If an activist can't own it, he can't benefit from improving it.
• The appearance of an activist typically triggers 1) a jump in share price  and 2) adoption of corporate measures such as a poison pill to stop them from buying more. For this reason activists need enough liquidity to amass a position before triggering public disclosure. The liquidity must be both high (lots of shares trading) and deep (it's not the same 10% flying back and forth, but enough to buy a large chuck without drastically changing the price.)

And finally, there is the activist's ability to uncover that value, either by convincing management to take some action or forcing them through the shareholder voting process. Ways this can happen:

• The activist needs to believe that existing large shareholders can be convinced, especially institutional holders who are used to taking an analytic approach and may have worked with the activist before. 
• The ability to become the company's largest shareholder. We are back to high and deep liquidity. (High liquidity is not helpful if it is only the same 10% of the company passing back and forth between traders.) 
• Very open management - the activists dream
• Known and/or sway-able board members
• Problem issues likely to receive the support of proxy advisers such as ISS 
• Abnormally high barriers to shareholder participation - Contrary to popular belief high legal and procedural barriers to shareholder action actually attract activists, since it give them a platform to build consensus with large institutional shareholders and their proxy advisers. 

A company must have all three to be interesting to a (sane) activist. 

• Only if an activist makes it all the away through the chain do they make money. They must 1) see value where others don't AND be correct, 2) come up with a plan to uncover the value that will actually work 3) believe he can convince or force the company to carry out the plan and 4) actually get the company to change in reality.