The Ultimate Value Investors
Richard L. Grubman first leapt to fame in 2000, when former Enron Corp. CEO Jeffrey Skilling called him a dirty name for asking awkward questions about the company's financials. Since then, he has been throwing the book at Reader's Digest Association Inc., one of the world's most conservative, family-run publishing companies, because its stock is down by half from 18 months ago.
It has worked. On Apr. 15, the company buckled to pressure from Grubman, announcing it would create a single class of stock, effectively putting control of the company into shareholder hands rather than the company's charitable trust. Grubman wants more concessions (table), but the stock has since been upgraded by both Merrill Lynch & Co. and Morgan Stanley Dean Witter.
Grubman, managing director of Boston hedge fund Highfields Capital Management LP, is one of a new breed of ultimate value investors. They are a hybrid of the often nasty, hyperbolic corporate raiders of the 1980s, such as Carl Icahn and T. Boone Pickens, and the pure shareholder activist types of the 1990s. They use many of the weapons of the old-style raiders. But there's one big difference. "These guys usually don't want to take over a company, but they want to put it in play," says Patrick McGurn, vice-president at Institutional Shareholder Services, a proxy advisory firm. "They want to challenge existing management strategy for the sake of value creation."
Right now, the new value investors are the hottest players on Wall Street. And they have an embarrassment of targets. The secretive David L. Cohen of Iridian Asset Management LLC and David Winters of Franklin Mutual Advisers Inc. are trying to oust Milan Panic, the controversial CEO of ICN Pharmaceuticals Inc., who was recently awarded a $31 million bonus. Providence Capital Inc.'s Herbert Denton, a lanky exec with a penchant for motorbikes, has forced Alaska Air Group, Great Lakes Chemical, and Navistar International to abandon poison pills this year, and persuaded Footstar and Toys `R' Us to modify theirs. Wiry Texas billionaire Samuel Wyly, who occasionally wears cowboy boots with suits, is said to be saddling up to take another run at Computer Associates International Inc., hoping to oust Chairman Charles Wang and other top brass.
Their style of investing is taking off like a Fourth of July bottle rocket, fueled by the two-year bear market. "Investors are using whatever tactic they can to extract investment returns," says Michael Useem, professor of management at the University of Pennsylvania's Wharton Business School. The Securities & Exchange Commission is right behind them. Earlier this year, it told money managers they should turn up the heat on companies in which they invest. Sometimes, that's all it takes. "Numbers of companies, knowing they are under fire, are making voluntary changes," says ISS's McGurn.
If companies balk, they expose themselves to the full fury of the current anticorporate environment. Enron's bankruptcy--which snuffed out $60 billion of investor wealth--has created unprecedented skepticism about the credibility of management, executive pay, and board independence. With that tide running strong, shareholder proposals, many fomented by the ultimate value investors, are garnering on average 52% of votes this year, as opposed to 42% last year.
Increasing institutional ownership of stocks is adding to the momentum. Since 1990, stock held by the likes of pension and mutual funds has risen to 65% of the domestic market, from 51%, according to Georgeson & Co., a shareholder research firm. The professionals have more incentive to slog it with management than individual investors. That's particularly true of index funds, which have to park the $351 billion they manage in certain stocks regardless of how poorly a company is run. "Index funds have to focus on ways of getting value through improving governance--getting independent auditors, making sure boards are independent, reducing option awards," says John C. Bogle, founder of Vanguard Group Inc. There's no shortage of dissidents ready to help out. Providence's Denton collects fees from index funds and regular mutual funds, such as Legg Mason Value Trust and Dreman Value Management LLC. "We sometimes get paid to do the dirty work for clients," says Denton.
The strategy can pay off. Consider the $156 billion California Public Employees Pension System, which takes underperforming companies to task. From Jan. 1, 1987, to Nov. 30, 2000, the 95 companies CalPERS targeted produced an average compound return of 2.6 percentage points a year above the Standard & Poor's 500-stock index, according to a 2001 study by Wilshire Associates Inc. In the preceding five years, the same 95 companies underperformed the S&P by 14 points.
Still, success isn't guaranteed. Investors have to back the right horses--companies that have a racing chance of turning around. Some shrewd observers say Wyly may be fighting a losing game. "Computer Associates is plagued with problems. The likelihood of a turnaround is very slim," says a money manager who asked not to be identified. Says a Computer Associates spokesman, "Wyly's interests are not aligned with the interests of either CA's shareholders or customers."
Even with a viable turnaround candidate, the strategy can bomb. Although Denton had Aetna Inc., the giant insurance company, in his sights for over a year. But his efforts were derailed when the stock got a lift from the recent rise in the insurance sector, and some big shareholders abandoned the cause. Moreover, some mutual-fund families refuse to back the dissidents. "Mutual funds are serving corporations, managing their 401(k) money," says Vanguard's Bogle. "They don't want to offend companies and risk being shut out of business deals."
Still, pressure and the resulting spotlight from folks such as Wyly and Denton can prompt positive changes. For instance, Computer Associates promised to abandon pro forma accounting and add more independent directors to its board after Wyly and others raised the issues. And Aetna said it would review its corporate governance policies. "Every shareholder wins when an investor goes in who's willing to rake management over the coals," says Stephen Davis, president of Davis Global Advisors Inc., a corporate governance consultancy.
More and more independent money managers are playing the ultimate value game. Hedge funds--which have proliferated in the past few years and operate in a much more renegade fashion than mutual funds--are increasingly using an active strategy. "We look for companies that are asset-rich and management-poor," says Robert L. Chapman Jr., an El Segundo (Calif.)-based hedge fund manager. "We're like sharks sniffing for blood."
Franklin's Winters and Iridian's Cohen are certainly circling ICN. With their combined 10% stake, they joined forces, solicited proxies, and claim to have elected three new directors at the May 29 annual meeting. If the full vote count confirms their victory, they'll seek to oust CEO Panic. Why ICN? Analysts say the company has good cash flow, excellent products, and a stock price that's cheap relative to its peers.
It also has dismal management. The SEC is seeking to bar Panic from serving again as an officer or director of any company, stemming from charges ICN had deceived investors over the approval status of a drug. "ICN's stock price reflects a high degree of investor skepticism that would be removed if dissidents take over the board," says Eric Miller, co-manager of the Heartland Value and Heartland Select Value funds. Panic said in a statement that while he disagreed with the dissident shareholders, "We pledge to take whatever actions are necessary on our part to maximize value for the shareholders of ICN."
Like Cohen and Winters, most activists are opportunists. They look for companies that are selling at about half of what they figure they're worth, and well below their 52-week highs. That narrows their scope to companies with one or two major, but fixable, problems. "We never go after a company that is too complex to understand or fix," says Denton. They then spring into action, purchasing substantial shares of the company, writing letters to the CEO detailing their concerns, drafting shareholder proposals, and lobbying other big shareholders.
Most like to see at least a 50% return within two years, which they harvest as soon as they get it. "We are a catalyst investor," says Ralph Whitworth, head of Relational Investors LLC, a large value house that has CalPERS as a client. "We get involved in companies that have fallen out of favor and work to turn them around. Then we exit and reinvest that capital in a similar opportunity."
The strategy can produce pay dirt if a targeted company is bought out at a premium. Denton netted a 111% return when Comsat Corp., an investment he made two years earlier, was acquired by Lockheed Martin Corp. in 2000. Some investors even work behind the scenes to find potential acquirers. "We do perform an investment-banking function at times, but an acquisition is usually not our goal," says Denton, who ran the mergers and acquisitions business at Jeffries & Co. before starting Providence in 1991.
Extracting value, however, may not require such extreme measures. According to a February, 2002, study by Paul A. Gompers of Harvard Business School, Joy L. Ishii of Harvard University, and Andrew Metrick at the University of Pennsylvania's Wharton School, "democracy" companies--those that encourage shareholder rights--outperformed "dictatorship" companies that restrict them by over 9% per year throughout most of the 1990s.
Even so, "most value investors put money in companies, cross their fingers, and pray they do well," says Whitworth. "We know the companies we invest in will do well, because we're in the driver's seat." And when those companies do well, it more than pays to be an ultimate value investor.
By Marcia Vickers in New York