Activist funds are still seeking tempting targets

The one hundred and forty first running of the Kentucky Derby, may have gone to form when punters' favourite American Pharoah romped home (2 May) but the corporate sponsor of America's greatest horse-race may not have enjoyed themselves quite as much as normal. Yum! Brands is the the operator of licensed brands such as KFC, Taco Bell and Pizza Hut, as well as the sponsor of the Run for the Roses but its strategy and financial performance are coming under scrutiny from so called “activist” investors.

Third Point Capital, a US hedge fund run by Daniel Loeb, revealed shortly before the race that it had taken a $1 billion stake in Yum! The value-seeking investor is already making suggestions as to how the company could improve both its menus and operational performance. Loeb, whose calls for change were implemented at auctioneer Sotheby's and Japanese engineer Fanuc, but rebuffed by Sony, stopped short of calling for Yum! to spin off its Chinese operations, the source of two food scares which have damaged the share price although newspaper reports that Corvex Management's Keith Meister had suggested a separation fanned these flames and also gave the stock a push.

Activist stake building is driving Yum! Higher

Source: Thomson Reuters Datastream

These share price runs are good for investors in Meister's and Loeb's funds, as well as the money managers themselves as their fees can include a chunk of any upside, as well as their annual charges. The Financial Times' story last week (5 May) that the world's top 25 best paid hedge fund managers earned $11.6 billion in 2014 may stick in the throat of some investors and Warren Buffett continues to argue their fee structures are too generous. (The Sage of Omaha is still running a contest to see if a tracker fund will outperform the hedgies on a 10-year view).

Only one of the top 10 best-paid men was a true activist, Pershing Square's Bill Ackman. He is a disciple of Buffett, a value hunter who focuses on a company's competitive position, and even if his mode of operation of different from the Berkshire Hathaway man he did have a good 2014, belting out a near-40% return. That means his Pershing Square vehicle had returned 723% since inception  in 2004, compared to a 134% gain in America's S&P 500 over the same horizon.

Whether such figures justify Ackman's pay packet is a debate that will run and run but investors can get involved, if they feel the risks are suitable for their portfolio and the 16% performance fee is tolerable. The closed-ended Pershing Square Holdings listed on Euronext Amsterdam in October 2014 at $25 a share and has since risen to $26.75.

Other active angles

If clients would rather not venture overseas, there are three quoted domestic activist options and then a further international one.

• Third Point Offshore Investors is a closed-ended investment company. Listed on the London Stock Exchange with the ticker TPOG it acts as a feeder fund for the US-based Third Point Offshore Fund, run by Daniel Loeb and his team. The portfolio is event-driven, based on bottom-up picks where a catalyst can unlock value.  At the time of writing, the fund trades at a 2.9% discount to net asset value (NAV), according to the Association of Investment Companies, and it comes with a 5.3% dividend yield, although the fees look hefty.

Third Point Offshore performance over the past year

Source: Thomson Reuters Datastream

• Sherborne Investors (Guernsey) is managed by Sherborne Investors and well known activist Edward Bramson. It makes only one investment at any one time as it seeks to unlock value by fixing what it perceives to be operational failings at a firm. The current target is investment company Electra Private Equity, in which the activist owns a 25.2% stake.

Sherborne Investors' performance over the past year

Source: Thomson Reuters Datastream

• Crystal Amber is AIM-quoted. The £145 million cap investment company trades listed in 2008. According to the AIC is currently trades at a 0.6% premium to net asset value and offers a 1.7% yield. Successful engagements in 2014 included airline Aer Lingus (now a bid target) and chocolatier Thorntons, while the fund has begun to agitate for managerial change at film and TV studio Pinewood.

Crystal Amber's performance over the past year

Source: Thomson Reuters Datastream

• The international option is the Global X Guru Index Exchange-Traded Fund, which trades on the NYSE Arca under the ticker of GURU. It tracks the performance of the Solactive Guru index, which is turn measures the price movements of the top US equity holdings of a select group of hedge funds, based on the quarterly regulatory declarations to the Securities and Exchange Commission known as 13F filings. These documents contain details of a hedge fund’s portfolio although the one drawback is the 13Fs must only be lodged within 45 days of a quarter’s end, so the contents may not be entirely up-to-date.  There is also a smaller version which tracks the returns from overseas hedge fund holdings, the Guru International Index ETF, whose ticker is GURI. For more information, go to www.globalxfunds.com.

US-listed GURU ETF

Source: Thomson Reuters Datastream

A further alternative is to be cute, read the funds' fact sheets and then buy their top-ten list of shareholdings, although this approach means you will not know precisely when they build, cut or change a position. To do this investors will also need to study the activists' US regulatory filings, a time consuming process if ever there was one.

A results business

In the end, activists want the same as any shareholder – to find an undervalued asset which then delivers improved total returns from capital gains or higher dividends or a combination of the two. When they get involved they and are not afraid of working hard to create the necessary catalyst for share price performance themselves. They will engage with management, propose changes and even seek representation on the board if they feel they are being ignored or the executive team is not up to the job. When they get involved, activists tend to focus on one of four things (or a combination of them):

• Operational changes, such as putting in new management and closing or restructuring poorly performing units
• Financial angles, such as special dividends, higher payouts or buybacks
• Strategic options, such as asset disposals, spin-offs or even looking for a bidder
• Better governance, whereby boardroom pay is reined in and the interests of managers and investors better aligned

Elliott's advance on Alliance Trust covered a few of these basis and the share price has already responded but this is not to say activists get it right all the time. InterContinental Hotels did not respond to Marcato Capital's calls to merge with a large rival (and the shares still did well), while Sandell got nowhere fast with rail-to-bus giant FirstGroup for example and its shares careered ever lower.

The risks

This may help to explain why not everyone approves of activists and detractors argue

• they encourage short-termism
• a shareholder with a relatively small stake can end up exerting undue influence
• management can be distracted from their real job – namely running the company

These are all valid comments and activists may not suit all clients, especially as they can sometimes use a lot of debt to gear up returns and they tend to run very few positions at any one time, so there's little protection from diversification, if anything goes wrong. When it floated last year, just three companies represented nearly 75% of the net asset value – drug firm Allergan, Canadian Pacific Railway and Air Products & Chemicals.

Investors must therefore do their homework on an activist to ensure their style fits with your own overall strategy, target returns, time horizon and investment for risk.

Russ Mould, AJ Bell Investment Director