A recurring theme to many of my posts on small caps is the reader question "Why aren't activist investors involved?" For a lot of small undervalued situations the solution to undervaluation looks simple on paper. An activist investor buys shares, they distribute or sell assets and then sell the company with everyone reaping large rewards. On paper everything is simple. In life nothing is simple.
In the book The Guns of August author Barbara Tuchman writes about the difference between German planning and French planning for World War I. The French relied on L'Esprit, an idea that plans were loose but soldiers would fight with so much enthusiasm that they would win battles. The Germans didn't rely on an emotional edge, instead they relied on planning. They wrote battle plans for all situations they could imagine, and wrote contingency plans, and logistic plans and plans for plans. Everything was planned and detailed. The book is excellent and I'd recommend it if you're interested in the pivotal first six weeks of World War 1. The summary is this, the French army's enthusiasm wasn't enough to win, their lack of planning was a downfall. On the other hand the German army could have won if they would have been flexible. They had a number of opportunities they never took advantage of because they weren't in the plans.
The market is filled with activist investors who embody both the French and the German approaches to war. Some investors plot and plan, they build 500 page Powerpoint slide decks and carefully telegraph their intentions at investment conferences. Others take the approach of buying a stock with gusto and approach the target company with guns a-blazin'. Sometimes these approaches work, but they're both prone to backfiring as well.
Activists are surprised when their massive Powerpoint snoozer doesn't move the needle, or when management takes offense to a new investor trying to throw their weight around. To those of us on the sidelines an activist investment appears simple. To those in the media activism is simple. To everyone it seems so simple. Yet activist investments are anything but simple, and if they were simple and straightforward why aren't more activists hovering around small undervalued companies?
Legally shareholders are considered owners of a company. There is a long list of rights shareholders have according to the law. The problem is shareholders are passive and management holds all of the power, no matter how many shares managers do or don't own.
In theory a company's Board of Directors answers to the company's shareholders. The Board is entrusted with managing the company for their shareholders. The Board is supposed to be responsive to shareholder requests and be independent.
Typically the Board of Directors for a given company has a very cozy relationship with the company's management. This is expected. A company's Board hires the CEO and potentially other top candidates. People naturally defend their choices, so if a Board picks a CEO it means they liked the candidate enough at some point to hire them. Most CEO's sit on the board of the companies they work for, and some are even Chairman of the Board.
What all of this means is that instead of standing up for shareholders Boards usually stand up for management. In many cases, especially small companies the Board and management are one in the same.
There is no legal requirement for a board member to own a certain amount of stock. Board members simply need to be elected by shareholders after being nominated by management. In most companies shareholders are asleep at the switch and simply elect whomever management decides to nominate. Managers are fond of nominating friends and others who are sympathetic to their own interests. This about this for a few minutes. The people who are entrusted with managing a company for shareholders often have no ownership interest themselves.
I've gone into the weeds to show how disadvantaged shareholders are before they even consider an activist approach. The proxy for shareholder interests don't stand for shareholder interests at all, they stand for management interests.
Many small companies are ripe for activist takeovers. There are just two problems, the first is acquiring enough shares, the second is taking control without management taking action to block the activist.
Let me share a small story. A few years ago Dave Waters texted me about a potentially lucrative small company. The situation was so lucrative we both dropped what we were doing to meet and discuss over coffee. The company had about $4m worth of NCAV and was selling with a market cap of $500k. Management owned less than 6%. This is the type of situation that is begging for an outside acquirer. This is also a situation that looks perfect on paper. Buy the company for $500k and instantly own $4m worth of value. Or fire the overpaid executives and free up operating cash flow increasing the valuation.
I went ahead and purchased as many shares as I could, which came out to about $2,000. Shares have been somewhat liquid on and off and someone could have built a position of maybe $50k relatively easily if they were patient. I stopped buying as I researched the company further.
A takeover had two issues, the first was the activist would need to fire the CEO and Chairman to free up operating cash flow. The majority of the company's operating income goes towards paying high salaries. Both of these officers had golden parachute packages that eliminated much of the potential gain. On the flip side with both officers gone operating income would be north of $1m per year.
The second hurdle related to the company's incorporation. They are incorporated in Florida and supposedly have operations there. Their operations consist of the CEO's home office in Southern Florida. The company actually operates out of Alabama. Here is the quirk, according to Florida law a shareholder loses their voting rights at certain thresholds, 15%, 25% and 50%. If a shareholder owns 14.9% of a company they have voting rights, if they acquire .1% more the voting rights are lost until the company's Board of Directors reinstates them. This means it's impossible to take over a Florida corporation without the company's cooperation. Of course there is a wrinkle to this. The Florida law only applies to companies incorporated in the state with the majority of their operations in the state. It remained unclear whether this statute applied to the company in question. I didn't know, and lawyers I talked to didn't know.
I did a lot of research on this company including talking to lawyers about the situation. My plan was to tender at 2-3x the bid for investors shares. Then fire the execs freeing up cash and figure out how to go forward from there.
Here is the math on the situation. Pay $1.5m to purchase a majority stake, pay $1.5m in a golden parachute fee. Then pay a substantial amount in legal fees to get the execs to actually leave. The unknown was the legal fees. The problem is management held so many cards that lawyer fees could be racked up quickly without much real progress. I could end up in a lawsuit regarding the Florida shareholder issue, or in a lawsuit over the firing, or in a lawsuit over a poison pill or almost any other situation that management could dream up. By the time I put together a worst case scenario the margin of safety between what the shares could be purchase for and what the company might be worth shrank dramatically. The potential margin shrank so much that it wasn't worth the opportunity cost and hassle to move forward.
I did nothing and the opportunity still exists. I have a stock certificate for the company sitting on my desk. In some ways it's a reminder to the potential opportunity, but it's also a reminder of the potential pain. In the end it's possible I would have made my lawyer rich and walked away with nothing.
My experience isn't unique. Jeff Moore who writes at Ragnar is a Pirate recently engaged in a battle with the small company Sitestar (SYTE). Jeff had managed to get a Board seat and management still pulled out a bag of tricks, from fraudulently signing his name to documents to making false claims. Jeff and a group of shareholders filed a lawsuit against the company to which the company responded with their own litany of tricks. Moore eventually prevailed, but it's yet to be seen if any change can happen.
If you walk away with nothing else from this post it should be that sometimes something that looks good on paper doesn't work out well in real life. The balance of power in a company is heavily tilted towards management and that power imbalance can cause costs to rise, or even thwart a legitimate takeover or activist attempt.