Activist Investors Play an Important Role

Posted in: Economics, General, Stock Market, Thought of the Week

Warren Buffett is one of the world’s most famous and successful “value investors” who coined a rather famous line many years ago:

“Price is what you pay, and value is what you get”

Although this statement may seem overly simplistic for someone whose net worth exceeds several billion dollars, the Investment Committee would highly recommend that every investor memorize this sentence (perhaps even print out a copy and hang it on a wall).

Let’s say that we were to find an Armani sweater hidden in the racks at a discount retailer for 75% off the retail price, simply because there is a small hole in the fabric. We could purchase the sweater, fix the small hole, and then have a very nice sweater for a fraction of the price.

Similar opportunities exist in equity markets, and value investing is predicated upon the idea that these markets overreact to negative information. In our example above, the Armani retail store overreacted to a small hole in a sweater and chose to dump it at an assumingly low price. Our savvy discount shopper realized the opportunity and bought an asset that was unfairly punished.

Value investors who make the mistake of focusing on price alone often end up buying “value traps”. These are stocks that screen cheap but are cheap for a reason. Let’s say that the hole in the Armani sweater was swapped for a large discoloration on the back of a sleeve. Had our shopper not thoroughly examined the sweater, he would have purchased something that would likely never be seen out in public.

Simply put, value investors do not buy stocks because they are cheap, but rather for the reason that they represent a good value. Furthermore, their level of involvement will classify them into one of two types:

  1. Passive: These investors buy value stocks and then wait for the value to be recognized by the market. The Investment Committee employs a passive strategy with our investments.
  2. Active: These investors see opportunity in stocks that they feel management is missing. They take an active role in the value creation and will often get aggressive if they feel that action is needed to get a company to change their ways.

Passive investing is relatively straightforward because it’s not much more than a “buy and hold” strategy. On the other hand, active investing can be quite complex and even highly aggressive at times. Here’s how it works:

The activist investor screens for undervalued companies and identifies the reason why a specific company is undervalued. If actions by management can make that value realized, they will acquire the stock. Some examples of potential management actions that can create value include spinning off subsidiaries or underperforming divisions, using cash to buy back stock or paying a larger dividend, sell the company, etc.

NOTE: Most activist investors need large amounts of capital because they must purchase enough stock to be taken seriously. In most cases, an activist investor needs 5% or more of the shares outstanding to have the “muscle” necessary to fight with management.

Simply put, the main difference between an active and passive investor is that although both strive to identify hidden value in a stock, an active investor will take part in unlocking that value whereas a passive investor leaves that job to the current management.

For more on Activist Investors and how they made Apple a more shareholder friendly company please read the entire Thought of The Week.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.