How Hedge Fund Activists Select Target Companies - dummies

By David Stevenson

The sad truth is that not every company listed on the UK or the US markets is run well. Even more importantly, many companies are technically well run (in that the managers are perfectly competent) and yet the share price is marooned at a low level because a key part of the corporate strategy isn’t working. As a result, thousands of potential activism targets are available.

Not all targeted companies are badly managed. Sometimes activists pick on companies where the strategy for growth isn’t working, no matter how diligent the management may be. In particular, many activists examine carefully how a company is looking to grow and generate more revenues.

Watch out for activist quarry

Despite an extensive list of potential candidates, the vast majority of companies are never targeted by an activist. Working out who the activists may hit next isn’t easy, but as a private, though ambitious, investor you can profit from shareholder activism in two general ways:

  • Locate potential target companies before hedge funds show up on the share register.

  • Wait for evidence that a hedge-fund activist is on the share register and follow its lead (the most common approach).

If you’re determined to buy into a potential target company before any evidence of hedge funds on the share register, look for some or all of the following common characteristics:

  • Hedge funds like to target profitable firms with decent profits or earnings.

  • Many hedge funds are especially keen on companies with a strong cash flow and growing cash reserves on the balance sheet. Many activists think that this hard money should be returned to the shareholders rather than wasted on other deals or projects.

  • Some activists look at the main investment strategies, such as capital expenditure (capex) spending (used to acquire or update the company’s physical property or equipment), or identify companies engaged in extensive merger and acquisition activity.

  • Hedge-fund activists tend to target relatively small companies. Median assets for firms targeted are about US$200 million in the US.

Hedge funds don’t like investing in companies in distress; that is, where the target is close to bankruptcy. The risk of failure and total capital destruction is just too great.

You’re going out on a limb when using this approach. Although getting ahead of activists can yield more profit, the risks are clearly higher. After all, no one may follow your lead.

Know when to get out

Investing in a company that has attracted the attention of activist shareholders can yield very positive returns. The changes spurred by the activists’ involvement breathe fresh life – and increased share price – to already strong, but possibly stagnant, companies.

Having said that, not all companies will go on to see greater growth nor are all activists ones to follow. Following are signs you can use to decide which activist funds and companies to steer clear of:

  • Attacking too many companies over a relatively short period of time (say, a year) might indicate a lack of focus

  • Attempting to make the company take on too much debt can ultimately end in disaster for all shareholders

  • A lack of sector specialism; that is, the hedge fund tries to target companies in all sorts of sectors without really understanding any particular sector in great detail

  • Lining their own pockets rather than the fund’s.