Activist Investors: Follow the Smart Money to Grab More Profits Per Year

Marc Lichtenfeld
by Marc Lichtenfeld, Chief Income Strategist Wisdom of Wealth Wisdom of Wealth

Activist Investors: Follow the Smart Money to Grab More Profits Per Year

by Marc Lichtenfeld, Investment U's Senior Analyst

Wednesday, October 20, 2010: Issue #1370

Every year, a tiny group of investors quietly outperform the stock market by more than 20 percentage points.

They're tough, direct, no-nonsense guys - and are arguably the best people to have fighting for everyday investors like you and me.

They're called activist investors.

So who are these guys? What do they do? And more importantly, what can they do for you?

"Activists" by Name... And by Nature

An activist investor is someone who owns a stake of 5% or more in a certain company and wants to make changes. They're required to file a 13D document with the SEC, outlining the demands they're making from management.

Those demands often include...

  • The sale of the company or certain assets.
  • Instituting a share buyback or special dividend.
  • Firing the CEO or replacing members on the board of directors.
  • Reining in executive compensation.

You can see why they're called "activists!" But these demands all have one goal in mind: to unlock shareholder value - i.e. make the share price rise.

So who are the big activist players?

Activist Investors Hit Headlines

Last week, one of the most prominent activist investors hit the headlines, as hedge fund manager Bill Ackman took large new positions in J. C. Penney (NYSE: JCP) and Fortune Brands (NYSE: FO).

And Ackman has overseen several other notable activist campaigns, too.

For example, he got Wendy's (NYSE: WEN) to spin off its Tim Hortons (NYSE: THI) unit. And investors who followed him into McDonald's (NYSE: MCD) have seen their shares double. However, Target (NYSE: TGT) was a famously disastrous position for Ackman and his investors. Having put all his fund's capital into Target options, the fund lost 90% of its value.

As for the other heavy-hitters...

Successful Activist Investors To Watch

Extremely successful activists that I keep a close eye on include Dan Loeb of Third Point, Barry Rosenstein of Jana Partners and Carl Icahn.

And they're all similar to Ackman in that they're incredibly smart, driven and opinionated (as most activists are).

For example, Loeb has notched up many victories, but he's perhaps better known for his scathing letters to ineffective CEOs. (These letters are submitted as part of the 13D filings.)

For example, he once wrote to former Star Gas Partners (NYSE: SGU) CEO Irik Sevin and lashed out: "Do what you do best: Retreat to your waterfront mansion in the Hamptons where you can play tennis and hobnob with your fellow socialites." Sevin did in fact retreat. He resigned a short time later.

And Loeb once said of his own company: "I suppose if Third Point were to have a website, rather than the feel-good background of two shaking hands, we would likely depict a well-worn boot colliding with the backside of an incompetent manager."

Over at Rosenstein's Jana Partners, the firm recently recorded a win when it forced Charles River Laboratories (NYSE: CRL) to withdraw from its high-priced acquisition of WuXi Pharmatech (NYSE: WX) and instead institute a stock buyback.

And the legendary Carl Icahn is known for many activist investing successes. One of the biggest was when he bought up shares of ImClone Systems below $30 and promptly took control of the board of directors. He ultimately ended up selling the company to Eli Lilly (NYSE: LLY) for $70 per share.

So as an everyday investor, the takeaway from this is simple: You should follow what activist investors are doing because it works. The numbers back it up, too...

When Activist Investors Get Tough, Your Gains Expand

According to a study published in The Journal of Finance, the stocks that activist investors target end up outperforming the market by an impressive 21.6 percentage points annually.

What does this mean in dollar terms?

Using historical averages, you'll see that $100,000 invested in the S&P 500 would be worth $131,000 in three years and $247,000 in 10 years.

But if your portfolio outperforms the S&P by 21.6 percentage points annually, that $100,000 grows to $225,000 in three years and $1.5 million in 10 years.

Following activist investors is similar to following insiders in that you're placing your bets with the "smart money."

Why it Pays to Follow Activist Investors

Remember that activist investors need to own 5% of a particular stock before they can start demanding changes. So you can be certain that they've thrown a lot of resources into research and due diligence. These guys simply aren't going to risk millions, tens of millions, or even hundreds of millions unless they're sure that the shares are heading higher (often with their help).

Now here's the thing: Activists target less than 1% of all stocks out there, which makes activists-fueled shares somewhat rare. So the key to making money is to know which activists to follow. Do that and this strategy can be extremely lucrative.

I mentioned some of my favorite activists a moment ago, but take a look at the 13D filings to see which ones make sense to you. You can access them for free on the SEC's website.

Hoping your longs go up and your shorts go down,

Marc Lichtenfeld

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