Now that everyone is finally focusing on the strategy of bloating any available company with massive leverage in order to use the proceeds to either buyback stock or engage in "synergy-creating" M&A (leading to countless pink slips), which is affectionately known as "activism", here is Bill Ackman's latest, Q2, letter with his take on this topic of how massive leverage which is great for shareholders now, but a disaster waiting to happen for employees and bondholders in the future as soon as rates rise, is the greatest thing since sliced bread.
There are Those that Argue Shareholder Activism Must Be Stopped
A few have argued that shareholder activism should be stopped or curtailed. Notably, the principal proponents of shutting down shareholder activism are not investors, but legal advisors who “defend” companies from activists and profit from this activity. The anti-activists justify their attacks against activism by conflating short-termism with activism. We are strongly in agreement that short-termism is bad for the long-term health of companies and industries, but successful shareholder activism is not short-termism. It is hard to argue that the changes we have wrought at Canadian Pacific, General Growth, Air Products, McDonald’s, Fortune Brands, Wendy’s, Howard Hughes, to name a few were those of a short-term investor. Our target holding period of four or more years is certainly not short term, and has increased over time as the quality of the managements and the businesses represented in our portfolio have improved.
Furthermore, the companies we have invested in, with extremely few exceptions, have continued to prosper even after we have exited, perhaps the best evidence of the long-term successful nature of our approach and its contribution to corporate America.
Activism has a “public good” problem for the activist in that all of the other shareholders who typically comprise 90% or more of a target can be considered free riders with none of the costs or the illiquidity, and with all of the upside. The only investors who don’t materially benefit from the activist’s involvement are those that sell out into the activist’s accumulation of its toehold investment in the target, a stake which is typically less than 10% of shares outstanding.
And even those sellers benefit, since they are able to sell at a price that has likely increased as a result of the activist’s purchases. The “public
good” problem is a reasonable cost for the activist to bear because it is typically the largest shareholder of the corporation.
Because activism comes with large costs, the largest of which is the opportunity cost of time, an activist must be able to build a large enough stake to amortize his or her opportunity and other costs. If the 13D rules were changed and required immediate disclosure at 5%, only those targets where a 5% investment in dollars would justify the activist’s time would be suitable targets, narrowing the activist investment universe, particularly for small and mid-cap activism. This cost in reduced activism would be borne principally by the passive institutions and retail investors who own the substantial majority of every corporation on the stock market. For this reason, the last attempt to change the rules failed years ago as a large group of passive institutions voiced their concerns about the public costs of a change in the 13D rules that were designed to thwart shareholder activists.
A hundred years ago, the Carnegies, J.P Morgans, and Rockefellers of the world were large shareholders of corporations and acted like owners because it was their own money they were investing. When their companies underperformed, they did not need shareholder activists because they themselves replaced underperforming boards and managements to unlock value.
And nowadays "activists" can just pretend they are like the Carnegies, JPMorgans and Rockefellers thanks to trillions in zero-cost debt. What can possibly go wrong.
Some other observations from Ackman, first on the company in which he bought a massive call stake knowing, in what many have said is an illegal trade, a strategic is about to make a takeover offer, namely Allergan:
a CEO is incentivized to have his company’s stock price rise gradually enough to keep his job, but not so quickly so the amount of options and restricted shares he receives each year is maximized and granted each year at lower stock prices. Only until the CEO is ready to retire, in the last year or so of his term is he now incentivized to unlock hidden value and motivated to catalyze the sale of the company so he can receive additional accelerated change-of-control and other benefits along with a control premium. While by no means do all CEOs behave this way, traditional management compensation encourages such an approach.
Allergan’s management appears to be Exhibit A in this kind of behavior. While Allergan has fabulous products with growing market appeal, it has been criticized for a decade by its shareholders for its high expense levels (at 40% of revenues its historic overhead has been 12 percentage points higher than the average of its closest competitors), and wasteful and unproductive early-stage R&D spending.
Allergan management’s sandbagging approach to running a business is best evidenced by comparing Allergan’s 12% to 15% earnings growth guidance, that was expressed on the company’s 2013 fourth quarter earnings conference call in February of this year, with management’s statements, guidance, and new plan introduced after we and Valeant offered to acquire the business on April 22nd.
On May 12th, Allergan management held a conference call at which they increased February’s 12% to 15% earnings growth guidance to 20% per annum over the next five years. The increase in earnings guidance was not due to the discovery of any new products or due to a projected increase in revenues but rather magically appeared in response to the bid and is driven by a planned gradual reduction in excess costs over the next five years.
Successive increases in our and Valeant’s bid for the company have elicited even stronger predictions of superior performance from Allergan management. On July 21st, Allergan announced its first large-scale restructuring with an expected $475 million of cost savings from a 13% overall reduction in personnel including a one-third reduction in the R&D workforce. While one might have expected Allergan’s compensation committee to adjust management compensation targets upwards in light of recent guidance; instead, the board has kept the existing incentive plans in place and granted additional equity incentives including restricted stock and options for management achieving the new earnings targets.
There is the usual Herbalife bashing:
Since our discussion of HLF at the annual dinner in February, there have been a number of materially positive developments which are confirmatory of our thesis.
On March 12th, HLF disclosed that it had received a Civil Investigative Demand (CID) from the FTC. This is not simply an informal staff inquiry. Commencement of this type of proceeding requires a preliminary staff examination of the facts and legal issues, an application to the full Commission, and the majority vote of the Commissioners to initiate formal proceedings. This is the most significant FTC action on MLMs and pyramids in over 35 years, and you can expect it will entail a thorough examination of the practices of HLF.
According to press reports, the Department of Justice in the Southern District of New York and the FBI have commenced criminal investigations of HLF. The Southern District is one of the premier prosecution offices anywhere in the U.S. An investigation could include mail and wire fraud, money laundering, tax evasion, false health claims, and RICO (Racketeer Influenced Corrupt Organizations). A RICO investigation could look at the top distributors, many of whom we have profiled on our website, and trace their coordinated, parallel illegal businesses, which continue to be facilitated and promoted by HLF.
And perhaps the market top-ticking signal of the year: Pershing Square, a hedge fund, is going public.
Because we are an active, control and influence-oriented investor, we have avoided being fully invested because of the risk of investor redemptions. For example, during 2009, despite a relatively strong 2008 and a 41% net return in 2009, we had to keep a substantial portion of our assets in cash because of the large amount of investor redemptions we received. We will hopefully begin to address this issue with the initial public offering of Pershing Square Holdings, Ltd. (PSH), targeted for later this year, which will increase the amount of our capital that is permanent
full letter below