Follow Shareholder Activists To Find 'Smart Money' Investing Opportunities

Shareholder activism has a history of creating positive change within companies. S&P IQ's research from 2013 and 2014 illustrate investing alongside Activist's delivers returns that are significantly higher than the market's returns. However, there are still a number of risks--even when a high quality activist is at the helm--and results can vary greatly.

The opportunity to invest with what S&P IQ calls the "Smart Money" is too promising to ignore. Following the work of an experienced and successful activist provides intelligent investors with a fertile list of undervalued targets for which the activist envisions a strategy of change designed to produce a clear path to value creation and a high probability of success.

An activist generally takes a minority stake in a company with the goal of creating value for all shareholders. The average shareholder isn't well versed about companies s/he owns, nor is s/he well informed enough to prevent or stop corporate corruption in the making. Generally shareholders neither exercise their right to vote nor read about the issues being voted on by the Board. They're also unlikely to organize and voice their dissatisfaction when corporate management performs poorly. Moat shareholders don't seek access to management. As such, management is in a position to enrich themselves at the shareholders' expense, while frequently owning very little of the company they govern. This well-named phenomenon is called "moral hazard."

S&P IQ's studies show shareholder activism produces returns that are more than double the overall market returns with much less risk--and, the correlation of the return is low enough to offer an intelligent diversification alternative for most investors, and qualifies as a satellite, for the "core-satellite" structure used by the wealthiest investors in the world.

Trouble = Opportunity

Companies attract the eye of a shareholder activist for many reasons. Typically the stock is undervalued due to issues the activist believes can be resolved through solutions s/he provides.

Challenges include: poor asset utilization or poor management decisions or failure to innovate in a competitive environment, to name a few. However, a corporation's Board recognizes the need for a change in management in hindsight long after a company spirals downward, revenues fall, profits evaporate, employees leave, and a once thriving organization turns into a decaying, vicious circle of negativity.

Where most shareholders see a sinking ship, the activist has an opportunity to implement effective change and restore shareholder value. Typically, companies turn around when experienced, engaged Board members work in concert with well-informed, motivated, organized activists that step in and pull the companies out of their downturn.

Activist shareholders are the ultimate value-investors: their own money will go up first as proof of confidence in their own ability to fix the company's problems--they're highly motivated as they have skin in the game.

Here's how a successful campaign evolves.

First, the activist has top-notch financial analysts and industry experts determine the difference between current price and true value. They then define the actions needed for the fixes, determining how long it will take to fix the company and how much it will cost. Then, they must be able to handicap the probability of success. In each segment of their analysis, they must be right.

Activism benefits the investing public by implementing change and most investors will prosper for doing nothing other than remaining patient and supporting the activists. In short, investors get "something" for doing "nothing." The S&P IQ reports shareholders supporting activism receive approximately 15% per year in returns over and above the market's returns.

What type of investors should get involved?

Value-investors are often a good fit as they're capable of determining the difference between the "true-value" of an asset and its current price. Their familiarity with investing in companies with problems allows for an appreciation of the company's true value once fixed. They're able to be patient during the turn-around process.

Event-Driven Investors are also a great fit, as there are always a series of events associated with an activist's campaign. The case for change and its timeline is typically outlined in the SEC filings by the lead-activists, making event-driven investors natural partners for activist investors.

Contrarian investors also tend to make great candidates for investing in the shareholder activist's target. Typically, the target of an activist campaign is a company which has depreciated significantly over the last 3-5 years and has had significant turnover in the shareholder base. Contrarian investors tend to have the vision to determine what the corporate assets will be worth once the problems at the company are fixed. It often takes a large set of "contrarian investors" to support a successful activist campaign.

Shareholder activism also offers a level of diversification as it allows participation in the equity markets, yet follows an appreciation path dominated by company-specific events, less related to the general market movements.

Part II covers how a typical activist campaign develops.

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This post originally appeared on April 12, 2016 on Forbes.com.