Assessing the Shareholders: An Integral Part of Investment Analysis
When evaluating investments, analysts are taught to focus qualitatively on the sources of competitive advantage and quantitatively on forecasts for growth, profitability, and returns on capital. Little emphasis is placed on the shareholder base. But not all businesses have the same shareholders, and the differences matter.
Different Shareholder Results
A business may have strong barriers to entry and well-managed operations, providing healthy and growing levels of free cash flow. Yet if these cash flows are diverted to other interests, a minority investor in the business could fail to see the benefits. Through elements of self-dealing, it’s possible for an influential shareholder to capture an outsize portion of the gains and leave others holding the bag. Depending on the specifics of the case and the governing legal framework, minority shareholders may have little recourse.
The Tech Situation
Influential shareholders have become topical recently, as several of the leading consumer technology platforms including Google, Facebook, and Snapchat have consolidated control in the hands of their founders using complex multi-class share structures. An investment in these companies is not just a wager on how quickly they can grow and monetize their user base.
While business outcomes will certainly factor into investment performance, it is equally important that the founders deploy capital for the benefit of all shareholders. Google has taken reassuring steps with its transition to the Alphabet holding company structure, which makes the company’s non-core investments explicit and signals that it will be appropriately disciplined. Facebook laid out a focused strategy and its investments in additional platforms and features have largely followed the guidelines it provided. As for Snap, the parent of Snapchat, it is too soon to tell, making that company a more speculative investment.
When Influence Passes from One Shareholder to Another
Consider VMware, the data center software provider. EMC acquired VMware in 2004 and sold about 15% of the company to public investors in 2007. Over the next eight years, EMC generally treated the public VMware shareholders fairly. In October 2015, Dell announced its $64 billion acquisition of EMC, which would give it control of VMware.[1] Nine days later, VMware said it would take EMC’s speculative and unprofitable cloud management business onto its books, and VMware shares declined 19%.[2] EMC ultimately retained the cloud business, but the reputational damage was done.
Today, the VMware tracking stock, which holds a portion of Dell’s interest in VMware, trades at a 30% discount to shares representing a direct interest in VMware. While a portion of this discount may be explained by liquidity, credit risk, and other factors, much of it is likely due to continuing investor mistrust of Dell.
Figure 1: VMware (VMW) stock price chart highlighting Dell offer for EMC and VMware plan to assume EMC cloud business. Source: Roosevelt Investments and Bloomberg.
Contrast VMware with Commonwealth Real Estate Investment Trust, an owner of office buildings. In February 2013, when Corvex Capital and Related Companies disclosed a 10% stake in Commonwealth, its stock advanced 55%.[3] At the time, Commonwealth was externally managed by REIT Management & Research and its board of trustees was also led by RMR leadership. This created a conflict of interest in which RMR benefited from asset growth at Commonwealth, even if this growth came at a cost to Commonwealth shareholders. After a contested election, Corvex and Related replaced the entire board at Commonwealth and transitioned its property management to CBRE.[4] Commonwealth’s valuation discount to similar office REITs has since narrowed considerably.
Figure 2: Commonwealth REIT (CWH) stock price chart highlighting Corvex and Related disclosure of a 10% equity stake in the business. Source: Roosevelt Investments and Bloomberg.
The VMware and Commonwealth examples demonstrate how a change in the shareholder base can significantly impact the value that investors will ascribe to a business. When control at VMware was set to pass from EMC to Dell, minority shareholders were discouraged. Conversely, when Corvex and Related began their campaign to wrest influence on Commonwealth away from RMR, shareholders perceived better prospects.
In each case, investor views were colored by prior behavior on the part of the influential shareholder. In 2013, Michael Dell partnered with Silver Lake to buy out the Dell public shareholders for $25 billion, which some considered an unfairly low price. Investors including Carl Icahn and Southeastern Asset Management voted against the deal and a Delaware court ruled that the buyers underpaid by $6 billion.[5] The issues at Commonwealth were similarly evident at other RMR-managed REITs in the single-tenant, hotel, and senior housing verticals, which also traded at discounts to comparable property portfolios.
It’s Not the Technique, It’s the Intent
To generalize, it’s not the specific technique used—tracking stocks, externally managed REITs, and so on—that’s important. Instead, the key is to judge whether influential shareholders will treat minority shareholders fairly. John Malone at Liberty Media has used tracking stocks repeatedly to carve out portions of his conglomerate for more direct investment in a tax-advantaged manner. Even though these vehicles have limited shareholder rights, trust in Malone, based on decades of experience, has supported their valuation under the Liberty umbrella and enabled long-term outperformance.[6]
The spinoff or sale of non-core assets is another technique that controlling shareholders may employ—and once again, the devil is in the details. Barnes & Noble is a bookseller whose business model has clearly been upended by the consumer shift to online purchasing as well as the digitization of books. Yet along the way, its influential shareholder and executive chairman, Leonard Riggio, created significant value for minority investors through spinoffs and sales.
B&N sold a stake in its online business in 1998 when valuations were high and then repurchased it in 2003 after the dot-com bubble burst. Riggio personally acquired video game retail assets out of bankruptcy and sold them to B&N, which rebranded the unit GameStop and spun it out to shareholders in 2004.
Today, the GameStop market capitalization is three times that of legacy B&N. In recent years, B&N sold a stake in its Nook e-reader at a high valuation, then repurchased it lower, and also spun out its campus bookstores to shareholders. While a tough competitive environment has challenged these ventures, investing alongside Chairman Riggio improved the profile of this traditional bookseller.
Compare Barnes & Noble to Sears Holdings, parent of Sears and Kmart, another traditional retailer on the losing end of the e-commerce revolution. Edward Lampert controls the company through his firm ESL Investments. With Lampert as chairman, Sears spun out its Lands’ End apparel brand and its Canadian stores. The company also sold its Craftsman tools unit and executed a sale-leaseback of 235 stores to a real estate investment trust. However, Lampert may have a conflict of interest, because ESL has loaned more than $1 billion to Sears, largely secured by the company’s real estate.
Today, the value that ESL retains in the spinoffs and loans is about twice the value of its equity in Sears.[7] In this light, the spinoffs, sales, and collateralized loans could help preserve value for ESL at the expense of minority shareholders. The company’s failure to invest in its store base could have a similar motivation. It is plausible that Sears may declare bankruptcy one day, rendering its common shares worthless, yet ESL could wind up profiting from its investment.
Crowded Trades
It’s valuable to understand the makeup of the shareholder base even when there is no single primary influencer. For example, with the rise of passive investment strategies, stocks with membership in broad market or sector indexes often trade differently than those excluded from these benchmarks. The index members tend to correlate more closely to investor sentiment for the market or sector in which they are grouped, which can create both opportunities and risks for active investors.
Hedge funds have also established a meaningful presence as equity investors. This has led to crowded trades in some stocks, where companies with complex structures or controversial elements may attract outsized attention from many hedge funds, investing both long and short. Such stocks are sometimes referred to as “hedge fund hotels.”
Berkshire Hathaway Chairman Warren Buffett once said, “You get the shareholders you deserve.” Companies that manage for the short term, focusing on the next quarter’s results rather than long-term value creation, tend to attract hedge fund investors equally focused on the short term. This may result in stock price volatility, magnifying the gains and losses that investors experience in reaction to short-term news flow.
All of this suggests that analysts must factor the shareholder base into their analysis or risk ignoring an important driver of investment performance.
About the Author
Jason Benowitz, CFA, joined Roosevelt Investments in 2009 as a securities analyst, was promoted to portfolio manager in 2011, and to senior portfolio manager in 2013. Prior to Roosevelt, Mr. Benowitz was a principal at Druker Capital, a long/short hedge fund manager, and a vice president in the US Equity Research Group at Morgan Stanley Investment Management. He was also an investment banking analyst at Merrill Lynch. Mr. Benowitz earned a BA in Computer Science from Harvard College and an MBA in Finance and Accounting from The Wharton School at the University of Pennsylvania, where he was a Palmer Scholar. Mr. Benowitz received his CFA charter in 2010.
[1] This was the largest technology deal ever, provided that the $182 billion AOL/Time Warner merger in 2000 is classified as a media deal.
[2] VMware also reported its third quarter earnings, so some of the decline may be attributable to its quarterly results and outlook. However, the company had already pre-announced preliminary results for the quarter.
[3] A letter from Corvex and Related to the Commonwealth Board was also disclosed, in which the investors offered to buy the whole company, so some of the appreciation may be attributed to deal-related speculation. However, there was no pre-arranged financing for the offer and no deal was ever pursued. The letter is available here.
[4] Corvex and Related produced a 51-page presentation arguing their case in the proxy fight, which is available here.
[5] This Wall Street Journal article summarizes the court’s opinion and the issues at stake.
[6] This Bloomberg article discusses Liberty’s success with tracking stocks where others have failed.
[7] This Business Insider article explores some of the various arrangements between Sears and ESL.