Here's What These Top Activist Investors Do to Stocks You Own

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Sooner or later, an activist investor will target a stock you own.

Activist investors have been more active than ever before over the past year and increasingly have gone after some of the most commonly held stocks in Corporate America, including Apple Inc. (Nasdaq: AAPL), The Procter & Gamble Co. (NYSE: PG), and J.C. Penney Co. Inc. (NYSE: JCP).

"No company, no matter how large, is beyond the reach of activists," Claudia Allen, a partner and head of the corporate governance practice at Katten Muchin Rosenman, told USA Today. "We are seeing some of the iconic names in Corporate America confronted by activists."

By now most investors realize what this scenario can mean to a company: Stocks can spike (or plunge), and the heads of CEOs may roll.

Just this year, top activist investors have made a lot of waves in the market. A few of the more prominent examples:

  • A series of mid-August tweets (the first on Aug. 13) from Carl Icahn, perhaps the best-known activist investor of them all, has helped push Apple stock up 5%. Icahn is urging Apple CEO Tim Cook to step up its stock buyback program.
  • The dramatic announcement that CEO Steve Ballmer would be surrendering the reins to Microsoft Corp. (Nasdaq: MSFT) within 12 months was driven in large part by efforts of hedge fund ValueAct. The activist shareholder used its large stake in the company to get a seat on the board. Among the items on ValueAct's agenda was a change at the top. MSFT shot up 7% on the day of the announcement.
  • Activist investor Bill Ackman finally threw in the towel this week on his three-year attempt to revive the fortunes of troubled retailer J.C. Penney. He sold his entire 18% stake, 39 million shares, to Citigroup on Aug. 26 for a loss of some $500 million. The episode has helped erase 50% of the value of Penney stock, although the announcement that Ackman had bailed out did give JCP a 2.5% boost.
  • Dan Loeb had much better luck than Ackman with Yahoo! Inc. (Nasdaq: YHOO). After building up a 5% stake over 2011 and 2012, Loeb pushed for the ouster of CEO Scott Thomson in favor of Marissa Mayer and persuaded the company to sell 7% of its stake in Chinese Internet company Alibaba. Yahoo bought back Loeb's shares in July, but was able to pocket a profit of nearly 80% - as were any YHOO shareholders who were along for the ride.

Clearly, it's a good idea to pay attention to what these shareholders are doing. If you know what to look for, and understand what activist investors do to stocks, you can profit from this growing trend...

Anatomy of an Activist Investor

The first thing people need to know is that activist investors are not the bad actors many believe them to be (which is exactly what most corporate boards, who fear the wrath of activist investors, want you to think.)

The negative image traces its roots back to the beginnings of activist investing in the late 1970s and early 1980s. Back then, such pioneers as Carl Icahn, derided at the time as "corporate raiders" and personified in the film character Gordon Gekko, would acquire large positions in a company and threaten to take it over unless appeased by a stock buyback or premium.

Companies often suffered as a result of the heavy-handed tactics. For instance, Icahn bought Trans World Airlines in 1985 and made nearly $500 million taking it private.

But as he managed TWA for his own profit, he undermined its ability to survive. TWA went bankrupt in 1992.

Since then, activist investors like Icahn have come to realize they can use more deft strategies and still make money.

Now hedge fund managers like Icahn tend to identify companies that they feel are undervalued for some reason and figure out a strategy to restore that value. That can be with a new CEO, a stock buyback, or something more creative, like David Einhorn's suggestion in February that Apple create preferred stock to pay an extra-large dividend.

"The big thing we do is we make the CEO and management accountable," Icahn told The Wall Street Journal recently. "[Activists] must do the job that, with exceptions, boards are not doing."

It turns out such actions usually help the company - to the benefit of existing shareholders - rather than harming it.

And there's proof that's true...

The Truth About How Activist Investors Affect Stocks

A study released in July, "The Long-Term Effects of Hedge Fund Activism," by Alon Brav of Duke University, Lucian A. Bebchuk of Harvard University, and Wei Jang of Columbia University, showed clearly that in most cases, activist investors have a positive effect on a stock.
activist investors
The study looked at 2,000 cases of activist investing from 1994 through 2007.

One key observation was that the activist investors targeted companies that were substantially underperforming their peers. Over the next five years, those companies closed two-thirds of that gap in terms of return on assets.

The study also found that stock gains made when an activist investor first announces his intentions, which average about 6%, held up over the ensuing five years.

So all the bluster from CEOs and board members about how activist investors are bad for companies is just that - bluster.

"The people who are saying that are usually just saying: 'Hey, give me more time to make the same mistakes,'" Ralph Whitworth, a founder of Relational Investors LLC, told the Journal. "This is what I always tell these people: We bought the stock from your long-term shareholders. And if I am here, I am the longest-term shareholder you've got."

What to Do When an Activist Investor Targets Your Stock

Perhaps the most important thing retail investors need to keep in mind when a restless hedge fund manager takes an interest in a stock they own is that by the time you've heard about it, there's little you can do.

In fact, if you already own a stock targeted by an activist investor, the best strategy is simply to hold onto your shares.

What you don't want to do, experts say, is chase after activist investors.

Although activist investors always begin by accumulating large stakes in the companies they target, those positions only get revealed in quarterly 13F filings, although the fund must file a 13D form within 10 days if the stake exceeds 5%.

Still, for retail investors, it's generally too late to jump on the bandwagon once an activist investor goes public with his intentions.

Yet there is one way retail investors can share some of the gains generated by activist investors - buy a fund that tracks what top hedge funds are doing.

Two exchange-traded funds apply proprietary screens to the 13F filings to generate their portfolios: the AlphaClone Alternative Alpha ETF (NYSEARCA: ALFA) and the Global X Top Guru Holdings Index ETF (NYSEARCA: GURU).

But the best bet for piggybacking on the strategies of the top activist investors is a mutual fund, the 13D Activist Fund (MUTF: DDDAX). This fund invests in the companies listed in the 13D filings of the most experienced activist investors, a strategy that has paid off well this year, with the fund up more than 24% in 2013.

Next: Will activist investor Bill Ackman's latest target - Air Products & Chemicals - pay off or end in disaster like his misadventure with J.C. Penney? Here's what to expect...

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