It’s trendy to talk about oversized capital gains available in flipping condos and the mind-numbing trading ranges in equity markets. However, I believe it’s time for some sector rotation out of real estate and back into equities. Today’s stock market environment is very conductive to making value-based equity investments. It’s truly a great stock pickers market that should continue to have its fair share of good, steady returns.
Ironically, this more somber environment is making the steady gains in equities fly under the radar of the mainstream investor. In the late 1990s, stocks received all the attention when CEOs, declaring they could post 100% growth year over year in the New Economy, came on CNBC to hawk their wares. The excitement of new technologies combined with ample liquidity and gun-slinging, overly-promotional executives, created an environment that caught the attention of everyone from hairdressers to Harvard MBAs.
Unlike the 1990s, stocks today are driven by cautious, conservative management teams that dare not give earnings guidance out of line with reality. Boards of Directors are finally re-asserting their duty to act in the shareholder’s best interest. And equity buyout firms are sharpening their pencils and putting their huge capital bases to work in buying solid but undervalued companies. While none of this is as exciting at 100% pie-in-the-sky growth, it’s what good equity returns are built on.
Here are five trends which make me bullish on equity prices for the next several years:
1. Boards of Directors are back on the equity investor’s side, not in the CEOs pocket.
Nothing characterized the greed and excess of the late 1990s technology industry more than Charles Wang’s $650 million pay out in restricted stock and options at Computer Associates (CA). He set the standard for convincing a clueless Board of Directors into giving him an absurd compensation package. The payout was so rich that the company had to take a special one-time charge to pay for his salary. As we know now, the company’s strong performance was largely based on aggressive accounting and the stock, which topped in the $80s in 2000, plunged to under $10 by 2002. Not only did the Board miss the questionable accounting practices but it also rewarded the CEO with one of the most outlandish payments in the history of public companies. The company is still recovering from the mismanagement of the last five years.
It turns out, of course, that CEOs who had accumulated large option stockpiles may have been motivated to artificially inflate stock prices and then cash out. Who knew CEOs could be so greedy?
Now, for the first time in decades, Board members understand the downside of blindly listening to the CEOs spiel and rewarding him based on his annual presentation to the Directors. Boards of Directors are now vigilant about accounting issues as well as excessive compensation for fear of being sued or having to pay damages out of their own pockets.
In addition, the steep prison sentences for Dennis Kozlowski at Tyco and the Rigas’ at Adelphia highlight the fact that there’s now a steep downside to fraud. The risk to reward for Boards to let irrational or illegal decisions slide has clearly moved back in favor of shareholders.
2. Dissenting Board of Directors Have a New Voice and its not Mickey Mouse. Investors should thank Roy Disney.
Until Roy Disney and Stanley Gold took their fight against Michael Eisner to the shareholders, dissident Board of Directors didn’t have much recourse except "retiring" or going along with the rest of the Board. The fact that Disney and Gold won their fight with Eisner, as powerful and entrenched CEO as you will ever find, gave testament to the power of dissident Board members who have the backing of shareholders.
In 2003, seventy-one year old Roy Disney and cranky value manager Stanley Gold seemed like a weak match for Michael Eisner, whom the two disgruntled Board members had actually hired in the mid-1980s to resurrect the company from extinction. Eisner had done a masterful job steering the company back to entertainment dominance, culminating with huge success of The Lion King in 1994. The turnaround earned Eisner huge options grants and the trust and confidence of the Board of Directors.
Success bred complacency, however. And after being able to do no wrong, Eisner could do no right. Disney lost its big screen dominance to Pixar and Dreamworks because of weak talent and poor scripts, the company lost its dominance of the amusement park market to Universal because of chronic under-investment in new infrastructure, and the company made a huge and expensive gamble to buy ABC… and lost. By, 2002, ABC was the worst rated TV network. To make things worse, the Board wasn’t about to make any changes. Despite a negative 10% shareholder return for the 1998 – 2000 time period, Eisner received $699.1 million in stock options and was number two on the list of executives who gave shareholders the least for their pay, according to Business Week.
But after Disney and Gold took the fight to Eisner, something magical happened. In 2004, California Public Employees’ Retirement System (CalPERS) announced that it wouldn’t back Eisner’s reelection bid. And while Michael Eisner squeaked by to win reelection, the voice of the shareholders and dissident Board members had been heard. Eisner and the Board decided to make changes before changes were made for them, with Eisner announcing his retirement as CEO and the Board becoming much more shareholder friendly.
Shareholders have Roy Disney to thank for the increase in Board member activism in the past year.
Roy Disney’s victory has lead to the ouster of other high profile CEOs who had the Board under their control. Carly Firorina mangled Hewlett Packard’s chances of turning around with the purchase of Compaq, but it wasn’t until Disney won his battle that HP’s Board gained some clout. No executive could be more powerful and entrenched than AIG’s Herb Greenberg. Despite the numerous scandals, I don’t believe he would have been ousted had it not been for the new power of Boards of Directors. And recently, despite having the backing of the Board, Morgan Stanley’s Philip Purcell decided to ‘retire’ after it was clear that shareholders were voting against his tenure.
Board members are becoming more active and are becoming more accountable to shareholders. In my mind, that means more and steadier returns for equity investors.
3. Hedge Funds, which are Having Trouble Making Money by Trading, are Instead Taking Controlling Interests in Turnaround Situations to Force Change
Master trader, investor and now business operator, Eddie Lampert, started the trend of hedge funds buying a controlling interest in a corporation with the expectation of taking a Board seat and turning around the operations. Lampert’s ESL bought a controlling interest in Kmart while the company was in bankruptcy and turned it into a retailer to be reckoned with. In the process, he earned himself a $1 billion last year.
Of course, no good hedge fund manager wants to be left behind. Pembridge Capital Management, a New York-based activist hedge fund, has given notice to Topps that it intends to nominate its own slate of directors at the company’s 2005 annual meeting.
ValueAct Capital Partners, a hedge fund that no management team wants to see on their top investor list, recently announced it is prepared to buy Acxiom, a chronically underperforming company which provides customer information to businesses.
And Highfields Capital, a $6.5 billion money manager best known for its activist role at Enron, recently offered to acquire Circuit City for $17 a share in cash.
We would be remiss to omit Kirk Kerkorian’s hedge fund, Tracinda Corp., which announced an offer to purchase up to 28 million shares of General Motors at $31 apiece when the stock was trading at $28. The fund now owns over 5% of the company.
4. Don’t Call it a Comeback – the Leverage Buyout Fund Never Really Went Away, it Just Became a Team Player.
The downside of low interest rates is that it forces investors to accept higher risks in search of better yields. The upside is that low interest rates mean lower costs of doing business for leveraged buyout funds. And that spells more buyouts of weak or underperforming companies. One of the new trends in LBOs is teaming up with other investors to make a big bet.
Last year, a group of seven private equity firms bought SunGard Data Systems Inc., a software manufacturer specializing in financial programs. At nearly $11 billion, it was the second largest LBO ever. In 2004, Kohlberg Kravis Roberts, Bain and Vornado Realty Trust teamed up to buy Toys-R-US in a $6.6 billion deal.
These mega deals come on top of the steady stream of "smaller" deals such as Apollo Management’s buyout of and distributor Metals USA for about $700 million and last week’s $1.2 billion offer from Thomas H. Lee Partners to buy Callaway Golf. Even weak companies in the technology industry are finally being bought as Hellman & Friedman’s buyout of DoubleClick for $1.1 billion shows. These deals create a great environment for value investors because they essentially create a "bottom" for stock prices at which an LBO is a no-brainer.
4. Industries with Overcapacity are Finally Being Consolidated
One of the enduring problems facing equity investors in the 21st century is the overcapacity in almost every industry, new and old. From fiber optic cable to telecom services to drugs, retail, and autos, it seems there’s too much capacity to build and sell everything. Overcapacity is a debilitating problem because it causes severe price pressure and keeps investors from earning a decent return on their investment.
However, management teams and Board of Directors have finally realized they have the power to do something about the overcapacity problem – buy weaker firms to acquire customers and shut down the excess capacity.
Federated’s purchase of May department stores is a classic example of this strategy finally beginning to take root. The $17 Billion buyout will allow Federated to close competing stores and allow the department store retailers some room to breathe.
Similarly, the huge overcapacity in the telecom industry finally seems to be shrinking with the acquisitions of AT&T and MCI. These companies were classic examples of what happens in overcapitalized industries with too much capacity to begin with. With Verizon and SBC taking these ailing telecom giants out of their misery, capacity can be rationalized and customers can be transitioned into higher profit businesses such as wireless.
Finally, the on-line financial services business seems to be consolidating as well with the purchase of Ameritrade by TD Waterhouse. The financial industry is a perfect candidate for consolidation – while customer acquisition costs have increased exponentially, customer profitability has declined with lower and lower commission rates. The only way to survive and earn a return on investment in this industry is through economies of scale, which will only come through continued acquisitions.
5. Selling Bad Businesses to China
In the late 1980s and early 1990s, the greatest market worry was that Japan was beating the US in every industry – electronics, technology and automotive. Nothing represented that worry more than when Mitsubishi took a controlling stake in Rockefeller Center in the late 1980s. Of course, it turns out that the Japanese bought at the top of the market and the Rockefeller’s knew what they were doing the whole time. By the mid 1990s Mitsubishi took Rockefeller Center into bankruptcy because of the crushing debt burden it had taken on to buy the building. In 1996, it sold the building to Goldman Sachs – to a group that included, yes, you guessed it, David Rockefeller.
Today, the same is occurring, except instead of trophy real estate, the US is selling its low margin, low value businesses to the Chinese. Lenovo’s take over of IBM’s desktop PC business for $1.7 billion highlights this trend. For the $1.7 billion, Lenovo received 5 percent of the worldwide PC market – a tough and unprofitable position which is at the mercy of industry leaders Dell and HP.
Similarly, Maytag recently received an offer from Chinese Appliance Maker, Haier, a month after Maytag agreed to be acquired by an investor group that wanted to take the company private. With its unfunded pension obligations and high debt load, Maytag is in need of serious repair. While the brand name might be worth something to a low-cost, Chinese manufacturing company, US investors will say good riddance to the chronically mismanaged and underperforming company which has consistently lost market share to Whirlpool, General Electric and LG.