Six Reasons I’m Bullish
While good earnings, ample liquidity and low interest rates
are certainly a major part of the recent rise in stocks, I believe several
subtler bullish trends that favor shareholder rights are helping lift equities.
Unlike the late 1990s, Boards of Directors are finally
re-asserting their duty to act in the shareholders’ best interest by keeping a
closer eye on management and selling underperforming businesses. And
equity buyout firms are sharpening their pencils and putting their huge capital
bases to work in buying solid but undervalued companies.
While it is not as exciting as 100% “pie-in-the-sky†growth that
managements propagated in the late 1990s, I believe these trends will keep a
floor under equity prices.
Here are six trends that make me bullish on equities for the
next several years:
1. Boards of Directors Are Back on the Equity the
Shareholders’ Side, Not in the CEOs Back 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 in recovery because of the
mismanagement of the last five years.
It turns out that CEOs who accumulated large option
stockpiles may have been motivated
to inflate stock pricescolor:black”>and then cash out.
Now, for the first time in decades, Board members understand
the downside of listening to the CEO’s spiel and rewarding him based on his
annual presentation to the Directors. Boards are finally acting in their
original capacity, which is to be a watch guard for shareholders.
Boards of Directors are now vigilant about accounting issues as well as
excessive compensation for fear of being sued, or worse, having to pay
damages out of their own pockets.
In addition, the steep prison sentences for Bernie Ebbers at
Worldcom, Dennis Kozlowski at Tyco and the Rigas’ at Adelphia highlight the fact
that there is a downside to fraud. Boards have little incentive to let
irrational or illegal management decisions slide and that is clearly in favor of
shareholders.
2. Dissenting Board of Directors Have a New Voice and
It Is Not Mickey Mouse. Until Roy Disney and Stanley Gold took their fight against
Michael Eisner to the shareholders, dissident Board of Directors did not 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,
who was firmly entrenched as CEO, gave testament to the power of dissident Board
members who have the backing of shareholders.
In 2003, seventy-one year old Roy Disney and value manager
and one of the original shareholder activists, Stanley Gold, seemed like a weak
match for Michael Eisner, whom the two disgruntled Board members had actually
hired to resurrect the company. 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 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.
It lost its amusement park dominance to Universal because of chronic
under-investment in new infrastructure. And
it made a huge and expensive gamble to buy ABC. By, 2002, ABC was the
worst rated TV network.
To make things worse, the Board was not 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, which according to
Business Week made him number two on the list of executives who gave
shareholders the least for their pay.
But after Disney and Gold took the fight to Eisner, something
truly magical happened. In 2004, California Public Employees’ Retirement
System (CalPERS) announced that it would not back Eisner’s reelection bid.
And while Michael Eisner squeaked by and won 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 previously had the Board under their control. Carly
Firorina mangled Hewlett Packard’s chances of turning around the company with
the purchase of Compaq, but it was not until Disney won his battle that HP’s
Board was able to unseat Firorina.
No executive could be more powerful and entrenched than AIG’s
Herb Greenberg. Despite the numerous scandals, I do not 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 accountable to shareholders
and that, in my mind, translates to better returns for equity investors.
3. Hedge Funds Are Increasingly Taking Controlling
Interests in Turnaround Situations to Force Change
Master trader, investor and now business operator, Eddie
Lampert, breathed new life into the investor-as-activist trend. While he
did not originate shareholder activism, he certainly revived its popularity.
Lampert’s ESL bought a controlling interest in Kmart while the company
was in bankruptcy and helped turn it into a revitalized retailer.
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 because of their history of
shareholder activism, 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.
I 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. Leveraged Buyouts Are Now A Team Sport
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, including 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
SunGuard Data Systems Inc., a software manufacturer specializing in financial
programs. At nearly $11 billion, it was the second largest LBO ever.
Investors recently snapped up the junk bonds issued by SunGuard, indicating the
markets have a high appetite for backing additional deals.
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 Metals USA for
about $700 million and Thomas H. Lee Partners’ $1.2 billion offer 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 floor for stock prices.
As long as the corporate bond market stays healthy and receptive to new
issues, the LBO funds will continue to buy undervalued companies.
5. 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
telecom to retail to automotive, it seems there is 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.
They can 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 — rampant price pressure which leads to the failure of almost every
competitor. 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.
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 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.
6. 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. 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 five 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.
Long Term Bullish Trend
color:black;mso-ansi-language:EN-US;mso-fareast-language:EN-US;mso-bidi-language:
AR-SA”>These five trends are longer term in nature and should continue to keep a
bid under equity valuations. And while
the buyout trends require that the bond market stay receptive to high yield
paper, the changes in management and Board attitudes should benefit shareholders
well over the long term.
Thomas Neuhaus is a principle of Investment Management of
Virginia, a registered investment advisory firm for which he co-manages. Mr.
Neuhaus’ career has encompassed all aspects of the investment business from
investment banking to sell-side research to buy-side portfolio manager.