How to Think About Activist Investors

By Markets Fool.com

Following up on a listener question. we look into rumors that Mentor Graphics (NASDAQ: MENT), a company that supplies tools used by semiconductor manufacturers, is considering selling itself -- in part due to the influence of activist hedge fund Elliot Management.

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In this week's Industry Focus: Tech, analyst Dylan Lewis and contributor Evan Niu explain what activist investors do and, from a retail investor's perspective, the pros and cons of activist interest in a company. Then, they discuss how activist investor Carl Icahn helped spur some big changes at Apple(NASDAQ: AAPL), how Mentor Graphics' activist story will likely play out, and whether Mentor shareholders should be worried about a potential sale.

A full transcript follows the video.

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This podcast was recorded on Oct. 21, 2016.

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Dylan Lewis:This episode of Industry Focus is brought to you by Rocket Mortgage by Quicken Loans.Rocket Mortgagebrings the mortgage process into the 21st century with a fast,easy, and completely online process. Check out Rocket Mortgage today at QuickenLoans.com/fool.

Welcome to Industry Focus, the podcast the dives into a different sector of the stock market every day. It's Friday, Oct. 21, and we're talking about activist investors. I'm your host, Dylan Lewis, and I'm joined in the studio -- for once --by Fool.com senior tech specialist, Evan Niu. Evan, how's it going?

Evan Niu: It'sgood to be in town.

Lewis:It'scool to have you here. So, pretty much every year,we do a writers conference for our Fool.comcontributors. Rather than be Skyping with Evan,I have the pleasure of having him next to me in the studio. Hopefully we'll be able to pick up on ournonverbal cues,maybe not cut each other offlike we do occasionally when we're Skypingeach other.So, I mentioned in the beginning, we're doing a show on activist investors. Really, this started with an email fromone of our listeners. Earlier this week, I heard from Mark S. He asked, "Recently,there have been some rumors thatMentor Graphics may be looking to be acquired. Thecompany is a major supplier of CADtools that are used by integrated circuit designers, andas such are a crucial supplier for all the semiconductor companies. ShouldI as an investor or user beconcerned about their looking around?"

Prior togetting back to Mark, I did a little homeworkto see what some of the circumstances surrounding that sale were. There was aFortune articleposted a few days ago. "Mentor Graphics company, a company thatmakes software for designing semiconductors,is working withBank of Americato explore strategic alternatives,including a potential sale,according to people familiar with the matter. Mentor has beenunder pressure since activisthedge fundElliott Management Corp reported an 8% stake in the company last monthand said shares were deeply undervalued." That seemed like a good point tolaunch into a discussion about how investors should feelwhen activists get involvedin a company that they're invested in.

I think,before we get too far into this conversation,let's just take a look at what an activist investor is. Evan, what do you have?

Niu: They'reusually just in it for the money. Activist investors basically pick up a bunch of shares,enough to get a pretty meaningful stake in the company,to the point where they can get board seats,they can get the ear of management,they can actually really get in there and try to have some influencebecause they have that big stake in the company. Certainly, it's easier to do thisfor a smaller company, becauseit doesn't take as much money to buy a big stake. If you want to buy 10% of a giant company versus a small cap,I think it's a little more reasonable for the small cap. In this case, I'm not too familiar with Mentorspecifically, but I know they're pretty small.

Lewis:They're a $3 billion company.

Niu: Right. So,it's not too hard for an activist investor,if they think that shares are undervalued, they can pick up a pretty sizable stakefor not too much money and try to make some change,make some money.

Lewis:Andwhat are we typically talking aboutwhen we say changes? You see the term"strategic alternatives"thrown around a lotin those types of press releases.

Niu: Usually,they just want to maximizethe value. That can take a couple of forms,like actual changes to the business,if they think there are problems with the way the company is run. If they think there's problems with management, sometimes they'll try to oust management and getbetter people in to run the company. Other times,they might have better input oncapital structure. Big investors tend to think more about -- at the Fool,we always talk about how you have to distinguishbetween investing in the company and the business of the company. There's two aspects of it. Andmanagement is mostly focused on the business,whereas investors are more focused oninvesting financials. Of course,all companies try to look at both. But some companies aren'treally good at looking at the financially deep stuff,for things like capital structure, capital allocation. So in some cases,where management isn't as good atfocusing on those things,I think activist investors canreally help in that sense.

Lewis:Yeah,add some value, bring in some of that morefinancial expertise. Some of the other things you might see activist investors push for,we talked about capital allocation, something they need, buybacks, dividends realm,maybe spinning off specific segments, trying to drive value there. But really, at its core, activist investors see a company thatisn't being properly valued, and thinkthat they have a way to boost the value throughsome sort of strategic action.

Wetalked about this a little bit, but Mentor is not a company that either of us cover all that much. In some ways, it's kind of a niche within a niche, as asemiconductor supplier. So,as we talked about this company, we're going to be looking more broad stroke at theirsituation, and less specific to their financials. Standard caveats here that this is notpersonalized financial advice for Mark. But,because they're shopping around,and it's really at the behest of activist investors,I don't see that as a huge problem. It's not the same way thatTwitterisshopping itself around,kind of desperate for dancing partner. This is something that we see,and it's fairly commonwith activist investors.

Looking atwhat's been going on with Mentorover the past couple years, theirvaluation right now is a $3 billion company. That puts thempretty much at the height of where they've beenover the last five years. Youthink about these newshareholders with a huge stake in the company,and people who may have owned shares for quite some time, theirinterests are going to be fairly alignedwhen it comes to avaluation if there is a sale.I think the worry with these types of situations is, maybe you bought at highs a year and a half ago, and due to whatever, poor guidance -- which did happen in Mentor Graphics' case -- there was a big sell-off in late 2015, but they have since recovered. But, theseactivists getting in ata much lower valuationand then being willing to take, say, a30% premium that undercuts your costbasis and doesn't let yourthesis play out on the stock.

Niu: Younever get to break even.

Lewis:Yeah,you never hit that point where, maybe you have something that's more of a three- to five-year horizon onwhatever you're looking to see from the business, andactivist investors, on the flip side, might say --

Niu: "We want to cash out."

Lewis:"Wewant to cash out in six months, or a year." And then,you might not get to see that come to fruition. So that's something to be mindful of. I do think, because that's the case here with Mentor, as an investor, and my advice to Mark assomething to watch would be, beless mindful ofwhat's going on on the sale side, and paycloser attention to anything managementmight push in terms of capital allocation,or what to do with specific business units. If they'relooking to hold this, that's the thing that'sgoing to be most disruptive to the thesis and the business that you originally had when you bought shares.

Niu: Yeah.I think, certainly,if an activist investor is pushing for sale of a company,it's really hard to say, "That'snot in line with my interests,"because obviously, the stock will go up. But it depends onwhat the activist investor wants. There's lots of different things they could want, their goal could be a wide range of things. But, in this case, if it's justpushing for an outright sale, given that the stock is at five-year highs,I don't think many investors are going to be upset about it,having someone on their sidethat can get more value out of it.

Lewis:Yeah. The gains might be less thanwhat they would have been had you letthe company play out over that five-yearhorizon, but I don't thinkthere are going to be a lot of people who wind up getting kneecapped on their position because of that.

Inthe second half of the show, we're going to talk about more of the pros and cons, maybe talk about a high-profile example or two of some activist investors. But, before we do, this episode of Industry Focus is broughtto you by Rocket Mortgage by Quicken Loans. If you've ever bought a home, you know howfrustrating and time-consuming getting a mortgage can be.Rocket Mortgage brings the mortgage approval process into the 21st century by takingall the complicated, time-consuming parts of applying for a mortgage out of the equation. With Rocket Mortgage you can easily share your bank statements and pay stubs at the touch of a button, helping you get approved in minutes for a custom mortgage solution that's been tailored to your unique financial situation.Even better, with Rocket Mortgage you can do it all online with your phone or tablet.If you're looking to refinance your mortgage or buy a home, check out Rocket Mortgage today at quickenloans.com/fool, Equal Housing lender licensed in all 50 states, NMLS consumeraccess.org number 3030.

Evan,back to the second half of the show, we talkedabout some of the pros and cons. We touched on ita little bit in the first half. Activist investors get kind of a bad rep. Do you want to maybe play devil's advocate and provide some pros here?

Niu: What we touched on earlier, I think the big piece is,activist investors spend all day thinking aboutinvesting, and the deep financing of it,whereas management spends all day thinking abouthow to run the business operationally, andactually growing the business in whateverthe company does. To the extent thatthe investor knows more about some of the financial aspects,it can really bring a lot to the tablein terms of, if there's something that needs to be improved, if you have too much debtand they're pushing for you to pay down your debt,all these different things wherea company CFO generally handles those kind of decisions. Depending on the CFO andhow experienced they areand how cognizant they are -- because,companies have a wide range of how much they value their investors. A lot of companies really value their investors, they really value their input, they really want to deliver return. Other companies don't care as muchbecause there's so many stakeholdersin any company --

Lewis: Yeah,you have investors, you have consumers, you have employees.

Niu: And management, and the board. You have all these people. And,of course, every company is differentin terms of how they view and value each of these stakeholders. And,obviously, there any companies that are very bad about respecting theirshareholders. They just kind of do what they want,or they enrich themselves. There'splenty of cases of companies that don't really treatinvestors with a lot of respect,generally speaking. So if you get an activist investor that gets in there, itkind of forces them to respectthe shareholder base, in some ways.

Lewis: Yeah. To bring it back to the idea of,how should shareholders feel if they see this going onin a company that their invested in,I think the hypothetical where you're happyabout an activist investor hopping in is,maybe you love the core business and the market that it reaches,and some of the growth potential there,but you see management really mishandling thingson the financial side.

Niu: Exactly. And,it's hard to know when that's happening, butif an activist comes in there --even though it can be distractingfor management to have to deal withspending a lot of time catering towhatever this person wants and needs --most of the time, I think they do want to be helpful. Particularly from theperspective of a public investor,most of the time I think it's probably OK. They'retrying to help shareholders, in general.

Lewis: Yeah,it might just be that their horizon is a little bit different.I think "distraction" cues us up perfectly for a discussion on some cons for activist investors. Whenyou said distraction, the first thing that came to mind for me wasCarl Icahn andApple. Itseemed like, when he had a stake in that company,every two months we were saying a new valuation.

Niu: And a new letter.

Lewis: "I think shares are worth $900!" It was just every day in the news,that's what they were talking about. That becomes kind of a nuisance for management.

Niu: It is. I think, in Icahn's case,he's kind of a ruthless activist investor. He had a big position, and of course, a big position in Apple means 2-3% of the company.

Lewis: Yeah,I think he was just under 1%.

Niu: Yeah, it's single digits. There'sno way that anyone is buying 10% of Apple.

Lewis: Which is tens of billions of dollars, for that position.

Niu: Yeah,no one has the money for that. I think, in Apple's case,the specific thing that he was gunning after, which was this really big push for capital returns --

Lewis: Via buybacks.

Niu: Right,buybacks and dividends.I think that was a very valid cause,because Apple had been getting criticized for yearsabout that. Their cash position had grownridiculously large,unjustifiably. You can't justify having that much cash. Again,as a public investor, you're just sitting there, and you're like, "Guys,come on, you have way too much cash." But a public investor can't do anything about it. That's not to say that Apple doesn't know better. I think Apple was justbeing stingy at the time, choosing to do that. They had already started a buyback program, but Icahn came in here andreally pushed them to make it biggerandreally meaningful. Of course, they didn'tlisten to exactly what he said. But I think he was successful atgetting them to increase it,in which case, it's definitely a good thing for investors, because otherwise, investors have no recourseto get Apple to start giving backall this money that's just idly on the balance sheetdoing nothing, earning really crappy returns.

Lewis: Andhis pitch was basically, "Shares arecriminally undervaluedand you have all this cash. You should be buying back shares."I think the number that he threw out there was a $150 billionshare repurchase program.

Niu: Something like that.

Lewis: We've seen,in the last couple years,I think he began his position in 2013 and exited in 2015, he had about a two-year holding period. During that time, we saw thecompany acquiesce to that a little bit, and decide, "We'regoing to be buying back shares at a pretty significant clip." Itobviously wasn't to the extreme that he'd been hoping for.

Niu: I think,right now, they have bought back about $120 billion, so far, total. Whichis a pretty crazy numberin itself. That's a megacap company. They just bought back a megacap company. But, I think,in the example of this cash thing specifically,having too much cash really does affectsome of your financial metrics, too. Think about,for example, return on assets. If you have all this cash justsitting out there, and your asset number is humongous --

Lewis: Andyou're not returning anything on that.

Niu: Right, andyou're not giving back to shareholders, then your net income ratio to your assets is now smaller. So, your return on assets, return on equity,all these important financial metrics thatinvestors look at to judge theperformance of the company are now being artificially deflatedbecause you have a ridiculous amount of cash, and that cash is not doing anything. So, there are a lot ofmeaningful ways this impacts things. Beyond,when they start to buy back,then you get earnings creation. I think he did a good job in terms of really getting them to do something that needed to be done that was holding them back.

Lewis: Anything else on the con sidewhen it comes to activist investors?

Niu: I think we covered it.

Lewis: Well, listeners, that sounds like it does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email at industryfocus@fool.com. You can always tweet us @MFIndustryFocus. If you'relooking for more of our stuff, subscribe on iTunes or check out the Fool's family of shows at fool.com/podcast. As always, people on the program may have own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!

Dylan Lewis owns shares of Apple. Evan Niu, CFA owns shares of Apple. The Motley Fool owns shares of and recommends Apple and Twitter. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.