Most Graham and Dodd value investors tend to search for potential catalysts in depressed stocks that the rest of the market may not be focused on and hope that a catalyst will be recognized, triggered, and come to fruition to propel the company’s share price higher. If the stock investment premise does not get realized – usually due to management’s inability to execute needed internal firm change or respond quickly to market challenges – managers often acknowledge the investment loss as a value trap mistake, sell their position, and move on. For a relative few value managers, taking a stock position is just the beginning. These managers take an activist stance to support management and strengthen the firm’s efforts to solve their business challenges and enable their potential catalysts.
There are a range of activities under the banner of shareholder activism that are intended to result in some change in the corporation. These activities fall along a broad spectrum based on the significance of the desired change and the assertiveness of the shareholders’ activities including, private negotiations with management or board members, publicity campaigns or movements, proposing shareholder resolutions, proxy battles, litigation and more. On one end of the spectrum are one-on-one engagements between major shareholders and corporate management. The more aggressive end of the spectrum seeks a significant change to the company’s strategy, financial structure, management, or board.
To explore this activist investment arena further, we went to new Institute members Kevin Rendino, CEO and Portfolio Manager, and Daniel Wolfe, President and Portfolio Manager of 180 Degree Capital Corp. – a publicly traded closed-end fund and registered investment adviser (NASDAQ: TURN) that manages its own capital alongside separately managed accounts. 180 Degree focuses on positively impacting the business and valuation of microcap companies through a process they call “constructive activism”. Their goal is to invest in and provide value-added assistance to substantially undervalued small, publicly traded companies that have potential for significant turnarounds, and that these efforts lead to a reversal in direction for the share price of these investee companies, in other words, a “180-degree turn”.
Hortz: With an investment philosophy firmly grounded in Graham and Dodd value management, how did your firm develop your investment methodology/strategy focused on constructive activism? What research or experiences led you down this path?
Rendino: Starting with working at Merrill Lynch Asset Management in 1990, then BlackRock when we merged, I had one job with a Graham & Dodd Value focus for 24 years. I was either an analyst or, for the last 19 of those years, a portfolio manager of the Basic Value family of funds. It is the only way I have ever managed money, and the only way I ever want to manage shareholder assets, especially as a fiduciary of their investment capital.
And while I loved my time there, I left BlackRock in 2012 because I saw the advent of passive investing styles and had a desire to find an asset class that had less market efficiencies than my previous world of investing in Large Cap companies. Blackrock just bought iShares and it was apparent the large cap universe was becoming an increasing universe of ETF’s and index funds. I wanted to focus my attention on areas of the market that may not have been as ripe for ETF and index fund investing; a group of companies that were unloved, orphaned, not really covered by wall street. That was the microcap world.
I started a friends and family fund called RGJ Capital and focused on investing in microcap companies. What I learned was many of these companies had real businesses and management teams that needed help… a great deal of and variety of help. Perhaps it was in investing relations help, balance sheet help, a new CFO, a new CEO, better capital allocation decisions, etc…. So, I decided to call myself and act as a constructive activist, all the time employing the core principles of Graham & Dodd’s discipline about the valuations of businesses coupled with the prescriptions for good corporate management and responsible stewardship for the company. It worked well right from the beginning. I found a number of holdings that were not only cheap, but also management teams receptive to hearing the views of an experienced Wall Street investor who had been in the business for 25 years at the one of the world’s biggest asset management companies. RGJ Capital had initial investment success including an activist campaign designed to replace the management of a company called Xplore Technology. Ultimately the company was sold for a large premium to our cost.
It was then in 2016 that I was nominated to the Board by an activist investor to 180 Degree’s predecessor company Harris & Harris Group, which was a broken Business Development Company (BDC) focused on venture capital investing. Subsequent to my arrival on the Board, Daniel and I worked on a new path forward for the business and presented the board a strategy for how to fix the company. It centered on a Graham and Dodd investment strategy that had worked for me for years and I married that with the microcap activism I was doing since 2013. Essentially, we presented the business plan for RGJ Capital.
Wolfe: That is a good timeline on how the firm and its leadership came to its present mission and focus for investors. But I would also point to a fabulous article that always impressed me. The article suggests that investment activism’s birth can be drawn back to one of the two people we model our investment style on—Benjamin Graham.
I would also note that our structure as a close-end fund lends itself well to constructive activism and value investing. The capital within 180 Degree is permanent, meaning it is not subject to redemptions by limited partners. This permanency allows us to take advantage of market dislocations and other events that may lead to companies being deeply undervalued, in addition to ones that may be mismanaged. We can also focus on being investors with a longer cycle than one quarter or one year if the investment thesis supports such an opportunity. We also have the flexibility to manage outside capital alongside 180 Degree’s permanent capital and currently do so for a portion of a publicly traded company’s pension fund.
Hortz: Why are you strictly focused on microcap stocks? What makes them an attractive asset class for you?
Rendino: The sole motivation for 180 Degree Capital is to create wealth for our shareholders and Limited Partners. We have chosen the microcap world because the risk/reward of this investment universe is asymmetric and provides a low correlation to everything else in the market that is ETF’d and indexed. The world doesn't need another Large Cap Growth Fund focused on Apple and Google. But portfolios can be enhanced by using a differentiated product like ours.
We have chosen this asset class because there are limited participants and if our fundamental research proves correct, the upside is greater than most other areas of the market. Plus, many of these companies need help with our now 52 years of our combined experience in the financial markets. Sometimes they need our capital, sometimes they need our thought leadership on the Board, sometimes they simply need our advice on what Wall Street wants to see from the investee company.
Wolfe: We are doing everything in our power to provide an investment platform that seeks to achieve outsized returns by focusing on an asset class that provides great risk/return profiles that has very few participants. We invest in a concentrated manner with only 5 to 10 core names at a time and a small number of other starter positions. We believe the world doesn’t need another small-cap diversified portfolio of 80 names that hugs the benchmark. We are value investors first but seek to enhance our strategy by using a constructive activist approach. The microcap universe provides many companies that need change and we can be the catalysts for that change.
Hortz: How do you deploy constructive activism in this investment universe of stocks? What tools or methods do you have in your activist toolkit?
Rendino: Every company is different. As a value manager, we are looking to buy assets for pennies on the dollar. The companies we identify are being valued at pennies for a reason. We ask ourselves, “What is it going to take to get a company’s share price from a depressed price to a place, where it is, at a minimum, properly valued?” There is never a time where we are not deploying some level of activism. Activism starts with us “having an opinion” on why a company’s stock price is out of favor with a compressed valuation. It is the sharing of our views with the company that starts the conversation.
We are not corporate raiders. Our ultimate goal is to engage constructively with existing boards and management teams to unlock value through:
- Resolution of capital structure or other overhangs that we believe inhibit growth of shareholder value
- Realignment of financial performance to achieve growth of operating profits, not just revenues
- Improvement of investor relations strategies and outreach
- Evaluation of strategic options including mergers, acquisitions, sales, and divestitures
- Identification of complementary talent and expertise
- Introductions to what we believe are value-add resources and capabilities
- Alignment of interests with, and support from, large shareholders
Wolfe: While not our first choice, we are not averse to pursue change through other routes including private and public shareholder communications, proxy solicitations, and/or joining Boards of Directors of our portfolio companies. We have yet to need to run a competitive proxy solicitation, primarily because we have generally built positive and constructive relationships with the management and boards of our investee companies. That said, all of our efforts and decisions are grounded by and based on our fundamental research and diligence.
Hortz: Are there different levels of activist engagement you can deploy depending on the management challenges present?
Wolfe: As Kevin mentioned before, every company is different, and their needs and challenges are different. So, we do have different levels of activist engagement that we take as needed by the portfolio company. First off, no matter what the level of engagement is, we are bottoms-up oriented investors and spend all day long researching and maintaining coverage of our universe of portfolio companies.
Level 1 engagement is most often our initial level of engagement. These are investment opportunities that we believe do not require substantial time or involvement. Our approach is to identify what we believe are quality, deeply undervalued companies with strong management teams in the process of executing a turnaround. Our constructive activism here includes introductions to our institutional investors and/or individual investors that own or have owned 180 Degree Capital's stock and leverage our general knowledge of the public markets gained over our collective 50+ years of experience for advice and value-add introductions.
Level 2 engagement are with investment opportunities that we believe, or have come to believe, require time and involvement, but not yet a substantial commitment. Our approach is to identify what we believe are quality, deeply undervalued companies with strong management teams where we believe small changes can result in increased value, and management is interested in engaging constructively. Our constructive activism here is where we actively suggest changes to Investor Relations strategies and/or messaging and actively suggest changes in business related primarily to financial performance improvements.
Rendino: Now Level 3 engagement is where it can get very interesting.
Level 3 engagement results from our determination that we need to become deeply involved in the company to help to build or unlock shareholder value. Our approach is to identify what we believe are opportunities in which our capital and strategic involvement will result in immediate and long-term value appreciation. Our constructive activism here is to work directly with managements and boards to remove value overhangs and evaluate strategic options. We can even take seats on boards and leverage ownership and control to drive increases in shareholder value.
Hortz: What is your process in finding and determining the right companies to target for your strategy?
Rendino: Few investors are willing or able to spend the time and energy identifying, conducting due diligence on, and actively engaging with such companies to unlock their intrinsic value in this asset class. We believe the opportunity for value creation in US micro-capitalization publicly traded stocks exists because management and boards often:
- Prioritize revenue growth over operating profits
- Favor the status quo rather than change
- Lack understanding of “buy side” investors and the workings of public markets in general
- Expend capital resources on perceived long-term opportunities at the expense of near-term results
- Do not appreciate the impact of flawed capital structures on shareholder value
- Entrench themselves to protect their jobs and positions
Wolfe: We screen for companies based on a specific series of criteria:
Initial screening – out of the micro-cap universe of over 250,000 companies, we focus on the approximately 3500 US-based companies under $500mm in market cap that are exchange traded and select OTC opportunities looking for fundamental value and screen for the following valuation measures: 1/2 market price to book, 2/3 market price to earnings, 2/3 market price to cash flows/EBITDA, 1/2 market price to revenue, above average dividend yield.
Fundamental research – we narrow down from our initial screen of 300 – 600 companies through secondary financial screens on financial health, low concentrated ownership and evaluate their franchise within their industry. This usually brings us down to 100 – 125 companies that we have initial management conversations; review their recent presentations, shareholder calls and SEC filings; do catalyst identification and validation; then initial financial modeling.
Plan development – narrowed to 30 – 40 companies we continue discussions with management; have initial conversations with board members; review existing customer, shareholder, sell-side analyst calls (if any); back-channel diligence on management teams and boards; do deep industry and financial modeling; and then do competitive analysis/risk analysis company visits with management.
Execution - Establish initial position with 10-15 companies, identify path to build >5% position if investment thesis holds, develop strategies to improve financial performance, attempt to work with management/board to affect change, join boards of investee companies (if applicable), actively monitor risks, and, if required, issue private/public letters, proxy contests, etc....
Hortz: Can you walk us through an example or two to illustrate how this direct engagement with company management works? Why would they listen to you?
Rendino: As far as examples of activism, we were interested in TheStreet.com because of its assets, its new management, and the depressed valuation of its share price. We invested some capital in the open market to establish a starter position. It was clear to us that the overhang causing the shares to be depressed was a bad balance sheet. The company had a $50+ million senior liquidation preference preferred stock soaking up the majority of the capital structure. For years, the company had been unsuccessful in retiring this preferred stock instrument. Given that we know how to value preferred securities from our history of managing private holdings, we worked with the management team to raise $20 million, both from TheStreet.com’s balance sheet and ours; and retired the preferred stock with this cash and issuance of TST stock, thus removing the overhang on the equity. Coincident with this, we took a 17% stake in the company and agreed to join the Board of Directors. I soon became the chair of the strategic alternatives committee and we sold the business for a nearly 150 % gain in less than two years.
We did a similar thing with Turtle Beach when the stock was $4.00, although we felt the business was performing well and we did not need to go on the board. We achieved a nearly 400 percent return in less than three months. Turtle Beach listened to us because of our success with remaking the TheStreet.com’s balance sheet and subsequent share appreciation.
Wolfe: Most companies listen to us because: 1. we have over 50 years of investing and market experience, 2. we are the adults in the room, 3. we show up usually taking a 5 to 15 percent stake in a company making us a first page, top 5 shareholder that wields influence, and 4. we run a public company. The last point is a key differentiator between us and other investors. We understand what it means to talk to investors and the delineation between public and non-public information. We use the way we run our company as an example for our investee companies. We can also relate to the demands of investors and use that knowledge to frame how we work with our management teams. We believe it brings us a level of credibility that few other investors have to our approach to constructive activism and engagement with management teams and boards.
Hortz: How do you recommend that advisors work with and integrate investment activism strategies into their clients’ portfolios?
Rendino: Simply put, we offer a differentiated investment process, proven out over its tenure, that we believe is not only suitable but should be desired for client portfolios. We seek to minimize risk because, as value investors, we focus on paying a low price for the businesses we are buying. Since we are differentiated from other funds in terms of our investment style, in terms of our level of concentration and our activist approach, the correlation of 180 relative to the rest of the market (which feels like one gigantic ETF) is low. Client portfolios need differentiated diversification. And they need outperformance. We believe we provide both.