Deep Value E-Book

Tobias E. Carlisle

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch
• Veröffentlichungsjahr: 2014

Seitenzahl: 439

Beschreibung

The economic climate is ripe for another golden age of shareholder activism Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations is a must-read exploration of deep value investment strategy, describing the evolution of the theories of valuation and shareholder activism from Graham to Icahn and beyond. The book combines engaging anecdotes with industry research to illustrate the principles and methods of this complex strategy, and explains the reasoning behind seemingly incomprehensible activist maneuvers. Written by an active value investor, Deep Value provides an insider's perspective on shareholder activist strategies in a format accessible to both professional investors and laypeople. The Deep Value investment philosophy as described by Graham initially identified targets by their discount to liquidation value. This approach was extremely effective, but those opportunities are few and far between in the modern market, forcing activists to adapt. Current activists assess value from a much broader palate, and exploit a much wider range of tools to achieve their goals. Deep Value enumerates and expands upon the resources and strategies available to value investors today, and describes how the economic climate is allowing value investing to re-emerge. Topics include: * Target identification, and determining the most advantageous ends * Strategies and tactics of effective activism * Unseating management and fomenting change * Eyeing conditions for the next M&A boom Activist hedge funds have been quiet since the early 2000s, but economic conditions, shareholder sentiment, and available opportunities are creating a fertile environment for another golden age of activism. Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations provides the in-depth information investors need to get up to speed before getting left behind.

Leseprobe

Contents

Preface

Acknowledgments

About the Author

Chapter 1: The Icahn Manifesto

Icahn’s Wall Street Reformation

Grahamite Proto-Activism

Notes

Chapter 2: Contrarians at the Gate

One of The Mysteries of Our Business

Mean-Reverting Qualitative Elements

Notes

Chapter 3: Warren Buffett: Liquidator to Operator

The American Express Crisis

See’s Candies

How to Run a Candy Store (and a Few Things Buffett Learned About Business Valuation)

Notes

Chapter 4: The Acquirer’s Multiple

Analysis of the Magic Formula

The Enterprise Multiple

Notes

Chapter 5: A Clockwork Market

Beware the Fickle Goddess

Undervalued Markets

Blind to the Turn of Fortuna’s Wheel

Notes

Chapter 6: Trading in Glamour: The Conglomerate Era

Glitz and Glamour’d

Notes

Chapter 7: Catch a Falling Knife

Contrarian Value

The Broken-Leg Problem

Notes

Chapter 8: The Art of the Corporate Raid

The Terror of the Oil Patch

Cities Service

Capital Allocation and Restructuring

Notes

Chapter 9: How Hannibal Profits From His Victories

An Ideal Industry

An Archetypal Target

Returns to Activism

Notes

Chapter 10: Applied Deep Value

Cigar Butts, Net Current Assets, and Liquidations

Activism and the Acquirer’s Multiple

Conclusion

Notes

Index

End User License Agreement

List of Illustrations

FIGURE 4.1 Logarithmic Chart of Magic Formula and S&P 500 (Total Return) Performance (1964 to 2011)

FIGURE 4.2 Logarithmic Chart of Magic Formula (Market Weight), Earnings Yield, Return on Capital, and S&P 500 (Total Return) Performance (1974 to 2011)

FIGURE 4.3 Change in Median ROIC by Quintile (2000 to 2010)

FIGURE 5.1 Cumulative Average Returns for Winner and Loser Portfolios of 35 Stocks over 36 months (1933 to 1982)

FIGURE 5.2 Change in Average Earnings Per Share for Stocks in Winner and Loser Portfolios (1966 to 1983)

FIGURE 5.3 Change in Average Earnings Per Share for Undervalued and Overvalued Portfolios (1926 to 1983)

FIGURE 5.4 Albrecht Dürer’s

The Wheel of Fortune

from Sebastian Brant’s

Ship of Fools

(1494)

FIGURE 5.5 Global Markets Average Annualized Five-Year Returns for All Price Ratios (1980 to 2013)

FIGURE 5.6 Global Markets Annualized Average Five-Year Returns for Price-to-Book Value Quintiles (1980 to 2013)

FIGURE 5.7 Rolling Five-Year Annualized Value Premium (Discount) for Price-to-Book Value Quintiles (1985 to 2013)

FIGURE 6.1 Apple, Inc. 10-Year Stock Price Chart

FIGURE 6.2 Analysts Are Systematically Overoptimistic

FIGURE 7.1 Comparison of Unexcellent and Excellent Stock Portfolios (1972 to 2013)

FIGURE 7.2 Relative Performance of Unexcellent and Excellent Stock Portfolios (Trailing Three-Year Annualized Returns 1972 to 2013)

FIGURE 7.3 Comparison of Standard and Poor’s Stock Ratings and Returns (1986 to 1994)

FIGURE 9.1 Excess Buy-and-Hold Returns Around Schedule 13D Filing

FIGURE 9.2 In the Short Run, Activist Investments Outperform Passive Investments

FIGURE 9.3 In the Long Run, Activist Investments Outperform Passive

FIGURE 9.4 Activism Adds Value Beyond Selling Companies

FIGURE 10.1 Returns to Graham Net Current Asset Value Rule and Comparable Small Firms Index (1970 to 2013)

FIGURE 10.2 Performance of Value Stocks (by Enterprise Multiple) and All Stocks, Market Capitalization Weight (1951 to 2013)

FIGURE 10.3 Performance of All Value Stocks Compared to High- and Low-Quality Value Stocks and All Stocks, Market Capitalization Weight (1951 to 2013)

FIGURE 10.4 Performance of All Value Stocks Compared to Deep Value and Glamour Value Stocks and All Stocks, Market Capitalization Weight (1951 to 2013)

FIGURE 10.5 Compound Performance by Decade of All Value Stocks Compared to Deep Value and Glamour Value Stocks, Market Capitalization Weight (1951 to 2013)

FIGURE 10.6 Average Enterprise Multiple for Deep Value and Glamour Value Stocks (1951 to 2013)

FIGURE 10.7 Average Gross Profits to Total Assets Ratio for Deep Value and Glamour Value Stocks (1951 to 2013)

FIGURE 10.8 Comparison of Market Capitalization-Weighted and Equal-Weighted Performance of Deep Value Stocks (by Enterprise Multiple) and All Stocks (1951 to 2013)

List of Tables

TABLE 1.1 Icahn Partnership Memo: “Stock Prices During Unfriendly Maneuvers”

TABLE 4.1 Performance Statistics for Magic Formula (Market Weight), Earnings Yield, Return on Capital, and S&P 500 (Total Return) (1974 to 2011)

TABLE 4.2 Summary Performance Statistics for Magic Formula (Equal Weight), Earnings Yield, Return on Capital, and Market in the US, Europe, the UK, and Japan (1993 to 2005)

TABLE 4.3 Compound Annual Growth Rates for All Historical Price-to-Value Ratios (1964 to 2011)

TABLE 4.4 Relative Volatility and Volatility Adjusted Returns for Value Decile of Each Historical Price-to-Value Ratio (1964 to 2011)

TABLE 5.1 Average Annualized Five-Year Performance Statistics by Capitalization for Price-to-Book Value Quintiles (1980 to 2013)

TABLE 7.1 Average Five-Year Cumulative Return to Contrarian Value Portfolios and Glamour Portfolios (1963 to 1990)

TABLE 7.2 Average Five-Year Cumulative Growth of Fundamentals of Stocks Prior to Selection for Contrarian Value and Glamour Portfolios (1963 to 1990)

TABLE 7.3 Valuation Characteristics of Contrarian Value and Glamour Portfolios (1963 to 1990)

TABLE 7.4 Average Five-Year Cumulative Return of “High Growth” Value Portfolios and Contrarian Value Portfolios (1963 to 1990)

TABLE 7.5 Five-Year Average Growth of Contrarian Value and “High Growth” Value Portfolios (1963 to 1990)

TABLE 7.6 Valuation Characteristics of Contrarian Value and “High Growth” Value Portfolios (1963 to 1990)

TABLE 7.7 Average Yearly Returns to Profitable and Loss-Making Net Current Asset Value Portfolios (1970 to 2010)

TABLE 7.8 Average Yearly Return to Profitable Dividend Paying and Non-Dividend Paying Net Current Asset Value Portfolios (1970 to 2010)

TABLE 7.9 Average Five-Year Financial Characteristics of Peters’ “Excellent” and Clayman’s “Unexcellent” Companies (1976 to 1980)

TABLE 10.1 Performance Statistics for All Value Stocks, Deep Value Stocks, and Glamour Value Stocks (1951 to 2013)

TABLE 10.2 Performance Statistics By Decade for All Value Stocks, Deep Value Stocks, and Glamour Value Stocks (1951 to 2013)

TABLE 10.3 Orange, Inc. Summary Financial Statements, Statistics, and Ratios

Pages

ii

iii

iv

v

ix

x

xi

xii

xiii

xiv

xv

xvi

xvii

xviii

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

41

42

43

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

61

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

100

101

102

103

104

105

106

107

108

109

110

111

112

113

114

115

116

117

118

119

120

121

122

123

124

125

126

127

128

129

130

131

132

133

134

135

136

137

138

139

140

141

142

143

144

145

146

147

148

149

150

151

152

153

154

155

156

157

158

159

160

161

162

163

164

165

166

167

168

169

170

171

172

173

174

175

176

177

178

179

180

181

182

183

184

185

186

187

188

189

190

191

192

193

194

195

196

197

198

199

200

201

202

203

204

205

206

207

208

209

210

211

212

213

214

215

216

217

218

219

220

221

222

Guide

Cover

Table of Contents

Begin Reading

The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. For a list of available titles, visit our website at www.WileyFinance.com.

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.

Deep Value

Why Activist Investors and Other Contrarians Battle For Control of “Losing” Corporations

TOBIAS E. CARLISLE

Cover image: © iStock.com/davidhills

Cover design: Wiley

Copyright © 2014 by Tobias E. Carlisle. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone], or fax [phone].

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Carlisle, Tobias E., 1979–

Deep value : why activist investors and other contrarians battle for control of losing corporations / Tobias E. Carlisle.

pages cm. — (Wiley finance series)

Includes index.

ISBN 978-1-118-74796-4 (cloth); ISBN 978-1-118-74785-8 (ebk); ISBN 978-1-118-74799-5

1. Stockholders. 2. Corporate governance. 3. Investments. 4. Valuation. I. Title.

HD2744.C47 2014

338.6—dc23

2014012263

For my ladies luck, Nickole and Stella.

Preface

“The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.”

—Adam Smith, The Wealth of Nations (1776)

Deep value is investment triumph disguised as business disaster. It is a simple, but counterintuitive idea: Under the right conditions, losing stocks—those in crisis, with apparently failing businesses, and uncertain futures—offer unusually favorable investment prospects. This is a philosophy that runs counter to the received wisdom of the market. Many investors believe that a good business and a good investment are the same thing. Many value investors, inspired by Warren Buffett’s example, believe that a good, undervalued business is the best investment. The research seems to offer a contradictory view. Though they appear intensely unappealing—perhaps because they appear so intensely unappealing—deeply undervalued companies offer very attractive returns. Often found in calamity, they have tanking market prices, receding earnings, and the equity looks like poison. At the extreme, they might be losing money and headed for liquidation. That’s why they’re cheap. As Benjamin Graham noted in Security Analysis, “If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price. The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.” This book is an investigation of the evidence, and the conditions under which losing stocks become asymmetric opportunities, with limited downside and enormous upside.

At its heart, deep value investing is simply the methodical application of timeless principles proven by over 80 years of research and practice. The intellectual basis for it is Graham’s Security Analysis, the foundational document for the school of investing now known as value investing. Through his genius and his experience, Graham understood intuitively what other researchers would demonstrate empirically over the eight decades since his book was first published: That stocks appear most attractive on a fundamental basis at the peak of their business cycle when they represent the worst risk-reward ratio, and least attractive at the bottom of the cycle when the opportunity is at its best. This has several implications for investors. First, the research, which we discuss in the book, shows that the magnitude of market price discount to intrinsic value—the margin of safety in value investing parlance—is more important than the rate of growth in earnings, or the return on invested capital, a measure of business quality. This seems contradictory to Buffett’s exhortation to favor “wonderful companies at fair prices”—which generate sustainable, high returns on capital—over “fair companies at wonderful prices”—those that are cheap, but do not possess any economic advantage.

In the book, we examine why Buffett, who was Graham’s most apt student, sometime employee, long-time friend, and intellectual heir, evolved his investment style away from Graham’s under the influence of his friend and business partner, Charlie Munger. We examine why Munger prompted Buffett to seek out the wonderful company, one that could compound growth while throwing off cash to shareholders. We analyze the textbook example of such a business to understand what makes it “wonderful,” and then test the theory to see whether buying stocks that meet Buffett’s criteria leads to consistent, market-beating performance over the long term. Do Buffett’s wonderful companies outperform without Buffett’s genius for qualitative business analysis, and, if so, what is the real cause? We know that a wonderful company will earn an average return if the market price reflects its fair value. To outperform, the price must be discounted—the wider the discount, or margin of safety, the better the return—or the business must be more wonderful than the market believes. Wonderful company investors must therefore determine both whether a superior business can sustain its unusual profitability, and the extent to which the stock price already anticipates its ability to do so. This is a difficult undertaking because, as we’ll see, it is the rare company that does so. And we don’t well understand what allows it to do so. In most cases competition works on high quality businesses to push their returns back to average, and some even become loss makers. What appears to be an unusually strong business tends to be one enjoying unusually favorable conditions, right at the pinnacle of its business cycle.

The problem for investors is not only that high growth and unusual profitability don’t persist. Exacerbating the problem in many cases is that the market overestimates the business’s potential, bidding the price of its stock too high relative to its potential. The stock of high quality companies is driven so high that long-term returns are impaired even assuming the high rates of growth and profitability persist. The corollary is also true: A company with an apparently poor business will generate an excellent return if the market price underestimates its fair value even assuming the low growth or profitability persists. These findings reveal an axiomatic truth about investing: investors aren’t rewarded for picking winners; they’re rewarded for uncovering mispricings—divergences between the price of a security and its intrinsic value. It is mispricings that create market-beating opportunities. And the place to look for mispricings is in disaster, among the unloved, the ignored, the neglected, the shunned, and the feared—the losers. This is the focus of the book.

If we want rapid earnings growth, and the accompanying stock price appreciation, the place to look for it is counterintuitive. It is more likely to be found in undervalued stocks enduring significant earnings compression and plunging market prices. How can this be so? The reason is a pervasive, enduring phenomenon known as mean reversion. It can be observed in fundamental business performance, security prices, stock markets, and economies. It returns high-growth stocks to earth, and pushes down exceptional returns on investment, while lifting moribund industries, and breathing new life into dying businesses. Though Graham described the exact mechanism by which mean reversion returned undervalued stocks to intrinsic value as “one of the mysteries of our business,” the micro-economic theory is well understood. High growth and high returns invite new entrants who compete away profitability, leading to stagnation, while losses and poor returns cause competitors to exit, leading to a period of high growth and profitability for those business that remain.

Though it is ubiquitous, we don’t intuitively recognize the conditions for mean reversion. Time and again investors, including value investors, ignore it and consequently reduce returns. We can show that a portfolio of deeply undervalued stocks will, on average, generate better returns, and suffer fewer down years, than the market. But rather than focus on the experience of the class of deeply undervalued stocks, we are distracted by the headlines. We overreact. We’re focus on the short-term impact of the crisis. We fixate on the fact that any individual stock appears more likely to suffer a permanent loss of capital. The reason is that even those of us who identify as value investors suffer from cognitive biases, and make behavioral errors. They are easy to make because the incorrect decision—rejecting the undervalued stock—feels right, while the correct decision—buying stocks with anemic, declining earnings—feels wrong. The research shows that our untrained instinct is to naïvely extrapolate out a trend—whether it be in fundamentals like revenues, earnings, or cash flows, or in stock prices. And when we extrapolate the fundamental performance of stocks with declining earnings, we conclude that the intrinsic value must become less than the price paid. These biases—ignorance of the base case and, by extension, mean reversion—are key contributors to the ongoing returns to deep value investment.

In the book we also examine how the public stock market, by making possible an involuntary exchange of management control, creates a means for disciplining underperforming managers, and improving poorly performing businesses. Where high-return businesses attract competitors, low-return businesses attract outside managers. Through acquisition, or activism, these external managers—typically financial buyers like private equity firms, activist investors, and liquidators—compete for control of corporate resources with underexploited potential in the market for corporate control. The principal-agent conflict—caused by the separation of ownership and management in publicly traded companies—leads management to put its own interests ahead of the shareholders. Activists seek to resolve this conflict by pressuring boards to remove underperforming managers, stop value-destroying mergers and acquisitions, optimize capital structures, or press for a sale of the company, and earn a return doing so. They are thus incentivized to foment catalysts in otherwise neglected stocks, and are an important participant in the market for deeply undervalued, underperforming stocks.

As a portfolio, deeply undervalued companies with the conditions in place for activism offer asymmetric, market-beating returns. Activists exploit this property by taking large minority stakes in these stocks and then agitating for change. What better platform than a well-publicized proxy fight and tender offer to highlight mismanagement and underexploited intrinsic value, and induce either a voluntary restructuring or takeover by a bigger player in the same industry? Activist investing can be understood as a form of arbitrage. Activists invest in poorly performing, undervalued firms with underexploited intrinsic value. By remedying the deficiency or moving the company’s intrinsic value closer to its full potential, and eliminating the market price discount in the process, they capture a premium that represents both the improvement in the intrinsic value and the removal of the market price discount. We scrutinize the returns to activism to determine the extent to which they are due to an improvement in intrinsic value, or simply the returns to picking deeply undervalued stocks. Finally, we examine valuation metrics used to identify the characteristics that typically attract activists—undervaluation, large cash holdings, and low payout ratios. These metrics favor companies with so-called lazy balance sheets and hidden or unfulfilled potential due to inappropriate capitalization. Activists target these undervalued, cash-rich companies, seeking to improve the intrinsic value and close the market price discount by reducing excess cash through increased payout ratios. We analyze the returns to these metrics and apply them to two real world examples of activism. The power of these metrics is that they identify good candidates for activist attention, and if no activist emerges to improve the unexploited intrinsic value, other corrective forces act on the market price to generate excellent returns in the meantime.

The book is intended to be a practical guide that canvasses the academic and industry research into theories of intrinsic value, management’s influence on value, and the impact of attempts to unseat management on both market price and value. Each chapter tells a different story about a characteristic of deep value investing, seeking to illustrate a genuinely counterintuitive insight. Through these stories, it explores several ideas demonstrating that deeply undervalued stocks provide an enormous tail wind to investors, generating outsized returns whether they are subject to activist attention or not. We begin with former arbitrageur and option trader Carl Icahn. An avowed Graham-and-Dodd investor, Icahn understood early the advantage of owning equities as apparently appetizing as poison. He took Benjamin Graham’s investment philosophy and used it to pursue deeply undervalued positions offering asymmetric returns where he could control his own destiny. More than any other, Icahn’s evolution as an investor mirrors the evolution of activism. In the following chapters we step through the looking glass to examine the theories of deep value and activist investing from Graham to Buffett to Icahn and beyond.

Acknowledgments

I was the beneficiary of a great deal of assistance in the production of the manuscript for Deep Value. First and foremost, I’d like to thank my wife, Nickole, who took over the primary parental responsibilities for our newborn, Auristella, whose arrival marked the midpoint of the preparation of the first draft. I’d like to thank the early reviewers of that primordial first draft: Scott Reardon, Taylor Conant, Travis Dirks, PhD, Peter Love, Toby Shute, and my mother and father, Drs. Wendy and Roger Carlisle. I’d like to thank Jeffrey Oxman, PhD for his assistance with backtesting the various strategies discussed in the book. Finally, I appreciate the assistance of the team at Wiley Finance, most especially Bill Falloon, Lia Ottaviano, Angela Urquhart, Tiffany Charbonier, and Meg Freeborn, who provided guidance and advice along the way.

About the Author

Tobias Carlisle is the founder and managing director of Eyquem Investment Management LLC, and serves as portfolio manager of Eyquem Fund LP. He is best known as the author of the well regarded web site Greenbackd.com, and co-author of Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (2012, Wiley Finance). He has extensive experience in business valuation, portfolio management, investment research, public company corporate governance, and corporate law. Prior to founding Eyquem in 2010, Tobias was an analyst at an activist hedge fund, general counsel of a company listed on the Australian Stock Exchange, and a corporate advisory lawyer. As a lawyer specializing in mergers and acquisitions he has advised on transactions across a variety of industries in the United States, the United Kingdom, China, Australia, Singapore, Bermuda, Papua New Guinea, New Zealand, and Guam. He is a graduate of the University of Queensland in Australia with degrees in Law (2001) and Business (Management) (1999).

Chapter 1The Icahn ManifestoCorporate Raider to Activist Investor

“Had we but world enough, and time,

This coyness, Lady, were no crime . . .

—Andrew Marvell, To His Coy Mistress (c. 1650)

bouleversement\bool-vair-suh-MAWN\, noun:

Complete overthrow; a reversal; an overturning; convulsion; turmoil.

—Comes from French, from Old French bouleverser, “to overturn,” from boule, “ball” (from Latin bulla) + verser, “to overturn” (from Latin versare, from vertere, “to turn”).

Over the fall of 1975, Carl Icahn and his right-hand man, Alfred Kingsley, hashed out a new investment strategy in the cramped offices of Icahn & Company. Located at 25 Broadway, a few steps away from the future site of the Charging Bull, the iconic 7,000-pound bronze sculpture erected by Arturo Di Modica following the 1987 stock market crash, Icahn & Company was then a small, but successful, discount option brokerage with a specialty in arbitrage. Kingsley, a graduate of the Wharton School with a master’s degree in tax from New York University, had joined Icahn in 1968. Immediately impressed by his ability to quickly grasp complex transactions, Icahn had asked Kingsley what he knew about arbitrage. “Not a thing,” Kingsley had replied.1 Soon Kingsley was spending most of his days arbitraging the securities of conglomerates like Litton Industries, LTV, and IT&T. Arbitrage is the practice of simultaneously buying and selling an asset that trades in two or more markets at different prices. In the classic version, the arbitrageur buys at the lower price and sells at the higher price, and in doing so realizes a riskless profit representing the ordinarily small difference between the two. Icahn had Kingsley engaged in a variation known as convertible arbitrage, simultaneously trading a stock and its convertible securities, which, for liquidity or market psychology reasons, were sometimes mispriced relative to the stock. Litton, LTV, IT&T, and the other conglomerates had issued an alphabet soup of common stock, preferred stock, options, warrants, bonds, and convertible debt. As an options broker, Icahn used his superior market knowledge to capitalize on inefficiencies between, say, the prices of the common stock and the warrants, or the common stock and the convertible debt. The attraction of convertible arbitrage was that it was market-neutral, which meant that Icahn & Company’s clients were not subject to the risk of a steep decline in the market.

Icahn and Kingsley shortly progressed to arbitraging closed-end mutual funds and the securities in the underlying portfolio. A closed-end mutual fund is closed because it has a fixed number of shares or units on issue. Unlike open-end funds, management cannot issue or buy back new shares or units to meet investor demand. For this reason, a closed-end fund can trade at a significant discount or, less commonly, a premium to its net asset value. Icahn and Kingsley bought the units of the closed-end funds trading at the widest discount from their underlying asset value, and then hedged out the market risk by shorting the securities that made up the mutual fund’s portfolio. Like the convertible arbitrage strategy, the closed-end fund arbitrage was indifferent to the direction of the market, generating profits as the gap between the unit price and the underlying value narrowed. It was not, however, classic riskless arbitrage.

As it was possible for a gap to open up between the price of the mutual fund unit and the underlying value of the portfolio, it was also possible for that gap to widen. When it did so, an investor who had bought the units of the fund and sold short the underlying portfolio endured short-term, unrealized losses until the market closed the gap. In the worst-case scenario, the investor could be forced to realize those losses if the gap continued to widen and he or she couldn’t hold the positions, which could occur if he or she failed to meet a margin call or was required to cover the short position. Unwilling to rely on the market to close the gap, Icahn and Kingsley would often take matters into their own hands. Once they had established their position, they contacted the manager and lobbied to have the fund liquidated. The manager either acquiesced, and Icahn and Kingsley closed out the position for a gain, or the mere prospect of the manager liquidating caused the gap to wholly or partially close. The strategy generated good returns, but the universe of heavily discounted closed-end funds was small. Icahn and Kingsley saw the potentially far larger universe of prospects emerging in public companies with undervalued assets. This was the new investment strategy they were shaping at 25 Broadway in 1975.

Already moribund after a decade of stagflation, an oil crisis, and a failing U.S. economy, Wall Street was sent reeling from the knockout punch delivered by the 1974 stock market crash, the worst since the Great Depression. Out of the bear market punctuating the end of the Go-Go 1960s, the stock market had rallied to a new all-time high in early 1973. From there it was brutally smashed down to a trough in October 1974 that was some 45 percent below the January 1973 peak. (The market would repeat this wrenching up and down cycle until November 1982, at which point it traded where it had in 1966, fully 16 years before.) Stocks that had become cheap in 1973 had proceeded to fall to dust in 1974. Bonds, ravaged by runaway inflation, were described by wags as “certificates of confiscation.”2 Investors were still shell shocked in 1975. Even if they could be persuaded that they were getting a bargain, most seemed unwilling to re-enter the market, believing that undervalued stocks could start dropping again at any moment. If they would take a call from their broker, they simply wanted “the hell out of the market.”3

Although few could sense it, a quiet revolution was about to get under way. Icahn and Kingsley had seen what many others had missed—a decade of turmoil on the stock market had created a rare opportunity. After trading sideways for nine years, rampant inflation had yielded a swathe of undervalued stocks with assets carried on the books at a huge discount to their true worth. Recent experience had taught most investors that even deeply discounted stocks could continue falling with the market, but Icahn and Kingsley were uniquely positioned to see that they didn’t need to rely on the whim of the market to close the gap between price and intrinsic value. Kingsley later recalled:4

We asked ourselves, “If we can be activists in an undervalued closed-end mutual fund, why can’t we be activists in a corporation with undervalued assets?”

As they had with the closed-end mutual funds, Icahn and Kingsley would seek to control the destiny of public companies. Their impact on America’s corporations would be profound.

ICAHN’S WALL STREET REFORMATION

Icahn’s progression from arbitrageur and liquidator of closed-end funds to full-blown corporate raider started in 1976 with a distillation of the strategy into an investment memorandum distributed to prospective investors:5

It is our opinion that the elements in today’s economic environment have combined in a unique way to create large profit-making opportunities with relatively little risk. [T]he real or liquidating value of many American companies has increased markedly in the last few years; however, interestingly, this has not at all been reflected in the market value of their common stocks. Thus, we are faced with a unique set of circumstances that, if dealt with correctly can lead to large profits, as follows: [T]he management of these asset-rich target companies generally own very little stock themselves and, therefore, usually have no interest in being acquired. They jealously guard their prerogatives by building ‘Chinese walls’ around their enterprises that hopefully will repel the invasion of domestic and foreign dollars. Although these ‘walls’ are penetrable, most domestic companies and almost all foreign companies are loath to launch an ‘unfriendly’ takeover attempt against a target company. However, whenever a fight for control is initiated, it generally leads to windfall profits for shareholders. Often the target company, if seriously threatened, will seek another, more friendly enterprise, generally known as a ‘white knight’ to make a higher bid, thereby starting a bidding war. Another gambit occasionally used by the target company is to attempt to purchase the acquirers’ stock or, if all else fails, the target may offer to liquidate.

It is our contention that sizeable profits can be earned by taking large positions in ‘undervalued’ stocks and then attempting to control the destinies of the companies in question by:

a) trying to convince management to liquidate or sell the company to a ‘white knight’; b) waging a proxy contest; c) making a tender offer and/or; d) selling back our position to the company.

The “Icahn Manifesto”—as Icahn’s biographer Mark Stevens coined it—was Icahn’s solution to the old corporate principal-agency dilemma identified by Adolf Berle and Gardiner Means in their seminal 1932 work, The Modern Corporation and Private Property.6 The principal-agency problem speaks to the difficulty of one party (the principal) to motivate another (the agent) to put the interests of the principal ahead of the agent’s own interests. Berle and Means argued that the modern corporation shielded the agents (the boards of directors) from oversight by the principals (the shareholders) with the result that the directors tended to run the companies for their own ends, riding roughshod over the shareholders who were too small, dispersed, and ill-informed to fight back. According to Berle and Means:7

It is traditional that a corporation should be run for the benefit of its owners, the stockholders, and that to them should go any profits which are distributed. We now know, however, that a controlling group may hold the power to divert profits into their own pockets. There is no longer any certainty that a corporation will in fact be run primarily in the interests of the stockholders. The extensive separation of ownership and control, and the strengthening of the powers of control, raise a new situation calling for a decision whether social and legal pressure should be applied in an effort to insure corporate operation primarily in the interests of the owners or whether such pressure shall be applied in the interests of some other or wider group.

Berle and Means gave as an example the American Telephone and Telegraph Company (AT&T), which they said had assets of $5 billion, 454,000 employees, and 567,694 shareholders, the largest of whom owned less than one percent of the company’s stock:8

Under such conditions control may be held by the directors or titular managers who can employ the proxy machinery to become a self-perpetuating body, even though as a group they own but a small fraction of the stock outstanding. In each of these types, majority control, minority control, and management control, the separation of ownership from control has become effective—a large body of security holders has been created who exercise virtually no control over the wealth which they or their predecessors in interest have contributed to the enterprise. In the case of management control, the ownership interest held by the controlling group amounts to but a very small fraction of the total ownership.

Icahn cut straight to the heart of the matter, likening the problem to a caretaker on an estate who refuses to allow the owner to sell the property because the caretaker might lose his job.9 His manifesto proposed to restore shareholders to their lawful position by asserting the rights of ownership. If management wouldn’t heed his exhortations as a shareholder, he would push for control of the board through a proxy contest—a means for shareholders to vote out incumbent management and replace them with new directors. In a proxy contest, competing slates of directors argue why they are better suited to run the company and enhance shareholder value. If he didn’t succeed through the proxy contest, he could launch a tender offer or sell his position back to the company in a practice known as greenmail. A neologism possibly created from the words blackmail and greenback, greenmail is a now-unlawful practice in which the management of a targeted company pays a ransom to a raider by buying back the stock of the raider at a premium to the market price. Warren Buffett, who said of greenmail that it was “odious and repugnant,” described the nature of the transaction in his 1984 Chairman’s Letter in characteristically colorful terms:10

In these transactions, two parties achieve their personal ends by exploitation of an innocent and unconsulted third party. The players are: (1) the “shareholder” extortionist who, even before the ink on his stock certificate dries, delivers his “your-money-or-your-life” message to managers; (2) the corporate insiders who quickly seek peace at any price—as long as the price is paid by someone else; and (3) the shareholders whose money is used by (2) to make (1) go away. As the dust settles, the mugging, transient shareholder gives his speech on “free enterprise”, the muggee management gives its speech on “the best interests of the company”, and the innocent shareholder standing by mutely funds the payoff.

Icahn accepted greenmail on several occasions prior to it being outlawed, on one such occasion attracting a class-action lawsuit from the shareholders of Saxon Industries, a New York-based paper distributor that fell into bankruptcy following the transaction. The lawsuit charged that Icahn had failed to disclose to the market that he had requested greenmail in exchange for not undertaking a proxy contest. When Saxon Industries announced that it had paid Icahn $10.50 per share as greenmail, giving him a substantial profit on his $7.21 per share average purchase price, the stock fell precipitously. According to a lawsuit filed against Icahn, upon the sudden announcement by Saxon that it had purchased Icahn’s stock, the market price of Saxon’s stock nosedived to $6.50. While the bankruptcy of Saxon Industries was arguably more directly the result of its chairman Stanley Lurie’s accounting fraud, the complaint demonstrated two ideas: First, the inequity of greenmail. The substantial premium paid to the greenmailer comes at the cost of all shareholders remaining in the company. Second, the complaint illustrates the power of the activist campaign. Icahn’s threat of a proxy contest had pushed the stock price from around $6 to $10.50. Absent the possibility of a proxy contest, the stock fell back to its average pre-campaign price of $6.50.

While gaining control gave him discretion over the operating and capital allocation decisions of the company, Icahn’s experience with the closed-end funds had taught him a valuable lesson—simply calling attention to the company’s market price discount to its underlying and underexploited intrinsic value would attract the attention of other investors. He hoped that by signaling to the market that the company was undervalued, leveraged buy-out firms or strategic acquirers would compete for control and, in so doing, push up the market price of his holding. Icahn could then sell into any takeover bid by tipping his shares out onto the market or delivering them to the bidder. It was the classic win-win situation Icahn sought—even if he didn’t win a seat on the board, the proxy contest would act as a catalyst, signaling to other potential bidders in the market the company’s undervaluation and mismanagement.

Theory into Activism: Tappan Stove Company in Play

Icahn’s first target was Tappan Stove Company, a sleepy range and oven maker still chaired by a member of its eponymous founding family, Dick Tappan, almost a century after it was founded in 1881. Tappan stock was already depressed along with the rest of the stock market following the crash in 1974. It fell off a cliff when it posted its first loss in 40 years following a disastrous move into a new market for Tappan—heating and cooling—and a slump in its old home building market. Kingsley, who identified it as an attractive candidate, said:11

At the time we took our position in Tappan, everyone else was hot on Magic Chef, but I said, “The multiples on Magic Chef are too high. Where is it going to go from here? Magic Chef was at the top of its cycle and Tappan was at the bottom. That’s where I preferred to stake our claim.”

At Kingsley’s suggestion Icahn started acquiring the stock in 1977 when it was selling for $7.50 per share. He saw that Tappan, as a niche player in a market dominated by the likes of General Electric and Westinghouse, was an attractive candidate for strategic acquisition by one of those behemoths. With a book value of around $20 per share, Icahn figured his potential upside was around $12.50 per share, or about 170 percent. In what would become a typical Icahn analysis, he saw that the discount in the stock provided limited downside risk, and the potential for a significant gain if he could chum the waters enough to foment a takeover. Tappan made an ideal first target for his new strategy: If the coin fell heads, he would win big; if tails, he wouldn’t lose much.

Icahn built his position in Tappan through 1977 and then, in early January 1978, he and Kingsley placed a call to Tappan’s president, Donald Blasius, to alert him of their presence. Icahn told Blasius that he had acquired between 10,000 and 15,000 shares of Tappan and was considering making a “substantial additional investment.” Seemingly oblivious to Icahn’s overtures, Blasius noted in a subsequent memo to Dick Tappan, Tappan’s chairman, that Icahn “seemed pleased that we took the time to talk to them about the company.” In an effort to keep up the pressure, Icahn and Kingsley called Blasius again in late February, by which time they had acquired 70,000 shares of Tappan stock, to let Blasius know that Icahn was interested in Tappan for its potential as a takeover candidate. As he had after the first call, Blasius dutifully sent a memo to Dick Tappan in which he noted that Icahn had told Blasius that he “had made a lot of money in buying low-priced stocks that were in the process of turnaround. In some cases, the turnaround improved the value of the stock, but in other cases a buy-out was completed which approximately doubled the stock price.” Blasius further noted that “they consider [Tappan] a good possibility for this occurring, which is added incentive for their investment.”12

Icahn continued to build his holding in Tappan stock to several hundred thousand shares—a sizeable position, but still too small to require him to file a Schedule 13D notice with the SEC. The Schedule 13D notice lets the market know the intentions of a shareholder who owns more than 5 percent of a company’s outstanding stock and who proposes to undertake some corporate action, including a takeover, liquidation, or other change-of-control event. Icahn had hoped that his continued purchases might alert others to the situation developing at Tappan, including risk arbitrageurs—investors who bet on the outcome of takeovers—other potential strategic acquirers, and their investment bankers. In the 1980s, risk arbitrageurs with a position in a stock would often turn a rumor about a takeover into a self-fulfilling prophecy. Unfortunately for Icahn, the explosion of takeover activity that followed in the 1980s hadn’t yet kicked off and, in the absence of a 13D filing that might draw attention to Tappan, the stock languished for the next nine months.

Icahn opted to take matters into his own hands, setting up a May 1978 lunch between Blasius and Fred Sullivan, the chairman of the conglomerate Walter Kidde & Co., who owned a large block of Tappan stock. Icahn hoped that Sullivan might want to bolt Tappan’s stove business onto its Faberware division. He had, however, neglected to mention to Blasius that anyone else would be at the lunch. Blasius was enraged when he discovered on the morning of the lunch that Sullivan would be attending and, further, that he was interested in acquiring Tappan. At the lunch, Blasius made it clear that the company was not for sale. Taken aback, Sullivan told Blasius and Icahn that he wouldn’t entertain a hostile takeover, so the acquisition was a non-starter. Blasius’s post-lunch memo noted that Sullivan “understood that we were not for sale and, therefore, would not go any further. Then he added without any suggestion on my part, ‘If anyone comes along that you are not interested in, or you would like to come to a friendly port, we would be very happy to talk to you.’”13 If Blasius was relieved when he heard Sullivan say that he wouldn’t take the Tappan acquisition any further, Icahn heard that a Tappan acquisition was in the offing if he could find a buyer prepared to proceed on a hostile basis. Blasius’s memo also noted that “[Icahn] repeated that this was not an attempt to accomplish, or the beginning of a buy-out—that they felt the stock was undervalued at approximately $8 and had good growth potential. He also indicated that we should not be worried if a [13D] were filed as it would not be intended as the beginning of a takeover attempt.”14

Icahn stepped up his attempts to find a buyer for Tappan, but without success. He also continued buying Tappan stock. By late November 1978 Icahn’s position was big enough that he was required to file a 13D with the SEC, and Wall Street finally got the news that Tappan was “in play.” The stock surged and, in January 1979, Icahn let Blasius know that if the shares were to rise two or three more dollars he would be a seller. He also teased Blasius that an anonymous strategic acquirer had approached him to buy him out for between $15 and $17 per share. He reminded Blasius that Sullivan stood ready to serve as a “white knight,” a friendly acquirer who might retain existing management. Icahn viewed his shareholding as being large enough to qualify him for a tenth seat on the board to be created just for him, and said as much to Blasius. Blasius rejected the request out of hand. In Blasius’s memo to the board, he noted:15

I explained that our board was limited to nine members with only two being representatives of management and that the number had been fixed by the board either last year or the year before. I also gave him an outline of the board strength that I felt was represented and that I really believe we have an efficient board match—independent, very capable and doing a good job and that I, personally, saw no need or desire to add a tenth member.

The company, now fully apprehending the threat Icahn presented, moved to issue preferred stock in an effort to block any hostile interest. Icahn found out about the move along with the other shareholders. Said Kingsley, “We first learned of the serially preferred tactic through a proxy statement that came in the mail. As soon as I saw it I said, ‘If we’re going to do something, Carl, we had better do it now.’”16 The risk, as Kingsley saw it, was that the preferred stock could be used to derail any hostile tender offer. If Icahn couldn’t use his major shareholding as a catalyst to sell the company, much of his influence would be gone.

Icahn responded by launching a media campaign to defeat the preferred stock issue and have Tappan sold at full value. In the face of Icahn’s towering indignation, the board folded almost immediately, agreeing to withdraw its proposal for the issue. Icahn pressed on regardless. In an April 1979 letter to Tappan shareholders he argued for a seat on the board and the sale of the company at a substantial premium to the prevailing market price:17

I am writing this letter to ask you to elect me to the Board of Directors at the Annual Meeting of Shareholders on April 23, 1979. As the largest shareholder of Tappan, I would like to see our company acquired or tendered for at a price close to its December 31, 1978, book value of $20.18.

Channeling Berle and Means, Icahn argued that management was insulated from Tappan’s poor performance by their overly generous compensation package:18

During the past five years Tappan, under its current management, has lost $3.3 million on sales of $1.3 billion and during the same period [Dick] Tappan and [Donald] Blasius, Tappan’s Chairman of the Board and President, respectively, received salaries and bonuses totaling $1,213,710.

The letter contained a chart comparing Tappan’s earnings and Dick Tappan and Blasius’s salaries on an annual basis. Referring to the chart, Icahn said:19

If I personally owned a business with these operating results and which had a substantial net worth, I would certainly seek to sell that business. I believe the same logic should apply in the case of Tappan.

Taking advantage of any lingering doubts shareholders might hold about the motives of management, Icahn resurrected the specter of the withdrawn preferred stock issue. Saying that management had admitted that such an issue “might have the effect of discouraging some future attempt to take over the company by a cash tender offer or otherwise,” Icahn pledged that, if elected to the board, he would “discourage any such future proposals in their embryonic stages.”20

As a director of Tappan my first act will be to recommend that we retain an investment banking firm (unaffiliated with me) to solicit proposals from third parties to acquire our company at a price near its book value, which at December 31, 1978, was $20.18.

Although management has stated to me that they do not desire the acquisition of Tappan by another company, I assure you that, if I am elected, I will inform would-be suitors that at least one member of the Board does not share management’s views with respect to the acquisition of Tappan by another company. I will attempt to see to it that shareholders are made aware of any indications of interest or actual offers to acquire our company, which are received from third parties.

The letter had the desired impact, and Icahn won his seat on the board.

As a director, he moved quickly to sell Tappan’s assets. At the first board meeting he pushed for the liquidation of the company’s money-losing Canadian subsidiary, Tappan-Gurney, which owned valuable real estate in Montreal, and for the sale of Tappan’s Anaheim, California, factory. He also pressed on for the sale of the entire company, shopping Tappan to leveraged buy-out firms and strategic acquirers. Recognizing that Icahn had won, and would shortly find a buyer, management moved to find their own white knight. Tappan and Blasius met with the giant Swedish appliance maker AB Electrolux and offered Tappan up on a platter. Electrolux bit, bidding $18 per share. The bid delivered a $2.7 million profit on Icahn’s 321,500 shares, representing an almost 90 percent gain on his $9.60 per share average purchase price.

In a surprising move, Dick Tappan was so impressed with Icahn’s strategy that he subsequently became an investor in Icahn’s partnership:21

We held a final board meeting, at which time the directors approved the company’s sale to Electrolux. Icahn attended that meeting and sometime during the course of the evening I said, ‘Icahn has done us a favor. We got a 50 percent premium over the company’s market value, and Electrolux is going to make capital investments in Tappan.’ I said, ‘If you have any deals you want to cut me in on—’ That’s when Icahn said, ‘Yes, I have one going on now.’

And so Dick Tappan became a limited partner, investing $100,000 in the Carl C. Icahn Partnership. It would prove to be a great investment for the former chairman.

Tappan would become the template for Icahn’s later sorties. In Tappan, the theory outlined in the Icahn Manifesto