How to Crush the Market by Following Billionaire Activist Investors

As the mainstream press has repetitively told you, most Hedge Funds and Mutual Funds underperformed the stock market in 2012. There was a sector of funds, however, that crushed the market. The sector: activist hedge funds.

Daniel Loeb’s Third Point Capital, which manages $9.3 Billion, returned 33.6%. That’s more than double the S&P 500’s 13.6% return. JANA Partners, another billion dollar activist hedge fund, returned 33.3% in 2012.

The fact is, activist hedge funds have crushed the market over the past six years. According to alternative investment consultant, Cliffwater, a group of the largest billionaire activist hedge fund managers returned 9.6% versus a 1.5% return in the S&P 500 over the same time period. But this group of activists didn’t just beat the overall market by more than SIX times, they did it with a lot LESS RISK than an investor would have endured investing in the S&P 500 alone.

So how do activist hedge fund managers achieve this incredible outperformance?

First, they act like private equity investors. By that, I mean, they buy companies. They don’t trade stocks. By definition, activists acquire more than 5% of a company’s stock — an amount the SEC deems to be a controlling interest. In fact, when any investor or institution acquires more than 5% of a company’s stock, they are required to file a 13D form with the SEC — a disclosure, for public record.

Activists typically take such large positions in companies because they WANT control.

Second, like private equity investors, activist hedge funds are concentrated. They tend to own less than 15 stocks in their portfolio, even though they manage billions of dollars in their fund. That makes every position in their portfolio, very important to their success.

Third, activist investors act like consultants. They usually attach a letter or strategic plan to their 13D filing. This usually details a plan on how to turn the company around, and/or proposes various strategic actions they would like to see the company implement. These actions might include a stock buyback, a special dividend, an asset sale, and/or even a sale of the company itself.

Of course, as a large shareholder, these activist measures are targeted to be very shareholder friendly, with the goal of creating a change of sentiment on the stock.

According to an academic paper out of NYU, the average target company of an activist over a 15-year period (up to 2006) had an excess return, over the stock market, of 5% one-month after the activist filed a 13D or announced their 5% ownership.

This outpeformance occurs for two reasons. First, many individual investors and traders like to piggyback these investors, creating demand. And second, anyone who is short the stock usually covers their position knowing that the activists will bulldog their way to creating value in the stock.

Now, activists do a ton of homework! Many activist hedge funds do as much as six months of research before they initiate a position. This research includes everything from talking to competitors, vendors, analysts, consultants and more.

Bottom line: Activists have a competitive advantage over other investors. They have control.

Piggy-Backing Activists
What’s in it for the average investor?

Because activist investors are long term investors, that acquire huge chunks of a company’s stock, they cannot easily sell their position quickly. And because they take such large positions, they are required to disclose these positions to the SEC (which becomes public record). This makes it very easy for every day investors to follow the lead (i.e. piggy-back) these large, influential investors.