Value” Misses Opportunities

Valeant might be in the news more of late, but one of Ackman’s most high profile positions might be Herbalife (HLF), about which he released details in a 342 slide presentation in late 2012. We highlighted the strengths of  Herbalife’s business in August 2013 and despite continued criticism, the company continues to counter each of Ackman’s claims, as well as investigations by the SEC. Instead of going to $0/share, as Ackman predicted, HLF increased over 144% in 2013 and remains up over 80% since Ackman first announced his position.

We noted the strength of Herbalife’s business in our report and the thesis hasn’t changed. Over the past decade, Herbalife has grown NOPAT by 15% compounded annually and increased its ROIC from 21% to a top quintile 32% over the same timeframe. Best of all, Herbalife remains undervalued. At its current price of $ 55/share, HLF has a price to economic book value (PEBV) ratio of 1.4. This ratio means that the market expects Herbalife to only grow NOPAT by 30% over the remainder of its corporate life. If Herbalife can  grow NOPAT by just 7%  compounded annually over the next decade, the stock is worth $80/share today – a 37% upside.

Activist Investors Should Play A Positive Role… But They Don’t

There is no shortage of targets out for activist investors that truly want to unlock long-term value. Many companies have  misguided executive compensation plans that push management towards acquisitions and other activities that destroy shareholder value. Just look at how misaligned executive compensation plans helped push profitable Men’s Wearhouse (TLRD) into the  disastrous acquisition of Jos. A. Bank.

Activist investors have more opportunity than ever to push back against misaligned executive compensation plans. The  Dodd-Frank Act in 2010 requires all companies to allow “Say On Pay” votes where shareholders can make their voices heard on executive compensation.

We’d love to see activist investors with the resources to take on big companies make a push to better align executive compensation with long-term shareholder value. We have compelling proof in the form of AutoZone (AZO) that linking executive compensation to ROIC can help companies  deliver market-beating returns.

Unfortunately, activist investors seem to be going the opposite direction.  Between 2009-2014, fewer activist campaigns targeted issues surrounding executive compensation and corporate governance. Instead, activist investors radically increased their demands for buybacks, spin-offs, acquisitions, and other feats of financial engineering.

Activist investors also seem to be taking a short-term on their investments.  84% of all activist investments last less than two years, according to FactSet.

The good news? These types of activists have  underperformed this year. Ackman has led the pack downward. Even before Valeant dropped 50% in March, his losses in 2015 and 2016 had  already erased any gains he made in 2014.

Maybe this underperformance will push activist investors away from the financial engineering and towards more substantive changes that truly benefit shareholders.

Until then, don’t listen to activist investors claiming they can unlock value unless they articulate a  focus on ROIC  and long-term cash flows. Look past the typical noise and focus on fundamentals. Find companies that consistently generate profit, earn a quality return on invested capital, and have a stock price where  expectations for future cash flows are low.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

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