I’ve thought about this problem before, but always thought it was more of a curiosity until I read this on page 66 of Jeff Gramm’s very good book, Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism. (Note: anyone entering through this link and buying something at Amazon, I get a small commission.)
I saw Eddie Lampert, a hedge fund manager who is chairman of Sears Holdings, make some interesting points at a New York Public Library event in 2006. When he was discussing the challenges of managing a public company, he raised a question few people in the room had considered. How do you run a company well when the stock is overvalued? What happens when management can’t meet investors’ unrealistic expectations without taking more risk? And what happens to employee morale if everyone does a good job but the stock declines? Lampert, of course, knew what he was talking about. Sears closed that day at $175 per share versus today’s price of around $35. In an efficient market, it’s easy to develop tidy theories about optimal corporate governance. Once you realize stock prices can be totally crazy, the dogma needs to go out the window.
The price of Sears Holding is around $13 now, though there have been a lot of spinoffs. Could Eddie have done better for shareholders? Before answering that, let’s take a simpler example: what should a the managers/board of a closed end fund do if it persistently trades at a large premium to its net asset value [NAV]? I can think of three ideas:
1) Conclude that the best course of action is to minimize the eventual price crash that will happen. Therefore issue stock as near the current price level as possible, and use it to buy non-inflated assets, bringing down the discount. What’s that, you say? The act of announcing a stock offering will crater the price? Okay, good point, which brings us to:
2) Merge with another closed end fund, trading at a discount, but offering them a premium to their NAV, hopefully a closed end fund related to the type of closed end fund that you are. What’s that, you say? Those that manage other closed end funds are financial experts, and would never agree to that? Uhh, maybe. Let me say that not all financial experts are equal, and who knows what you might be able to do. Also, they do have a duty to their investors to maximize value, and for those that sell above net asset value this is a big win. In the meantime, you have reduced your effective economic discount for those that continue to hold your fund.
3) Issue bonds or preferred stock convertible into common stock at a level that virtually guarantees conversion. Use the proceeds to invest in your ordinary investment strategy, bringing down the effective discount as dilution slowly takes place.
Of all the ideas, I think 3 might work best, because it would have the best chance of allowing you to issue equity near the overvalued level. If the overvaluation was 50%, maybe you could get it down to 25% by doubling the asset base, in which case you did your holders a big favor. If it works, maybe repeat it in two years if the premium persists.
A closed end fund is simple compared to a company — but that added complexity may allow strategies one or two to work better. Before we go there, let’s take one more detour — PENNY STOCKS!
Okay, I haven’t written about those in a while, but what do penny stock managements with no revenues do to keep their firm alive? They trade stock at discount levels in order to source goods and services. This creates dilution, but they don’t care, they are waiting for the day when they can exit, possibly after a promotion. Also, they could issue their stock to buy up a small firm, adding some value behind the worthless shares. One guy wrote me after my penny stock articles, telling me of how he foolishly did that, with the stock being restricted, and he watched in horror as the price sank 60% before he was allowed to sell any shares. He lost most of what he worked for in life, took the company to court, and I suspect that he lost… it was his responsibility to do “due diligence.”
So with that, strategy one can be to issue as much stock as possible as quietly as possible. Offer your employees stock in order to reduce wages. Give them options. Where possible, pay for real assets and services with stock. Issue stock, saying that you have big plans for organic growth, then, try to grow the company. In this case, strategy three can make more sense, as the set of buyers taking the convertible stock and bonds don’t see the dilution. That said, the hard critical element is the organic growth strategy — what great thing can you do? Maybe this strategy would apply to a cash hungry firm like Tesla.
In strategy two, merge with other companies either to achieve diversification or vertical integration. Issue stock at a premium to the value received, but not not as great as the premium underlying your current stock price. Ordinarily, I would argue against dilutive acquisitions, but this is a special case where you are trying to reduce the premium valuation without reducing the share price.
This brings us to another set of examples: conglomerates and roll-ups. Think of the go-go years in the ’60s where conglomerates bought up low P/E stocks using their high P/E stocks as currency. Initially, the process produces earnings growth. It works until the eventual bloat of the businesses is difficult to manage, and the P/Es fall. Final acquisitions are sometimes ugly, leading to failure. The law of decreasing returns to scale eventually catches up.
With roll-ups an aggressive management team buys up peers. The acquirer is a faster growing company, and so its stock trades at a premium. If the acquirer is clever, it can shed costs in the target, and continue to show earnings growth for some time until it finally slows down and has to rationalize the mess of peer companies that have been bought.
This brings up one more area for overvalued companies: frauds. This past evening, my wife and I watched The Billion Dollar Bubble, which was the largest financial fraud up until Madoff. One thing Equity Funding did was use the funds that they had generated to buy other insurers. (That’s not in the movie, which kept things simple, and compressed the time it took for the fraud to take place.)
Enron is another example of a fraudulent company that used its inflated share price to buy up other companies. Not everything Enron did was fraudulent, but having a highly valued stock allowed it to buy up companies with assets which reduced some of its valuation premium, though not enough for the stock to go out at a positive figure.
It is an unusual situation, but the best strategy for a company with an overvalued stock is to try to grow their way