One of the investors we follow closely here at The Acquirer’s Multiple is Carl Icahn, and one of the best pieces ever written on Icahn’s investing strategy comes from Tobias Carlisle’s book, Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations. Carlisle illustrates how Icahn and Alfred Kingsley put together their audacious activist investing strategy. Here’s as excerpt from that book:
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.
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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.” 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.”
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: 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:
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.
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:
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.