#56 - Adam Katz: Activist Investing Insights

26:31And he'd wait for those mutual funds to go and start buying it. And now, because of passive flows, because of ETFs, whatever it may be, that process of discovery does not happen in the same way. And I think Cliff Asnes, from a more quantitative perspective, maybe top-down looking at different trends, has also sort of written some stuff lately about the challenges in markets and the ways in which markets might not be as efficient as when he started his career. And I think what we've – what I think maybe sets us apart is we just decided we're going to make stuff happen. And the universe of firms that actually make stuff happen as opposed to, say, just picking stocks, I think is reasonably small.

27:06And I think that's what sets us apart. One, the willingness to make stuff happen. Two, both the knowledge and ability to operate across the capital structure, I think, are probably our defining characteristics. So you just brought this up that most investors are passive. They buy and they wait. So at a high level, would you talk about how you add value to the companies in which you invest? How can a company be improved? One question, right? And if you think about, there are probably four or five, let's use four or five different categories. One category is you can improve the operational performance of the business, right?

27:41The operating margins of the business might be lower than it should be based upon benchmarking to peers that operate in the same industry, right? So you might be earning 15 % EBIT margins as opposed to 20 % or 25 % that your peers are earning. And maybe that's because you price your product incorrectly. And maybe that's because you have too many facilities and you've got to consolidate facilities. Maybe that's because you have a bloated workforce and you need to cut costs, whatever it may be. So there's improving the operating performance of the business. And what we do in our investments is we bring in, almost like private equity does, we bring in an operating partner, somebody from industry who helps us diligence the investment, diligence the business, and actually helps us put together a performance improvement plan for the company in which we're invested in.

28:21And so that person will help us figure out, okay, can we actually improve those operating margins? If we're going to improve those operating margins, how are we going to do it? Right. So those are that's you know, that's one operational improvement. It's one area. Second area might be capital allocation. You might have a business that's operated really well day to day, but they don't allocate capital all that intelligently. So they take the free cash flow of business and then they they spend it on the pre-cap ex, let's call it pre-R &D cash, free cash flow of business. and then they spend it on unnecessary capital expenditures.

28:49They spend it on wasteful R &D. They go out and do poorly considered, poorly thought through M &A, value destructive M &A. It's very common. There are a variety of different ways in which capital allocation can potentially be improved in a company. That's a second area. A third area can be just corporate governance. This is a company where the board doesn't have the right skill set to actually steer the company for the long run. There can be ways in which the company might have a dual class share structure and then trade at a discount as a consequence. The company might be incorporated in a jurisdiction, unlike Delaware, that is an expanded constituency state and trades at a discount as a consequence of that.

29:24There may be a variety of ways in which you can improve the corporate governance. It might be a staggered board and you move to a de-staggered board. That's one where shareholders can sort of elect the board each year as opposed to a subset of directors each year. There are a variety of ways you should improve the corporate governance of a company. The fourth area in which it sounds kind of soft, but we see a lot, is investor communication. actually communicating to investors, communicating to market participants. This is what we do. This is how we do it. This is why we're compelling an investment opportunity.

29:50This is why you as an investor should entrust your capital to us. Those are kind of four different buckets in which to think about how we improve a company. And it's obviously highly situation specific, right? So it's not like we have, okay, we always do X, we always do Y, we always do C. What I would say is it's rare for us, and I think we generally try to avoid situations that require a change in management to achieve the improvements that we seek. And the reason for that is pretty straightforward, which is, I think there's a mistake that is made off an outside looking at what people like me, activist investors do.

30:35We're not in the fighting business. Our job is not to go out and get into fights with companies. That's not what we want to do. That's not what we like to do. And I'd prefer if we were never in the newspaper. I would prefer if we never had to run a proxy. I'd prefer if none of that ever existed. Our job is to go out and make money. Our job is to go out and produce performance improvements that actually produce compelling returns for our investors. And the easiest way to get into a fight with a company is to sit down and sit across the table from the CEO. And you say to the CEO, he or she, you say, Mr.

31:04CEO, the way we're going to improve this company is by changing the CEO. Usually the CEO doesn't like when you say that. So we try to avoid those situations. I should add a fifth, and I think this is an important one. It's a big part of what we do, and I shouldn't have caused it. It would change maybe the organizational structure of the company. Maybe the company should be split apart. Maybe it should sell a division and sell some assets. Sometimes a company may be one thing. I'm talking about this about smaller companies. Sometimes a lot of these smaller companies shouldn't be public companies in the first place.

31:34These companies, it's unlikely that they're ever going to be appropriately valued in public markets. That's fine. And so if that's the case, the company should consider going private. So those are, I would say, the five different ways we can affect, we tend to try to affect change in a company. I like to double click on one of those items that you just mentioned, which I think was number four, this idea of clearly articulating the strategy and the approach. And I think that kind of goes back to this notion of, if you can be clear in your thinking and your understanding, clear in your writing, clear in your speaking about what the goal is.

32:08And usually that's at a higher level. I feel like so much of that is often missed because people are focused on the details. They're too zoomed in. And sometimes you have this experience of a fresh set of eyes comes in and see something. I view that as they're properly zoomed out and they see what the vision is and they can clearly articulate. It's such an important aspect of all this. I couldn't agree more. I think it's funny we're doing this in an interview type or conversation type format. I mean, I personally prefer writing. I mean, I think our view is clear writing is evidence, maybe necessary, but not sufficient evidence of clear thinking.

32:44We have a very written culture at our firm. We try to do a lot of things in the form of written communication, written memos, written letters to the companies in which we're invested in. So we're a very writing oriented firm. I think just to go through on your question, I think you'd be surprised, or I think most people, maybe you wouldn't be surprised, but most people would probably be surprised if you went to the CEO of a publicly traded company. And then you went to the board of directors and said to each person, hand them a piece of paper. And you said, can you write one page on how your company creates value for the owners of the company, the shareholders?

33:17I bet you a good number of them couldn't do it. What are the competitive advantages of your business? you know and and or they couldn't do it without writing a bunch of kind of corporate jargon and all that but couldn't like in very clear simple basic prose tell you how do you make money how do you create value for your owners why do you think that is i think it's what you said which is you get you get focused on you know if you're a ceo you think okay i'm hired by the board to do a job and that's not i mean anybody who owns a business doesn't think themselves as if you're a business owner you're on a small business you're a uh you're an entrepreneur who's built a business you don't think so i am my job is to run the company no your job you own the business your job is to create value at the enterprise that's your job right and i i think but most of you say okay i'm hired by the board i'm hired by the board to do a job my job is to increase the you know revenue of the business my job is to uh you know increase the your ebda of the business the earnings of the business or my my you know my job mostly is not to get fired.

34:16So that means hitting my quarterly earnings estimates every quarter. Those are the kind of things that most CEOs think about day to day. It's understandable. This is not because these CEOs aren't smart. It's not because they're not capable. It's not because they're not thoughtful people. It's just the pressures of the job are immense. And the day-to-day demands of the job are immense. So I think one is maybe if I break it down, I'll probably try to make this as clear as possible. One would be there's a psychological thing about how CEOs approach the job. They're doing a job as opposed to owning a company, one.

34:54Two, and this, by the way, is true of the board, members of the board, too. I think a lot of board members view themselves as being their job is to be a good director as opposed to be a good owner. Okay, so that's one. Two, I'd add the incentive structures for CEOs and for executive teams are often not necessarily aligned with the ways in which value can be created for shareholders. That's another way in which we can often improve companies by increasing the alignment around value creation for shareholders with the ways in which the executive team gets paid.

35:27So one, psychology. Two, incentives. Three, I'd just say the day-to-day demands of the job.

35:36If you're running a business, there's usually a crisis every day. And then you've got, on top of which, you've got public markets, you've got a quarterly cadence. So you're quartering every quarter. You're worried about how people can react to that, how are analysts going to react to that. So I think those are probably three things, sort of psychology, incentives, and just natural sort of day-to-day demands are the reasons why. What you're saying makes sense to me in that if you can identify and clearly articulate and execute creating value for the owners, then that should benefit everybody. and you can mess that up in a lot of ways.

36:14So it sounds like a lot of what you're thinking and your perspective is you see the gaps in creating value for the owners and you come in and try to execute that. And I guess a lot of it has to do with convincing everybody involved that this is the way it should be approached. Yeah, I think that's exactly right. And look, some of these things, right? I mean, I don't, there's a larger conversation, But I think that we haven't quite figured out how to appropriately pay executive teams and public companies. I mean, I think the way in which I think that if you look at there's a reasonably linear relationship, let's call it, a high correlation between the size of a public company and the compensation of the CEO.

37:00It's not obvious that that should be the case. And certainly that in and of itself generally creates a misalignment of incentives. Okay, maybe a company should get smaller. Maybe it's really good. Maybe it's got five divisions, and it's great. It's really well positioned in two of those divisions. It's competitively advanced in two of those divisions. It earns compelling returns of capital, can deploy incremental capital at high rates return in those businesses. But the three other ones, it should maybe just sell those three businesses. It should exit those three businesses. But then the CEO is running a much smaller company, and then maybe the compensation of that CEO goes down.

37:30I mean, maybe the ways in which we compensate the CEO generally in terms of, you've got to go read the proxy. And it's like reading a proxy is like it's this Byzantine kind of thing to try and figure out, OK, how is the CEO actually paid? There's an annual incentive plan, an AIP. There's an LTIP, a long-term incentive plan. And then the long-term incentive plan is around these four different metrics modified by this TSR metric modified by these board qualitative assessments. It's just it's a mess. And I don't think we've quite figured out how to create good alignment and proper alignment necessarily between public company executives and their shareholders in terms of creating long-term value.

38:06And that's an ongoing challenge. And look, that makes sense. I mean, basically, it's the broader principal agent problem that we consistently are trying to solve when you have a distributed shareholder base run by a concentrated management team. Also, you have a stock price that people look at every second. and that that drives more short-termism than it does long-term you know perspectives of creating value absolutely but i think the funny you know that's a one of the things that there's a uh i love this you know all the on the defense side and uh defense being that the advisors the law firms the bankers that advise companies when dissonant shareholders like us or an idea shareholders like us get involved uh they always say they always talk about guys like me as we're the short-term ones.

38:51We're short-termists and all that. And I think the most short-term person on the planet is sort of the CEO or is the management team, okay, when there's a heck of a shareholder involved. They're focused on the stock price. They're hyper-focused on the stock price day-to-day. We're not, actually. And I've been surprised, negatively surprised by how focused boards and management teams are on the day-to-day share price. I mean, we often just take us to back, or we constantly are telling companies, just do the right thing. If you think something's going to create value, just do the right thing. It's also a weird thing, too, because I think management teams tend to have this markets will figure things out.

39:29They think that, oh, if you can do something in the short run that makes things look better in the short run, markets won't see through that. Markets tend to see through that kind of stuff, and vice versa. If you have to take some pain in the short run for long-term benefit, markets, too, can sort of look through that and price appropriately. So we're always telling companies just do the right thing. It's so interesting. you know, if I'm an observer of this conversation that doesn't know much about the markets, there's a lot of parts of it that seem quite counterintuitive. So you're an outside investor coming in and you recognize that predicting the future is hard.

40:03So you want to hedge out the market risk. Whereas the people managing the company, they theoretically have more control over the outcome, but they're more focused on the things that they can't control. And they're driven by the things that they can't control. You know, the market price that changes every second. Yeah. It's also a funny thing too, or they're driven by the market price that change every second, which they can't control. And yet in many cases, boards and management teams own very little stock. So it's, but it's the stock price is viewed as this like day-to-day scorecard in terms of how they're doing.

40:34So it's coming slower. I've heard you talk about having an owner's mindset and you touched on that a little bit. Would you delve into that a little more? I mean, it's just this. It's thinking about what are the actions in any given situation that are going to maximize the value of the enterprise for its owners. And that's how a company should be run. Our job is to make MPB positive decisions at companies and not worry about all the other kind of noise that's out there in markets and press and all that kind of stuff. That's easier if you're running a private company, but it shouldn't be really different from a public company.

41:14Yeah. I mean, I think that's, I think the basic insight, I think that the private equity firms have done is they've tried to collapse some of the principal agent problems that exist, right? By getting essentially closer, by collapsing ownership and control, the distinction between ownership and control, right? So, you know, it's obviously not the PE partners that are running the companies that PE firms own, but generally it's the PE partners that sit on boards of the companies they own. Whereas by contrast, in a public company, you've got a public shareholder base, the shareholders elect the board, then the board then picks the management team.

41:44And the misalignment sort of occurs, the sort of board picking the management team and the board members not necessarily being fully aligned with the shareholders. And so the P guys try to collapse that distinction between ownership and control. But in theory, there should be no difference between the way a CEO approaches running a business that's a public company versus running a business that's a private company. what's value maximizing in a private context is no different than what's value maximizing in a public context. I mean, the number of times I've had executives say to us, well, if I do this, the market's going to hate, you know, it's the right thing for the company to do, but the market's going to hate it.

42:15And we're like, no, the market's fine. The market will be okay. Just explain it. Explain why it's great value, why it's a good decision, why it's thoughtful, why it makes sense, why it's an NPV positive decision, and the markets will understand it. And, you know, So that advice is often hard. That doesn't necessarily come, it's not all that successful. In your experience, how common is it to find public companies that are operating relatively inefficiently? I think the universe of public companies that are operating inefficiently is vast. I think the question or the massive, there's tons of them.

42:49I think the tricky part for us is not necessarily finding companies that are operating inefficiently. It's finding situations where we can make a difference, right? And so, and then that, there's a variety of considerations. It's one, you know, what is the type of change that needs to happen at this company? And are we in well-positioned to help that company affect that change? Two is, you know, given the nature of the shareholder base, given the nature of who owns this company. You know, remember, ultimately, any sort of, we're talking about equity activism, put aside credit for a minute. Any change that we make is ultimately about the power to persuade, right?

43:23Because basically the nature of securities laws in this country, right? Generally, you file a 13-D when you get to 5 % of the ownership of common stock of a company. You're subject to short-term profit rules at 10%. You're generally owning, if you're a shareholder like us or even a big firm like an Elliott or Bill Ackman or Carl Icahn, they're just operating in bigger companies than we are. But we own 3 % to 7%, 8 % of a company. We don't own – we can't force anybody to do anything. So we have to persuade the management team. We have to persuade the board of directors. We have to persuade other shareholders that we are correct in sort of what we think this company should do to create value.

43:56So question one is sort of what change does a company need? Or question two is are we well positioned to sort of affect that change? Three, do we know something about the change that has to happen? Are we intelligent and thoughtful about that change? Question three would be are given the nature of the shareholder base, given the nature of the matchmaking board, Or are we well positioned to make that change happen or to persuade the necessary folks of the merits of that change? And then fourth and probably the most important question, and by the way, it's a question that we start everything with, is putting aside all the things we want to do to this business, is this a compelling investment?

44:34Are we buying a business that we actually want to own? Because I think one of the challenges when you're in my job, I don't want to say it's like every year, when you've got to hammer everything, it looks like a nail kind of thing. But one of the challenges that I think – one of the ways in which activists or engaged shareholders tend to screw up, tend to mess up. Andy and I spent a lot of time thinking how do we screw – I mean I think it started this about our partnership. How do we mess this up? How do we blow up? What are the ways in which we get it wrong? And one way that we have seen activist investors like us get it wrong is just because something can be fixed doesn't mean you should spend your time trying to fix something.

45:10It doesn't mean maybe it's a business that's in a broken industry. Maybe it's an, you know, the number of, give you an example, you know, the number of investors that over the years, and not to say that there's not money to be made here in some way, but certainly not for us, that over the years have tried to go in and take positions in department stores, for example, okay, and go and try and, you know, fix department store chains, okay, or monetize the real estate department store chains, or all these other different ways in which people have tried to make money in department stores. and it's just and and i don't know if any of those have actually worked i mean you might know better than i do but it seems like that's just a really really hard way to make money uh and so what we've got to do before we even do all this stuff about you know what you know the the changes that are necessary our ability to affect that chain or ability to persuade all that which is this is a business that we actually want to own at a price that we want to own it and only if we can answer that question in the affirmative do we even get to the other questions about our ability to produce change.

46:01With as much detail as you're comfortable, could you provide any examples of how you've successfully improved companies in the past? Yeah. I mean, we've been involved at everything from a biotechnology company where we've encouraged that company to monetize a number of assets at that company that were under monetized. And we put an independent director in that boardroom and worked with that company to actually get two shareholder representatives at that company. And that company's in the process of cutting unnecessary costs, monetizing some assets and returning capital to shareholders. I've recently sat on the board of aerospace, kind of a subscale aerospace and industrial conglomerate that was overlooked in the public markets that's ultimately decided to sell itself to a private equity sponsor.

46:43We've been involved in a media business that owns a hodgepodge of assets, let's call it really good, high-quality assets, but kind of an unwieldy collection of assets. And we've been encouraging that company to sell some of those assets to split itself up in various ways, and it's in the process of undertaking a strategic review. We're involved in a healthcare services business where we're trying to reset the compensation structure for the executives in a way that better aligns the executives with the sort of value creation for shareholders. That's great. Now, do you feel that being a smaller investor, obviously there are some advantages, but are there some challenges as well?

47:21I think if you'd asked me that question a decade ago, I would say to you that the challenge is it'd be extremely difficult to do what we do, this engaged investing, non-investing, without bringing a lot of resources internally into the firm and bringing in terms of lawyers and PR folks and bankers and advisors and all sorts of people around these engagements. Over the past decade, decade plus, there's been the engaged investing, active investing world. There's been like a real cottage industry that has developed. And there is now a robust network of law firms, advisors, bankers, academics who are operating in this universe.

48:05And we can tap into those folks on an as needed basis. And so I think a lot of the disadvantages that existed as recently as even seven, 10 years ago have gone away. What would you say are the biggest challenges and opportunities in activist investing over the next five to 10 years? It's going to be really interesting. I mean, one ongoing question is going to be, how does the shift in assets from actively managed mutual funds to passive ETFs, how does that affect corporate governance in America? I think one of the most under-discussed things is there has been a quiet revolution where, if you look at a US-listed index-included company today, five out of the top five shareholders, certainly the top 10 shareholders, it's probably Vanguard, BlackRock, State Street, probably in that order.

48:58And that wasn't necessarily the case a decade ago. We've all seen these charts where it's passive flows are up and to the right, and active flows are sort of down to the right. And that doesn't seem like there's any sign of that changing necessarily. Right. So you're going to find yourself in a world where, you know, you know, corporate America is essentially owned by these big passive, you know, these passive giants. And how are they going to wield that power? John Coats, who's a professor in Harvard Law School, has written an interesting book. I think it's called The Power of Twelve. I think it's The Power of Twelve about how these organizations wield their power in the marketplace.

49:31So I think that's an ongoing question. I don't know if it's a pro. I don't know if it's a con. I think it's just an ongoing question as to how we navigate a world that is increasingly dominated by those three institutions in particular, but certainly that's just broader flow into passive investment strategies. So that's sort of one. I think, too, it's going back to this conversation about David Einert said, the universe of companies that are two, three,$4 billion companies. I mean, it's amazing to me. You have two, three,$4 billion companies. They're covered by one, two, sell-side analysts. Right?

50:00So it's also that being the investment research. I know you know this, but the investment research shops that put out research. So they're covered by one or two South Sudanels. Often these companies, their shares, they don't trade all that much. They'll trade 50 basis points in the market cap every day. And so the coverage on the buy side is a consequence of the limit of liquidity. That's also increasingly thin in terms of that coverage. I mean, there's a massive opportunity in these companies that probably shouldn't be public companies. probably have various ways that they could be improved even as public companies.

50:34They're just overlooked. So I think the universe of everybody's focus, right? Look, the S &P 500 was, I mean, you know, the S &P, I think last year was up 25 or so with dividends reinvested, I think it was S &P 500. The S &P 500, I think equal weight, correct me if I'm wrong about this, was up maybe 14 % equal weighted, right? So not capitalization weighted, but equal weighted. And then the S &P 600 small cap index, I think, was up 8.5%, 9%, if I'm not mistaken. So, I mean, beneath the surface of the extraordinary performance of a handful or two handfuls or so of securities, there are, I think, a number of companies that are increasingly undervalued, increasingly under-followed, increasingly ones that are attractive for us to make an investment catalyzed in positive change.

51:19So Adam, if you were to look back on your career so far, what would you say are the most valuable learning experiences or even the biggest mistakes that you've had? The biggest mistake and most valuable learning experience often go hand in hand, right? But when I was at LA, we were involved in the separation of what was then Alcoa Inc., the sort of broad integrated business into three companies, Alcoa, Arconic, and Howmut Aerospace. and I think we initially got, we had a thesis about the operating performance of the business being improved, but probably needed a management change at the business.

51:56And it took us a number of, took us multiple shots on goal, let's say, until we got the right CEO in place to do the management change. And that CEO, who now is running HowMed Aerospace today, who's an extraordinary CEO, a remarkably talented guy named John Plant. If you look at the returns to HowMed, it's been exceptional, but it took us a number of times to get the right person in John into that seat. And so the lesson that I take away from that is that, one, initially we had to have a proxy contest with Alcoa, with Arconic, initially to sort of get the first initial management change. So one was that lesson of, hey, if you want management change, you're often going to end up in a fight.

52:36That's one. Two, picking CEOs is really hard, really, really, really hard. And so I try to avoid, even if we're successful in advocating for change in management, I try to avoid situations where we have to change management. That makes sense. So Adam, the last question I'm going to ask you is, what is a contrarian view that you hold about markets or investing that you feel that most of your peers may disagree with? I think markets are pretty darn efficient, which doesn't sound all that contrarian. Well, today it's more contrarian. Right. But meaning, obviously, we've had this discussion about Einhorn and Cliff Adams and all these people saying markets are less efficient than they used to be.

53:14And I think that's very possible. And I think that's increasingly true. But I think broadly, I mean, look, one, one, the state, the obvious, right? You. I don't believe and the reason I say that that was a bit of a flip answer in some sense of saying, hey, I think markets are efficient. But I think certainly, you know, there are a lot of folks who spend a lot of time trying to figure out who think that they can. that the analyst, he or she, can have a better view on, say, NVIDIA's earnings power in five years or Microsoft's earnings power in five years or Apple's earnings power in 10 years or what the terminal value of Google is.

53:47I have no idea how anybody can be convinced that he or she has a better ability to predict the terminal value of those companies or the earnings power of those businesses in five, 10 years than the next person. I certainly don't think I can. I'm certainly not smart enough to do that. And so that's what I believe. And there's a lot of capital, a lot of investment, a lot of dollars managed by very, very, very smart people devoted to trying to figure that out. And I just don't think I have that. I have a hard time understanding how people believe that they can figure that out. Well, you can be fooled into believing that by guessing right and then the market confirming that you're right and then attributing skill to that rather than luck.

54:27Yeah, I think that's right. Well, Adam, I really enjoyed that conversation and I hope our audience did as well. Thank you for joining me. Great. Thanks, Alex. Really appreciate the time. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes. And don't forget to forward today's conversation to others you think would enjoy listening.

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