Notes on Dear Chairman, by Jeff Gramm

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General commentary by the author:

• Small caps, where the author spends a lot of time investing, can have “abysmal” corporate governance.
• Icahn draws a lot of flak, but the author contends, “The longer I’ve been a professional investor, the more I relate to Carl Icahn’s complete lack of faith in public company management teams. Why give them time to screw things up when you can engineer a quick profit for yourself and other shareholders by selling the company?”
• On the other hand, short-termism from activist investors can also be detrimental.
  • Gramm gives an example of a time when a new CEO arrived to an unnamed consumer company with superior brands. The company had a cash pile and a lot of untapped avenues for growth, including expanding internationally, and the author highlighted this in a letter to its board. However, when he observed other investors interacting with the company, they pushed for all manner of cash deployment other than reinvesting in the business.
    • The company appears to be Kenneth Cole Productions (ticker: KCP). Gramm posted the letter he wrote to KCP’s chairman here.
  • KCP decided to continue with its plan to go private, and Gramm said, “I couldn’t really blame them.”
• Mgmts will occasionally play down the value of their businesses to investors:
  • “This is a rite of passage for value investors—holding on to a position even after people with more information tell you how you would sell the stock if you only knew what they knew.”
• Constructive activism is difficult to implement, since the few key decisions that significantly affect a company’s future will require disagreement with mgmt.
• The author addressed his first activist letter to Denny’s in 2004, while at Mellon HBV.
  • “For the young hedge fund set interested in fundamental investing, there were few ways to learn the craft outside of making money-losing mistakes on the job.”
• “Value investors are journalists at heart who feel compelled to gather their own facts and do their own analysis.”
• For an investor’s education, shareholders’ letters are about as good a resource as you can find: “A good letter from a shareholder to a company’s chairman or CEO teaches us how investors interact with directors & managers, how they think about their target companies, and how they plan to profit from them.”
• Financial history (old annual reports, etc.) actually isn’t as well preserved as other historical data.
• “Public companies are filled with contradiction and conflict of interest. The best place to study these peculiar institutions is at the fault line where shareholders and corporate managers & directors meet.”
• “It seems like every sustained bull market gives birth to a merger boom and a clever way to capitalize on it.”
• “The truth is, a board of directors on its own is rarely capable of successfully managing a company for the long term. This is why our fixation on making corporate boards infallible misses the point. Good governance doesn’t only require an able board of directors; it also demands the right shareholders and managers. For a public company to run well despite the inherent schism between managers and investors, it needs a fanatical CEO, a long-term-oriented, but attentive, shareholder base, and a vigilant board of directors.”
• The ability to benefit either through market-price appreciation or taking control of a company offers what Buffett called a “two strings to the bow” situation.

Benjamin Graham versus Northern Pipeline: The Birth of Modern Shareholder Activism

• In 1914, bonds were traded much more than stocks.
• Railroad stocks accounted for 40% of all publicly issued equity.
• At the time, rumors and inside information drove markets.
• Concentrated ownership made activism hard in the early 20th century.
• Graham launched Newman & Graham in 1936, more than a decade before A.W. Jones, the “first hedge fund”.
• “Benjamin Graham was a thoughtful outsider in the investment community, and he used it to his advantage. He was the perfect man to sift through Wall Street’s bullshit in search of intrinsic value.”
  • Graham saw that undervalued common stocks could offer a margin of safety and more upside than bonds.
• Holding stock also allowed a shareholder to participate in corporate governance: “the stock market was the market for corporate control.”
• Northern Pipeline was one of 8 Standard Oil daughter pipeline companies, and it reported very little information to investors.
• Northern Pipeline traded at $65/share with $6 in EPS and owned investment securities worth $90/share.
  • Graham discovered the Northern Pipeline’s securities holdings by consulting its report to the Interstate Commerce Commission.
• After becoming convinced Northern Pipeline could pay a $90/share special dividend, Graham met with mgmt.
  • Mgmt said running a pipeline was a difficult business, they had significant experience doing so, and if Graham didn’t approve of their policies, “may we suggest that you do what sound investors do under such circumstances, and sell your shares?”
• However, Northern Pipeline had almost no CapEx requirements and no expansion options via acquisition or organic growth.
• Graham then tried to present at Northern Pipeline’s annual shareholder meeting, which was held, on purpose, in far-away Oil City, Pennsylvania.
  • Predictably, only insiders were present at the meeting, and they denied his motion to present.
• After being ingloriously sent home, Graham decided to wage a proxy campaign.
• In 1927, Rockefeller sent a letter to the Rockefeller Foundation and met with its financial advisor.
  • He explained the case for realizing the full value of Northern Pipeline, while stressing other disadvantages, such as the double-taxation that occurred when Northern accrued interest income from its bond holdings.
  • The Foundation declined to vote in Graham’s favor.
• Instead, Graham went from one individual investor to another in order to secure enough votes for 2 board seats out of 5.
  • The CEO gasped when one friend’s share block ended up voting in favor of Graham: “He’s an old friend, and I bought him lunch when he gave me his proxy.”
• Though Graham was still in the minority on the board, the company approved a cash distribution plan within a few weeks of the election.
  • Graham later learned that when the Rockefeller Foundation submitted its proxy in favor of mgmt, it stipulated that the company distribute its surplus cash to shareholders.
• Even today, remote shareholder meetings, like Chevron’s in Midland, Texas, and shareholder silencing techniques like question time limits are common.
• Northern Pipeline’s lackluster share performance was caused by a disinterested shareholder base and a board that had 3 members of mgmt and 2 directors affiliated with other ex-Standard Oil companies.
• A board’s job is to balance the usually LT-focused, but also self-preserving and self-serving, mgmt view with activist shareholders’ desire to take ST profits.
  • Boards usually don’t do a good job of balancing these two forces.
  • Self-dealing by mgmts has a long history.
    • Occidental Petroleum, for example, spent $150 M on a museum to house CEO Armand Hammer’s art collection.
• However, “shareholder-friendly” moves, such as repurchasing shares when the stock price is rising, are the result of mgmts trying to please investors and can backfire.
  • Winn-Dixie and Office Depot both returned too much cash to shareholders rather than reinvesting it in their businesses, helping hasten their failure.
• Even mgmts that excel at operating businesses can be poor stewards of capital.
  • This is where activist investors come in, theoretically.
• Academics who espoused efficient market theory focused on different information asymmetries (e.g., distribution of earnings announcements to investors) rather than looking at collective manias and misjudgements, which were much more likely to cause large stock-price swings.

Robert Young versus New York Central: The Proxyteers Storm the Vanderbilt Line

• The Proxyteers of the ’50s marked the dawn of corporate raiding.
  • They benefited from an increase in outsider ownership and shareholder fragmentation.
• Investor Robert Young started out in corporate finance at DuPont and GM, leaving when he became assistant treasurer and could ascend no further.
• Young became treasurer of investment firm Equishares, which was run by Pierre du Pont and John J. Raskob.
  • Raskob loved speculative investments.
    “These mistakes of Raskob’s were due largely to his unjustified faith in other men, coupled with an unquenchable bullish outlook,” Young said. “They were mistakes which I admired and loved him for… At no time from October 1929 to March 1933 would he admit that the next month held promises of anything but a great boom.“
  • From March 1931 until January 1934, when he terminated his investment relationship with clients, Young’s portfolio gained about +40% while the market fell -70%.
  • When one of his mentors, who was a client, “had a tantrum about Young taking an overseas vacation without seeking permission, Young realized that the independence he enjoyed from running his own money was an illusion. Not only did Young have bosses to report to, but they were the very same bosses he had reported to a decade earlier at GM.”
• For a time, he managed his and clients’ money.
• He became an operator by buying effective control of railroad Alleghany Corporation, which was freshly out of bankruptcy in 1937.
• Young began a proxy battle for control of C&O Railroad in 1938, but he had bought his C&O shares on margin from Guaranty Trust.
  • Since the value of the shares had fallen below the minimum collateral required, the bank wanted to vote his own shares against him.
    • Many bankers sat on railroad boards, and Young suspected J.P. Morgan was responsible for the pressure.
• A judge enjoined either side from voting the loaned shares, causing the fight to move to small C&O shareholders.
  • Young’s slate won 70% of the free shares.
• In 1944, Young made a run at train car maker Pullman, but the company selected an equal-sized bid from a railroad consortium.
• New York Central, the country’s 2nd-largest railroad, became his next target in 1947.
  • However, Young was enjoined from serving on the C&O and New York Central boards simultaneously.
• In 1954, Young resigned from C&O’s board and Alleghany sold all of its C&O holdings while buying a “substantial” amount of New York Central stock.
• New York Central CEO William White allocated his entire advertising budget to the proxy fight, hiring elite PR and law firms to present the company’s case.
  • White had refused an offer to serve as COO under Young, since he himself had presided over +37% earnings growth since becoming CEO a year and a half prior.
• The railroad counted many powerful bankers on its board, including George Whitney, the chairman of J.P. Morgan.
  • Two Vanderbilts also served on the Central board.
• Young wrote his ads himself and took a populist stance, portraying the fight as a David-vs-Goliath battle.
  • “One PR executive at the time marveled at Young’s ability to write powerful material ‘using words of only one syllable.'”
• Young’s points were:
  • His board candidates had substantial share ownership, while the New York Central’s board was dominated by bankers with interests that differed from shareholders’.
  • The Central had had a poor operating and dividend record compared to the C&O.
  • He had a vision to offer: high-speed, comfortable commuter rail and nonstop transcontinental service.
• In contrast to White, Young did not have to run a railroad at the same time he fought the proxy battle.
  • Young could also attack White for using company resources and time to focus on the fight.
• After it became clear Chase National Bank, which was the trustee of the 12% of the Central held by C&O and also sat on the board of the Central, would vote the shares against Young, he engineered the sale of the stake to oilmen Sid Richardson and Clint Murchison, Sr.
  • Alleghany and Young’s partner loaned the two men 60% of the purchase price in addition to writing them a put for the Central shares.
  • Young also added the two newfound owners to his director slate.
    • Together, Young’s director candidates owned 1.09 M shares to the incumbents’ 74,000.
• The campaign quickly became acrimonious by ’50s standards, with Central mgmt and board taking personal offense.
  • Young kept pushing: “Just ask yourself why the four bankers on the present board, together owning only 450 shares of Central, are so determined to hang on to your company. Is it not because of the substantial benefits which have accrued to their four banks?”
• To make their cases, the two parties slung impressive-sounding metrics back and forth, but each set of figures was cherry-picked, and it was not clear-cut that Young was the better operator.
• Young also appointed a woman, a retired railroad engineer, and an executive who was “a good Catholic” to his board, while White refused to change the slate.
• The 1954 shareholder meeting took on an almost political character: more than 2,000 shareholders arrived to Albany, with a bunch wearing “Young at Heart” or “We Want White” buttons. Chaos broke out throughout the day.
• Young won a sweeping victory.
  • However, the entire industry suffered a decline in the late 1950s. As the broader economy slid into recession in 1958, the Central’s earnings plummeted -78% and the company had to cancel its dividend.
• Amid these and personal financial difficulties–which were virtually indistinguishable–, Young committed suicide later that year.
  • Young also suffered from depression.
• Several other railroads fell prey to Proxyteers in the ’50s, including the Minneapolis & St. Louis.
  • Even if they were modernized, these railroads often had exorbitant executive perk packages.
• Louis Wolfson, one of the prominent Proxyteers, bought 51% of Washington DC’s Capital Transit Company.
  • When Wolfson was called in by Congress to explain his refusal to capitulate amid an employee strike, he said, “I have a responsibility to stockholders, like that little old lady in Washington telling me that her whole income depended on her transit dividends and that she was praying for me to win. What kind of human would I be if that didn’t touch me deeply?”
  • The author’s take: “Louis Wolfson was the kind of hard-nosed businessman who would protect the dividends of one little old lady by making a bunch of others walk their little old asses home during a transit strike.”
• Proxyteers like Tom Evans put in place the same sort of anti-shareholder provisions they had railed against after gaining control of their corporate targets.
• The 1959 proxy battle for United Industrial Corporation formed the training ground for Joe Flom (of Skadden, Arps) and Martin Lipton (inventor of the poison pill).
  • Companies began preparing takeover defense playbooks and early protective measures such as specialized loans or counter-takeovers.
  • However, simply buying enough shares to guarantee control was the most foolproof takeover defense.

Warren Buffett and American Express: The Great Salad Oil Swindle

• “It is very hard to avoid career-imploding mistakes with a hyperconcentrated value investing strategy. Warren Buffett is the exception that proves the rule.”
  • Value investing in the Buffett style “is tailor-made to magnify irrational thinking.”
  • “Nothing is going to coax out the inherent irrationality of a portfolio manager—his or her weakness to the forces of greed and fear—like supersize positions.”
• Dempster Mill and Sanborn Map were decidedly asset-rich and declining cigar-butt investments.
  • A brief Buffett-ism from The Snowball: when he won a board seat at Sanborn Map, he complained, “I remember cigars getting passed around. I was paying for thirty percent of every one of those cigars. I was the only guy not smoking cigars.”
• An anonymous tipster called American Express’s warehousing subsidiary to inform them that millions of pounds of soybean oil guaranteed by the company were nonexistent, but AmEx did nothing more than order an “independent” investigation that found the inventory accounting was mostly correct.
  • The warehouse employees who conducted the investigation were previously employed by Tino De Angelis, the CEO of the company “shipping” the soybean oil.
    • They were being employed by him at the time, too, it later surfaced.
  • After an informant called higher, AmEx’s CEO ordered an investigation.
    • It turned out that De Angelis had a history of various kinds of fraud and was being investigated by the SEC for inventory inflation in a previous, now bankrupt, venture.
• The field warehousing business was one AmEx should have avoided, since it was unprofitable after accounting for the fraudulent soybean oil segment.
  • The subsidiary’s mgmt thus relied on De Angelis to maintain their profitability.
    • Blinded, the executives groveled to maintain De Angelis’ business and even invested money with him.
  • Meanwhile, AmEx’s CEO was too slow to realize the danger.
• The scandal broke in 1963–three years after the first inspection–, when De Angelis’s company filed for bankruptcy and creditors found water instead of oil.
  • Over this three-year period, soybean oil in “storage” had increased tenfold.
  • Many prominent banks and non-bank companies were creditors.
• AmEx fell -50%, with worries about the extent of the fraud compounded by the fact that the company was the last major joint-stock corporation, meaning shareholders could be personally liable for AmEx’s obligations.
• Some American Express investors filed suit, encouraging the company not to pay out for the missing soybean oil.
  • They argued that AmEx had no legal obligation wrt the warehousing subsidiary’s liabilities.
• In a letter to mgmt, Buffett encouraged the company to pay its salad-oil claims in full.
  • Buffett knew that to ignore claimants on a technicality would cause significant harm to AmEx’s brand.
• AmEx marked the beginning of Buffett’s shift to purchasing asset-light businesses on the basis of their quality.
  • The company’s travelers checks created a large float between the time of their purchase and time of use.
• The ’60s merger wave was characterized by growth for the sake of growth, not horizontal or vertical integration.
  • Jimmy Ling of Ling-Temco-Vought (LTV), one of the most notorious conglomerates, borrowed against his own shares, destroying his wealth.
    • Shades of Pearson.
• Harold Simmons rolled up opportunistic spinoffs and other undervalued investments to phenomenal LT success, using hostile tenders as his main tool.
  • He observed Ling, discovering that he was smart, but “also a consummate bullshitter. He spoke quickly and used a lot of confusing jargon when he explained his ideas, yet he was often blind to critical and obvious details.”
  • Two weeks after Ling finished his employment with Simmons’ firm (long after LTV blew up), Ling announced he would make a hostile bid for Simmons’ conglomerate.
    • However, Simmons owned 42% of the shares.
    • Ling was unsuccessful in crossing the 50% threshold, selling back the remaining shares to Simmons at a -40% discount to their peak value.
• However, blue-chip corporations were still off limits for raiders.
  • When Saul Steinberg’s Leasco conglomerate tried to buy Chemical Bank, the DoJ, the state of New York, and the Senate all raised objections to the takeover, in large part because it was a big bank.

Carl Icahn versus Phillips Petroleum: The Rise and Fall of the Corporate Raiders

• The 1980s, the “deal decade”, involved more than 22,000 instances of M&A.
  • Among these were PE LBOs, strategic acquisitions in an accommodative antitrust environment, and foreign buys of domestic businesses to enter the US market.
• Corporate raiders derived Proxyteer-like power from something more potent than public support: cash.
  • This was, of course, enabled by HY issuance.
• Though journalists signaled the 1987 crash as the end of debt-fueled M&A, it was actually only the beginning.
  • Aside from high-flyers like Milken/Drexel, the majority of participants emerged unscathed.
• Carl Icahn’s “anti-Darwinian” theory of mgmt stipulates that “corporate America rewards politically minded people who don’t rock the boat.”
  • It gets worse: “Because the CEO then secures his position by making sure his second in command is even dumber than he is, the corporate governing class evolves into a vast idiocracy.”
• T. Boone Pickens routinely experienced misaligned incentives and complacent mgmt at Phillips Petroleum.
  • Once, he and and his boss had to continue drilling a low-producing well even though the well would not recoup its completion cost.
    • Mgmt wanted to avoid reporting a dry well.
  • An executive told Pickens, “If you’re ever going to make it big with this company, you’ve got to learn to keep your mouth shut,” prompting him to leave.
• In 1984, Pickens, now Phillips’ largest shareholder, made a hostile tender offer for an additional 15% of the company.
• Pickens stated he would not accept greenmail, since public sentiment opposed those kinds of deals with mgmt.
• However, after Phillips mgmt fought back and oil prices fell, Pickens negotiated a buyout from mgmt and signed a standstill agreement.
  • Since Pickens was concerned about shareholders’ rights, he demanded to be treated on equal footing with other Phillips holders.
  • The parties eventually agreed for Phillips to repurchase more than 1/3 of its shares–including Pickens’ stake–with $53/share in cash and debentures.
    • However, when the deal became public, analysts valued the package at $45.
• This discount from the $60 Pickens had initially been willing to bid attracted Icahn’s attention.
• On Icahn’s early years: “At Princeton, Icahn didn’t take his meals at the Ivy Club and transform himself into a future titan of Wall Street. He played a lot of chess, majored in philosophy, and won an award for his senior thesis, an epistemology paper on the empiricist criterion of meaning.”
• After bouncing from medical school to the army to Wall Street, Icahn suffered a total wipeout in the ’62 crash and ran an options pricing newsletter to recover financially.
• Icahn started his own firm in 1968, focusing on convertible arbitrage.
  • Bayswater Realty, A REIT he took control of in 1977, financed his later acquisitions.
• He observed that public-company mgmts had very little share ownership, and thus very little interest in realizing the fair value of their companies.
  • Moreover, few investors wanted to raid these companies, especially the larger ones.
• Icahn’s four win conditions:
  • Convincing mgmt to sell or liquidate.
  • Gaining control by proxy.
  • Gaining control by tender offer.
  • Selling back his position to the company.
    • Icahn took greenmail in more than half of his activist positions early on.
• He haggled with Drexel, which none of the bank’s other clients did. Notably, he refused to cede equity in exchange for more debt funding.
  • “I don’t like giving up equity. I’ve learned over the years, a dollar bill is a better partner than a partner.”
• In brainstorming Icahn’s offer to Phillips, Drexel suggested for the first time ever that instead of providing a commitment letter, Drexel could state it was “highly confident” it could raise the money.
  • In the future, Drexel would charge 1% fees for this innovation.
• In 1985, Icahn offered $55/share for Phillips, with a 50/50 cash-debt split.
  • He also offered to stand down if Phillips went private for $55/share.
  • Otherwise, he warned, he would run a proxy contest to defeat Phillips’ pending recapitalization and make a hostile tender offer for the remaining shares.
• Phillips employed Martin Lipton to devise a poison pill that would convert each share into $62 of debt yielding 15%.
  • Icahn’s response letter indicated that he would “swallow the pill” by tendering for an additional 25% of Phillips’ stock.
  • The poison pill riled up shareholders, who were already upset by the greenmail deal.
• Icahn followed up with a $60 tender offer for Phillips.
  • The tender was contingent upon shareholders choosing Icahn’s slate of directors and voting down the recapitalization plan at Phillips’ shareholder meeting.
  • If he did not win the ’85 shareholder meeting, Icahn said he would run another proxy fight the next year–with a liquidation if he won.
• With support from frustrated institutional investors like CalSTERS, Icahn won the vote at the Bartlesville, OK shareholder meeting.
  • Mgmt drew out the meeting over four days, but to no avail.
• Icahn renegotiated a richer recapitalization package that was broadly agreed to be worth $55/share.
  • His profits were about $50 M for 10 weeks’ work.
• Subsequently, Icahn beat out Continental Airline’s Frank Lorenzo for control of TWA, but this was ultimately a Pyrrhic victory.
  • TWA went bankrupt in 1992.
• The financier behind many of these deals, Milken, raised capital through a tightly knit network of captive customers (including daycare and savings & loan companies), loyal clients like Ivan Boesky, and his own investment partnerships.
  • Structurally, falling interest rates and the US’s economic growth contributed to strong HY issuance.
• Corporate raiders also benefited from large, slow-moving institutional investors.
  • These investors’ incoherence when confronted with ’80s activism and corporate maneuvering caused them to adopt a more informed & critical stance on corporate governance.

Ross Perot versus General Motors: The Unmaking of the Modern Corporation

• I was surprised at how much of a badass Perot was: he flew to Tehran personally, gathering a task force to bust two senior employees out prison.
  • He also attempted to deliver a plane’s worth of gifts to American Vietnam POWs, protesting outside Laos’ Vietnamese embassy when he was denied entry.
• GM President Alfred Sloan, who inherited a decentralized company in 1923, operated and built out the business  by running each segment for ROIC.
  • However, GM continued to prove difficult to run under some unified theory while ensuring autonomy.
• As a result, the company grew dependent upon Sloan’s leadership skills to keep its bureaucracy accountable, encourage dissenting opinions, and delegate appropriately.
  • After Sloan left, no competent leader stepped into his substantial shoes.
• John DeLorean’s On a Clear Day You Can See General Motors documents the company’s decline.
  • Accounts came to fill most of the senior GM roles, while rule by committee, pointless meetings, and disproportionate attention to irrelevant minutiae ensured that mgmt grew increasingly out of touch.
  • DeLorean had to build the Pontiac GTO, one of the most successful automobiles of the ’60s, in secret to avoid the project’s being nixed.
• The Chevrolet Corvair, dubbed “The One Car Accident” by Ralph Nader, was unstable at high speeds, but mgmt approved the vehicle anyway.
  • Even after driver deaths, mgmt initially rejected the idea of placing a $15 stabilizing bar on the Corvair.
• GM ruined numerous other vehicles.
  • “We think of Ford’s Edsel as the worst car launch in history, but Edsel was an ambitious project that failed to live up to its pioneering marketing blitz. GM’s disasters were missed layups, and they were ultimately much more damaging.”
  • The company also insisted on a practice of taking one car design and rebranding it with another marque, which hurt long-term brand value, especially when the base design was mediocre at best.
• In ’81, accountant Roger Smith became chairman and CEO of GM.
  • He vowed to invest in technology as the LT solution to the company’s woes and its increasing uncompetitiveness vs. Japanese automakers.
  • Smith also espoused an autocratic, angry managerial style.
• Thanks to the recommendation of John Gutfreund, GM bought Perot’s Electronic Data Systems (EDS), making Perot the company’s largest individual shareholder, with a stake of ~3%.
  • EDS was not a cultural fit, but Smith viewed the company–and Perot–as a way to change GM’s culture.
• After negotiating near-autonomy for EDS, Perot enthusiastically began to overhaul GM.
  • He met with employees & senior executives in small group dinners and visited GM dealerships.
• However, mgmt stymied Perot at every turn.
  • They took no input from factory workers, in stark contrast to Japanese automakers.
    • Toyota had received over 10 M worker suggestions by 1985.
  • Mgmt also refused to listen to dealers.
    • “When Perot asked a small group of Cadillac dealers how he could help them, one of the men responded, ‘Get me a Honda dealership!’ He wasn’t joking. Cadillacs were so unreliable that the dealer had to keep a hundred service bays running two shifts a day just to keep the cars on the road,” 10x the service requirement for Hondas.
• Japanese could build and operate plants for much cheaper than GM while producing a higher quality product with older equipment.
  • Smith, on the other hand, viewed GM’s workers as a lost cause to be replaced with technology.
    • Factory floors were beds of alcohol use, gambling, and prostitution.
• After GM collaborated with Toyota to produce a new Chevy Nova at a shuttered GM plant, the extent of the company’s rot grew clear.
  • Toyota hired back the same unionized workers and produced Chevy Novas with efficiency comparable to its Japanese plants’.
• When GM purchased Hughes Aircraft, Perot grew increasingly upset.
  • He wrote a letter to Smith that described his discontent with GM’s direction.
  • When Smith did not respond meaningfully, Perot gave a long, involved speech at the following board meeting and cast the sole dissenting vote wrt the Hughes acquisition–the first at GM in decades.
    • Directors owned very few company shares.
• Perot began making public comments in response to reports of his board vote.
  • The board subsequently bought Perot out for $700 M–a +85% premium to the public-market value of his shares.
  • Although Perot agreed to the deal, incredulous at how high a price GM had offered, he slammed the company in response.
    • “I just kept making obscene demands, and they kept agreeing to them,” he said.
    • Perot offered the board time to reconsider the greenmail in a scathing letter.
• Some institutional shareholders, long privately disappointed with GM, raised an outcry in response.
  • The State of Wisconsin Investment Board (SWIB) crafted a resolution to prohibit greenmail payments.
  • Smith embarked on an apology tour and helped quash the resolution by threatening to suspend capital investments in Wisconsin.
    • Even without SWIB’s support, the resolution still won 20% of the vote.
  • Smith could no longer have his way with the board, and his proposed additions to the director slate in ’88 were voted down.
• By the late ’80s, institutional investors owned 50% of America’s 50 largest companies.
• Today, institutional investors hold 70% of US public equities.
  • Somewhat ironically, GM had originated the diversified employee pension fund model in 1950.
• Events like the GM-Perot greenmailing meant that institutional shareholders were no longer a complacent equity slug.
  • Instead, investors like CalPERS and the New York State Retirement Systems began to pressure GM, for example, to have a say in choosing the company’s next CEO.
  • TIAA-CREF proposed the first ever dissident director slate in 1988.

Karla Scherer versus R.P. Scherer: A Kingdom in a Capsule

• R.P. Scherer was a soft gelatin capsule company underpinned by a proprietary technology developed by Bob Scherer in 1933.
  • By 1944, R.P. Scherer was making 5 B capsules a year and had 90% market share.
• Scherer built his business with the attitude, “Nothing I’ve ever done has been work.”
  • His passion was optimizing softgel manufacturing, and he devoted himself to it.
• After Scherer died in 1960, his son, Robert, Jr., became CEO.
  • Robert, Jr. embarked on a noncore, commodity-business acquisition spree: dental supplies, surgical instruments, cosmetics, cabinets & chairs, etc.
• Karla Scherer and her brother John owned 38% of R.P. Scherer directly, with an additional 9% held in trusts in their name.
  • Karla Scherer’s husband, Peter Fink, became CEO in 1979.
    • Almost all of Robert, Jr.’s acquired businesses were sold back to the ex-CEO in exchange for his R.P. Scherer equity.
• Though the company was free of its prior diworsification, Fink betrayed his word and began buying commodity businesses: aluminum caps for vials, an animal testing lab, and eyeglass/contact lens manufacturers.
  • The crowning acquisition in 1987 was Paco Pharmaceutical Services, a low-margin paper packaging company whose business eroded rapidly thereafter.
  • The company bought these businesses using cash and shares.
• Fink also expanded the commoditized hardshell capsule unit that Robert, Jr. had acquired.
  • The company’s new manufacturing facility was shuttered within 5 yrs.
• R.P. Scherer’s core capsule manufacturing segment, which consisted of the softgel & hardshell business, earned a pretax ROA of 29%.
  • Acquired business earned an ROA of 6%.
• FMC Corporation had expressed interest in acquiring R.P. Scherer in 1982, but Karla and her brother helped to defend Fink.
  • After having second thoughts, Karla asked her husband for a board seat several times in 1984. “I said, ‘If I am not nominated for the board, I will nominate myself.’ … The color drained out of his face and, bingo, I was on the board.”
• After the Paco disaster, Karla’s misgivings about her husband bubbled over and she decided to lobby the board to put R.P. Scherer in play.
  • Her brother and COO Ernst Schoepe agreed, but the other 7 members of the board (including Fink) gave BS reasons like, “You will emasculate Peter”.
• The board was totally captive.
• The company’s “largely ceremonial” 77-year-old chairman, who happened to be Fink’s mentor, was paid $400k/yr. alongside other perks.
  • The other board members were either Fink’s friends, R.P. Scherer’s bankers, or its lawyers.
    • 6 out of the 7 belonged to the same country club.
• After voting down the resolution to put the company up for sale, the board actually passed a resolution that it wouldn’t consider any offer to buy the company.
• In 1988, after divorcing Fink, Karla filed a 13D with her brother that expressed their interest in selling R.P. Scherer.
  • The company hired Martin Lipton, stalled on providing a shareholder list, passed an accelerated option vesting plan in the case of an acquisition, and added one of the company’s largest suppliers to its board.
    • R.P. Scherer had a staggered board, so even if Karla’s slate of 3 succeeded in being elected, they would now have a board minority regardless.
  • Fink successfully lobbied the bank holding Karla and her brother’s trust shares to vote them against a sale.
    • After a positive meeting with the bank, Karla later heard that the matter was “sensitive” and had been “kicked upstairs” to the head of the trust department, who had never met with Karla. The head then listened to Fink present his case at a private dining club before agreeing to side with him.
    • The bank parent company’s head was on R.P. Scherer’s board.
• In opposing Karla, the company stated that she had once asked to be CEO, which was a lie.
  • As the author points out, even if this statement had been true, the CEO aspirations by a longtime, significant insider only stuck as ludicrous because Karla was a girl.
• R.P. Scherer’s letter also calls out one of her board nominees, a former Michigan Supreme Court justice, for working for the same law firm that was negotiating her divorce.
• Karla’s directors won overwhelmingly.
  • The court blocked the trustee bank from voting Karla and her brother’s trust shares, but she would have won even without the injunction.
• After the election, the R.P. Scherer supplier on the board came over to Karla’s camp, giving her a majority to oust Fink and sell the company to Shearson Lehman Hutton in 1989.
• The company divested non-core businesses, and its softgel and hardshell revenues doubled within 6 yrs., while operating income tripled in 5 yrs.
  • Operating margins doubled.
    • This benefit accrued to the new owners, not Karla, and she could not have waged a successful proxy fight for control.
• The company is now part of Catalent (ticker: CTLT).
  • Though its IP is long-expired, the company’s know-how gives it an enduring moat.
• “More than any other party, the board of directors governs the company.”
• Though the board is supposed to align managers interests with shareholders’, it also chooses the CEO and has major decision making power.
  • Since boards are responsible both for implementation and for evaluation of strategy, this inherently produces conflicts.
• “The dynamics of the corporate boardroom ultimately tighten the bond between mgmt and directors.”
  • CEOs worsen this effect by picking and paying board members: in other words, offering prestige and remuneration.
    • CEOs, of course, would rather have quiet board members.
• Arthur Levitt, former SEC chairman, was considered but ultimately dropped for the Apple board of directors.
  • After flying him out to California, Steve Jobs read one of Levitt’s corporate governance-friendly speeches and exhibited second thoughts.
• Conflicts of interest are often difficult to assess, since the upper levels of the business world are tightly interconnected, whether in a social or professional context.
  • Often, the conflicts are blatant and hard to control for: Disney’s Michael Eisner placed his lawyer, architect, and children’s elementary school principal on the board. All were independent director.
    • Conversely, on paper, the least independent directors at R.P. Scherer were the dissidents, Karla and the company’s COO. As the author states, “true independence is a state of mind.”
• At Berkshire’s ’14 meeting, Buffett said, “The nature of boards is they are part business organizations and part social organizations. People behave part with their business brain and part with their social brain.”
  • Indeed, when Buffett wished to express his misgivings about Coca-Cola’s stock award plan, he talked to its CEO rather than voting against the plan. Even though he was the largest shareholder, the vote would have passed without him.
    • The author notes, “Being effective at a part-social, part-business organization requires that you sometimes play politics.”
• “Over time, most directors fall under mgmt’s sway anyway.”
  • Often times, the independent directors are the most susceptible to being suckered in:
    • Enron’s board was entirely independent, and the irony of Sarbanes-Oxley was that the Enron BOD would have been entirely compliant with the new regulations.

Daniel Loeb and Hedge Fund Activism: The Shame Game

• By the ’00s, chairman letters attached to investors’ stake filings had become much more acerbic.
  • In one, investor Ron Burkle called the CEO of Morgans Hotel Group a “spoiled child”, demanding he put the company up for sale and “ask your mother to buy you something else”.
• Robert Chapman helped pioneer the practice of publicly shaming mgmts via 13D filings.
  • “Ridicule is a radiating weapon,” he said.
  • Threats did not have to be as clear: he didn’t even mention a specific bank when expressing confidence wrt his takeover financing discussions.
  • Nor did the issues have to be as large as threatening a change of control: he expressed distaste over a CEO’s compensation package, which the company diminished.
• In lambasting the majority owner of American Community Properties Trust, Chapman said, “If the Trustees desire to continue running ACPT as a real-life version of Monopoly whereby a 32-year old graduate of Manhattan College in the Bronx and former bank loan administrator is named CEO by his father, then I strongly suggest you take the company private, wherein underserved, nepotistic practices are not scrutinized.”
  • Dan Loeb used this letter as a template for his own.
• In 1983, as a college senior, Loeb lost all his money (~$120,000) in a concentrated bet on medical device company Puritan-Bennett.
  • It took him 10 years to pay back his father.
• After working several years in different finance role, including at Island Records and a risk-arb hedge fund, Loeb couldn’t get another hedge fund job, so he went to work for Jefferies’ distressed trading desk in 1991.
  • Jefferies had just hired many of Drexel’s salespeople and traders.
  • Loeb made a name for himself by recommending a trade in bankrupt Drexel’s certificates of beneficial interest (CBIs), which were to pay out $646 per unit.
    • The CBI holders were mostly ignorant of this fact, so Loeb bought up the certificates for much less than they were worth and made significant money for his clients.
• In 1995, Loeb launched Third Point from David Tepper’s office weight room.
• Dan Loeb posted on message board SiliconInvestor under the name “Mr. Pink”.
  • The author cited investors from Graham to Buffett to Milken to illustrat that “there have been very few lone wolves in the investment world… Today, investors swap thoughts on Twitter. Maybe tomorrow they’ll strap on a VR headset and chat with AI bots programmed to look and think like Warren Buffett.”
  • Loeb’s missives took on some of the “flaming” character of online posts.
• In 2000, Loeb filed a 13D for animal feed company Agribrands, a Ralston Purina spinoff.
  • Agribrands had announced a merger with Ralcorp, another spinoff from the same parent.
    • Agribrands & Ralcorp chairman Bill Stiritz wanted to fold mature, cash-rich Agribrands into Ralcorp to grow by acquisition.
  • Stiritz had created significant shareholder value when he led Ralston Purina.
    • Loeb accused him of undervaluing Agribrands and awarding himself a huge option grant when the stock had plunged momentarily in 1998–ahead of a share repurchase and successful quarter.
    • Agribrands stock itself had been flat since the spinoff.
• In contrast to Chapman, Loeb did not hesitate to attack business luminaries like Stiritz.
• Three weeks after the 13D filing, Cargill made an unsolicited offer for Agribrands and ended up buying the business for $54.50, a +33% premium to Stiritz’s offer and a +50% premium to the undisturbed price.
• Writing to InterCept, Loeb criticized related-party dealings and nepotism.
  • The CEO’s daughter and husband both worked for InterCept, and when Loeb called the CEO’s son-in-law–also an employee–during work hours, he turned out to be at the golf course.
  • In response to mgmt attacks, Loeb was unflinching: “[C]alling your second largest shareholder ‘sleazy’ in the media is further evidence of your poor judgment and exemplifies the type of behavior that should provide you with ample opportunity to join your son-in-law on the golf course in the not too distant future.”
• Sometime’s, Loeb’s letters served no other purpose than to further embarrass the executives in question.
• Loeb also noted that “a town hanging [CEO ouster] is useful to establish my reputation for future dealings with unscrupulous CEOs.”
• Star Gas was a heating oil and propane business.
  • The business was mature and seasonal, but heating oil customers were loath to switch when providers offered good service.
  • Though it behaved like a utility, offering steady dividends, Star Gas actually financed this behavior by issuing more stock than dividends from ’98 to ’03.
  • In addition, Star Gas took several steps that drove customers away.
    • It consolidated its 90 long-standing regional brands to 2.
    • It reduced its service center reach.
    • It outsourced its call center to Canada.
  • Customer losses in ’04 were 5x higher than the trailing 3-yr. average.
  • Heating oil prices also doubled, which meant that the company’s working capital requirements increased.
    • In response, the company made a bearish bet on the price of heating oil, losing additional money in the process.
• After suspending its dividend in ’04, Star Gas stock fell -80%.
  • A month later, the company sold its more stable propane business to pay down debt. Since Star Gas was an MLP, this meant the sale generated a per-share tax bill that was larger than its share price.
• Loeb skewered Star Gas’s CEO, ex-banker Irik Sevin, for these and other missteps.
  • Star Gas had spent roughly half of its market capitalization in legal and banking fees in connection with the acquisition binge during Sevin’s tenure.
  • Sevin’s mother was a Star Gas board member.
    • “We further wonder under what theory of corporate governance does one’s mom sit on a Company board… We insist that your mom resign immediately.”
  • Loeb  closed, “It is time for you to step down from your role as CEO and director so that you can do what you do best: retreat to your waterfront mansion in the Hamptons where you can play tennis and hobnob with your fellow socialites. ”
• Three weeks later, Sevin resigned and one year later, PE firm Kestrel Energy recapitalized the company.
  • Star Gas went on to nearly its double per-gallon profitability by 2014.
  • Ben Graham wrote, “Investment is most intelligent when it is most businesslike.”
  • The author notes, “today’s accepted business practices, for better or for worse, tolerate a level of fanaticism that Graham might view as alien.”
• The author recommends David Einhorn’s Fooling Some People All of the Time, which discusses his small but relentlessly pursued 2002-2007 Allied Capital short.
• Later on, hedge fund targets became larger and more established, like Yahoo! and Herbalife.
  • Activist funds also usually maintain working relationships with institutional investors, which diminishes the need for scathing letters.
    • On the other hand, however, institutional investors are less likely to spring for stupid activist moves than they were in the ’80s.
• Today, every public company that doesn’t have voting control is a potential activist target.
  • ValueAct placed a representative on Microsoft’s board with less than 1% ownership.
• However, activist funds are inherently more ST-minded due to practical concerns like liquidity.
  • “Many hedge funds will tell you that their investors are committed and LT, but that won’t be true if their funds’ performance starts flagging.”
  • “To successfully run a long-term investment strategy with a hedge fund, you can’t just ignore your own short-term business pressures. You must consider catalysts and exit strategies.”
• Loeb didn’t stick it out for the operational improvements at Star Gas, since to do so would involve holding a dead-money stock for some time.
• Though on average, activists’ interests are more aligned with the average shareholder’s than in previous eras, there are still ways to profit at shareholders’ expense.
• Sardar Biglari of Biglari Holdings (owner of Steak ‘n Shake, First Guard Insurance, and Maxim) illustrates this well.
  • After a meteoric rise as an activist and presiding over an exceptional 2008 turnaround at Steak ‘n Shake, Biglari has entrenched and enriched himself.
  • Biglari Holdings invests in his hedge funds, which charges a 2% mgmt fee.
    • In fact, Biglari owns under 2% of his company directly, with almost 20% held through his hedge funds.
    • Biglari Holdings also has a 5-yr. lockup, protecting his ownership interest.
  • Biglari agreed to license his name to the company for 2.5% of sales/yr. if he is ever removed as chairman, CEO, or capital allocator.
    • In 2014, this would have been 70% of Biglari Holdings’ earnings.
  • Biglari also earns more than $10 M in cash and stock every year, more than the CEOs of McDonald’s, Burger King, and the like.
  • Biglari Holdings also made a rights offering at a -40% discount to the current share price, increasing the company’s book value–and Sardar’s compensation.
• Biglari has tried to get representation on Cracker Barrel’s board, but his activist credentials are mostly shot, and institutional shareholders declined to vote for him several years in a row.

BKF Capital: The Corrosion of Conformity

• Bill Ackman’s JCPenny campaign was widely proclaimed to be a disaster, with his hand-picked CEO, Ron Johnson failing to take the retailer upmarket.
  • However, that JCP is the poster child for bad activism “shows us the difficulty of post facto analysis in a results-oriented business”.
  • “Judging activism purely based on stock performance can be tricky and superficial.”
    • A ST gain from a sale, for example, can still be injurious to LT shareholders if the business was really worth more.
• Baker, Fentress & Company was an underperforming $500 M closed-end fund that also controlled a timber company.
  • In 1996, Baker, Fentress bought John A. Levin & Company, a large-cap value investing firm.
    • Its AUM was over $5 B and up +40% YoY, and the founder had a successful track record.
  • By 1998, Levin Management had an AUM of $8.3 B.
    •  Its largest hedge fund was an event-driven strategy run by CEO John Levin’s son, Henry.
    • Hedge funds were a more attractive business than the company’s traditional long-only purview: they accrued 80% of the firm’s fee revenues while constituting only 10% of its assets.
• In 1998, the company, which was still trading at a discount to asset value, liquidated its legacy business and renamed the Levin funds BKF Capital Group.
  • The company’s deregistration as a closed-end fund meant that its shares, once owned by mutual funds, became hedge-fund owned.
    • “Big structural turnover in a company’s shareholder base often results in the stock getting quite cheap”.
  • BKF attracted value investors like Mario Gabelli, while Warren Buffett bought shares immediately before the closed-end fund distribution.
• Amid tremendous industry growth, BKF Capital managed $13 B by the end of 2003, and fee revenue increased commensurately.
  • However, the stock fell to below the John A. Levin acquisition price.
• BKF stock was cheap on a price-to-revenue basis, but BKF spent a lot on employee compensation.
  • There was no comp moderation as assets and fees grew, and employees owned few shares, while Levin owned only 10% of the company.
• BKF’s board included James Tisch, Burton Malkiel, and other luminaries, and Levin believed his own importance to the business meant that activist intervention was unlikely.
  • The board instituted a poison pill in 2001 and ignored repeated shareholder resolutions to redeem the pill.
  • A 2003, 13D encouraging BKF to sell itself also went unheeded, and Mario Gabelli didn’t follow through on his threat of a proxy fight.
• In 2004, Warren Lichtenstein’s activist fund, Steel Partners, filed a 13D and demanded that BKF add 3 shareholder members to its staggered board.
  • When BKF failed to act, Steel Partners nominated 3 of its own directors.
  • Steel’s later letters focused on the poor margins, high comp, anti-shareholder actions, and Levin’s daughter’s consulting fees.
    • The fund asked for dividend increases or a share repurchase.
  • ISS and Glass, Lewis sided with the activist.
• Mgmt contended that the high pay was necessary to scale its assets long-term.
  • BKF also insinuated that Steel Partners might want the firm’s assets for itself.
    • Lichtenstein vigorously refuted this.
• Fund manager Carlo Cannell added a 13D letter of his own.
  • Cannell, somewhat of a loner, had made a killing in 2002 as the 13th-highest-earnings fund manager.
  • His bread and butter was L/S in small caps, and in support of his strategy, he returned $250 M when the fund got too large.
    • He employed activism when he thought mgmts of companies he held were making significant missteps.
• Cannell compared John Levin to corrupt Roman Senator Lucius Catilina.
  • In addition to the above objections, he highlighted that none of the supposedly LT value-enhancing comp was in the form of equity.
  • He pulled no punches.
    • “Your 56,000 square foot office in Rockefeller Center immolates cash at the expense of BKF’s shareholders”.
    • “All this excess would be dandy in a private company, but BKF is public.”
    • Cannell also questioned why the Wall Street titans on the board were standing idly by.
  • Cannell demanded that the BOD “take BKF private and squander privately”; sell the company; or resign in favor of a shareholder-appointed board.
• BKF scrambled to issue a special dividend and conceded virtually every shareholder-friendly change that Steel Partners had suggested, but the activists did not relent.
  • Lichtenstein contended that the issue of increasing margins and limiting compensation remained unsolved.
• Levin finally fired back at Cannell and Steel Partners.
  • The activists had given no concrete plan to reduce expenses, he said.
  • Moreover, comp, including his son’s was in line with markets, and his daughter’s consulting agreement was on the basis of her Harvard Medical School-earned biotech knowledge.
  • BKF was not losing money after adjusting for amortization.
  • After the corporate governance improvements, the only issue of contention left was the main one: choosing the set of directors that would make the company “grow or fail”.
• Shareholders voted out the incumbents.
  • Within two months, Levin resigned.
    • His son and the other event-driven professionals resigned two months later.
  • Four months after, BKF’s CFO left to work for Levin’s new firm.
• BKF ended the year with assets down -65%.
• One year after the vote, revenues were down -96%.
  • The firm’s long-only manager left shortly after and BKF announced a liquidation.
• The stock fell -90% in 15 months.
• This activist failure resulted from several factors.
  • Investors didn’t believe Levin was in it for the LT, since his ownership was relatively low and none of the compensation was in equity.
    • “Without perfectly aligned incentives, corporate governance becomes a matter of trust. But in the business world, relying on trust often backfires.”
  • The board’s reputation fell further form the poison pill and staggered board.
  • However, neither Levin nor his son earned above-average fund manager salaries.
    • The event-driven investment employees kept 2/3 of earnings, which was low by industry standards–3/4 or more was the norm.
  • Furthermore, the fund-manager comps used by activists, like Eaton Vance, were large firms.
    • Achieving their margins would have certainly hurt BKF’s growth.
  • Ironically, the activist hedge fund managers chose to ignore the fact that BKF’s pay was conservative on a relative basis, and the company was not a diversified mutual fund.
• “Many of today’s shareholder activists focus their efforts on maximizing operating margins. To a fault, they don’t give much credit to uncertain growth prospects, while viewing trailing earnings as future money in the bank. This is a very different kind of activism than Benjamin Graham’s, which centered on capital allocation.”
  • Levin wishes he had asked for supervoting shares when Baker, Fentress acquired his company.
• “Google’s AdWords is literally one of the best businesses ever to exist, and shareholders have chosen to cede their oversight rights in order to participate in its growth. Google’s relationship with its shareholders is thus a matter of trust and not much else. So far, investors have been richly rewarded. Shareholders raised their eyebrows at acquisitions like Android and YouTube, but they have been huge triumphs. Still, it will be fascinating to watch how these benevolent dictatorships work out over time. Google already betrayed its original agreement with shareholders by concentrating ownership back into its founders after generous employee stock and options grants diluted their voting stakes. How long will shareholders continue to trust the company? How long can you really trust anybody that says they aren’t evil?”
  • This is interesting when taken in the context that the author’s fund owns Alphabet.

Author’s concluding thoughts:

• Much like what had happened to AmEx, weak AIG oversight enabled a unit constituting less than 10% of its division’s profits to cause catastrophic damage to the company.
  • It wasn’t a broad-based incentive problem: employees lost $500 M, as their comp was heavily stock-weighted.
    • Rather, it was an accountability problem.
• Checklist-style governance reforms, such as those employed by ISS or Glass, Lewis, are not very useful.
  • For example, it doesn’t really matter whether a board is staggered or not.
  • When the author joined the board of Tandy Leather Factory (ticker: TLF), ISS advised investors to withhold votes from the rest of the board members simply because they had instituted a poison pill after the author hit 30% ownership.
    • The directors, who were composed of longtime operators and a value fund manager–who proposed the poison pill himself–were all highly qualified.
  • ISS also advised Coca-Cola holders to withhold votes from Warren Buffett because of conflicts of interest stemming from his Dairy Queen ownership.
    • “Apparently there was also no question on ISS’s checklist that asked, ‘Is the candidate the greatest capital allocator to ever live?'”
• Proxy access (e.g., allowing 3%+ owners for 3 yrs.+ to nominate 25% of the company’s directors) would increase mgmt accountability, since proxy fights could be bypassed altogether.
• Public companies controlled by activist investors often fall prey to other activists.
  • After writing a 13D letter, the author was nominated to the board of Peerless Systems, activist manager Tim Brog’s investment vehicle.
    • Peerless Systems proceeded to file a 13D on Highbury Financial, another acquisition vehicle that had a stake in a mutual fund company.
      • Highbury sold itself, and Peerless used the proceeds to buy out shareholders, including the author.
• “The business world consumes its own, and the life’s work of great investors is inevitably reabsorbed into the industrial complex with little acknowledgment of their accomplishments.”
  • The author suspects that one day, Berkshire Hathaway will be an activist target.
• On keeping activists at bay: “The best corporate defense requires anticipating your areas of weakness and educating your investors about them.”
  • “Because ignoring the shareholders is such a losing strategy, activism has made public companies much more responsive.”