September

2014

Effective Activism 2014

Among the frustrations of small-cap investing are the poor governance, misguided
strategies, and wasteful practices at persistent underperformers. Disappointed
investors (or opportunistic fund managers) sometimes turn to an activist approach
to realize value in these stubborn companies.

Two attributes of activism stand out: on the occasions when it succeeds it does very
well, and it can cost an investor a lot of money to do. We set out to improve the odds
of success, and lower the cost.

In 2010, 2012, and 2013, we identified a total of 73 undervalued companies that fit
the profile needed to pursue effective, cheap activism. Based on a simple valuation
model, at that time we estimated an investor could on average almost double their
investment in these companies, at a negligible cost relative to conventional activist
efforts. And, about one-third of the companies have become activist targets, with an
average increase in share price of 48%.

We have updated the earlier analysis, and identified some new companies that fit
the criteria. These companies have a concentrated investor base (ten largest
investors own at least 30% of the outstanding shares), which allows an activist to
influence management in creative and low-cost ways. They are also hardly microcap
investments, either. In this 2014 edition, the average market capitalization of the 29
identified companies is $368 million.

We think investors should consider effective, cheap activism in two situations:
a portfolio manager with an underperformer that wonders about the costs
and benefits of an activist approach.
an investment firm that finds activist returns attractive, but finds the costs of
activism daunting.

Success and Costs of Activism

Without a doubt, in the right situations activist investing can deliver meaningfully
superior returns. Anecdotal evidence abounds, both in terms of success at individual
activist targets, and for investment returns at specific activist funds.

The best recent evidence comes in the form of rigorous academic studies:

Brav/Jiang/Partnoy/Thomas found that activist investing delivers 700
basis points of higher relative return at time of announced activism, relative
to a benchmark, with no subsequent reversal over time. In this study,
activists succeed in full or in part in two-thirds' of their campaigns.1

Klein and Zur found that activist investing produces 21.6 percentage points
higher relative return one year after the announcement of an activist
campaign. In this study, activists succeed in 60% of their campaigns.2

On the other hand, activist investing has a cost. Direct expenses include legal fees
and proxy solicitors. It can extend to public relations efforts including extensive
print, Internet, and even broadcast advertising. For our purposes, based on our
experience we assume that the activist effort at an average small- or mid-cap
company would cost $1 million.

Is there a way to achieve activist results, with greater certainty in the outcome and
at less cost to investors and managers?

1 Alon Brav, Wei Jiang, Frank Partnoy, and Randall Thomas; "Hedge Fund Activism,
Corporate Governance, and Firm Performance", Journal of Finance LXIII No. 4
(August 2008), p. 1729-1775.
2 April Klein and Emanuel Zur; Entrepreneurial Shareholder Activism: Hedge
Funds and Other Private Investors, Journal of Finance, LVIX No. 1 (February 2009),
p.187-229
September 2014

Effective Activism - 2014

2.

A better way to round up support

Investors can exploit a little-used element of SEC regulation to pursue lower-cost,
more effective activist strategies.

Current regulations exempt an activist from filing proxy materials with the SEC if
the activist solicits proxies from ten or fewer investors in a given company3. This
merely means that the activist need not file any proxy documents with the SEC, as
long as they confine their communication to ten or fewer investors in that company.

For all its simplicity, an exempt solicitation has wide-ranging implications, and
yields many benefits. With an exempt solicitation, an activist investor can:

1. Avoid the expense of a formal proxy solicitation, including legal fees, proxy
solicitor costs, and public relations costs.
2. Coordinate support from a small number of larger blockholders, and assert
confidently that the activist in fact represents the predominant views of most
investors.
3. Conceal discussions with other investors from management and the board of
directors, since they do not file any materials publicly with the SEC.
4. Tailor proxy materials to the individual needs of a given investor.
5. Communicate with investors according to the activists schedule, rather than
according to SEC deadlines.
6. Act quickly and nimbly, since they dont need to file documents with the SEC
every time they communicate with investors.
7. Exert quiet, discreet pressure on the company, which can help encourage the
company to negotiate a prompt response and resolution to the activists
agenda.

An activist investor can undertake an exempt solicitation in a straightforward
manner. While specific tactics vary, in most cases the activist need only notify the
company of its intent to nominate candidates pursuant to the companys bylaws.
The activist can then request votes, ask to serve as proxy, and otherwise campaign
for election, free of interference from the SEC.

We would be remiss in omitting one caveat, related to what constitutes ten-or-
fewer investors. An individual that holds shares of a company in separate accounts
counts as one investor. But, an investment firm that has several different funds, each
holding shares of a company, counts as multiple investors, so that each fund within
the firm is one investor.

3 SEC Rule 14a-2(b)(2)
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Effective Activism - 2014

3.

Positive returns from effective activism

We analyzed the prospective impact of an exempt solicitation. We identified likely
companies at which activists can exploit this exemption, and evaluated the potential
investment returns.

First screen: value
We identified highly-undervalued companies among the 8,500 or so publicly-traded
equities in the U.S. We looked for companies with two attributes:
High current net worth (current assets minus current liabilities) relative to
market capitalization.
High book value relative to market capitalization.

These companies have valuable assets, including quality liquid assets and business
assets, which do not translate to current share price.

Second screen: activism
We looked for good activist candidates, meaning companies whose current
ownership would allow an activist to influence management meaningfully. These
companies have:
Insider ownership under 20% of outstanding shares.
Top ten institutions owning greater than 40% of outstanding shares.

So, insiders have much less voting control over the company relative to investors,
and, most important, an activist can reasonably obtain the support of a majority of
shares pursuant to the exempt solicitation.

Third screen: return
We looked for companies that would generate a reasonable return relative to the
current share price. Using a simple free cash flow valuation model, we estimate a
target price for the company, and identify those companies whose current price
represents at least a 10% discount to the target price.

2010-2013: 73 companies
In the previous versions of this analysis, we identified a total of 73 companies that
fit this profile, with averages for the portfolio as follows:

Market capitalization of $415 million
Current net worth of 104% of market capitalization
Book value of 110% of market capitalization
Insiders own 4% of shares
Top ten institutions own 55% of shares.

The average discount to the target price was 39%, thus producing an average
potential appreciation in share value of 58%.
September 2014

Effective Activism - 2014

4.




Among the 73 companies, almost one-third became subjects of an activist investor:
activist subject - 23 companies
acquired or buyout - 7 companies
bankrupt - one company
no activity - 42 companies

On average, these 73 companies have increased in value 48% since identified as
possible activist subjects.

2014 Results: 31 companies
We used the same criteria to identify 29 new companies (Table 1), with the same
interesting and unexpected attributes:
Market capitalization of $368 million
Current net worth of 144% of market capitalization
Book value of 133% of market capitalization
Insiders own 4% of shares
Top ten institutions own 53% of shares.

Table 1: Subjects of Effective, Cheap Activism September 2014

sector
Construction
Consumer Products
Retailng
Steel
Technology
Home Furnishings
Homebuilding
Manufacturing
Steel
Manufacturing
Aerospace
Services
Manufacturing
Metals
Manufacturing
Technology
Hospitality
Energy
Consumer Products
Manufacturing
Aerospace
Services
Consumer Products
Construction
Construction
Technology
Automotive
Technology
Automotive

market
capitalization
($ mil.)
56
178
29
253
132
42
485
208
230
75
91
74
1,004
699
142
498
18
866
1,112
719
1,119
675
232
206
341
312
357
330
180
368

insider
ownership
2%
7%
2%
1%
6%
6%
2%
3%
8%
5%
4%
9%
2%
1%
3%
1%
7%
3%
1%
4%
5%
6%
6%
1%
2%
4%
8%
3%
4%
4%

top ten
institutions
ownership
43%
48%
45%
50%
49%
54%
48%
55%
54%
53%
50%
54%
51%
43%
46%
48%
45%
42%
70%
45%
56%
58%
63%
79%
55%
54%
72%
52%
52%
53%

current net
worth/
market value
575%
459%
472%
185%
150%
134%
354%
112%
126%
134%
98%
64%
144%
55%
97%
86%
65%
32%
110%
86%
64%
52%
81%
59%
57%
82%
85%
96%
56%
144%

book value/
market value
456%
134%
265%
297%
176%
169%
50%
72%
74%
282%
98%
109%
91%
247%
114%
45%
242%
68%
96%
85%
50%
59%
93%
134%
69%
78%
60%
68%
81%
133%

discount
to target
price
96%
92%
82%
81%
70%
66%
62%
53%
52%
51%
50%
48%
44%
42%
40%
29%
28%
27%
24%
24%
23%
23%
20%
18%
18%
16%
13%
12%
10%
42%

September 2014

Effective Activism - 2014

5.



The average discount to the target price is 42%. This is a slight improvement over
the 39% from the 73 companies analyzed in previous years. This discount implies a
potential average share price appreciation of 72%

Once again, these are not micro-cap companies. The average market capitalization is
$368 million, ranging from a low of $29 million to a high of $1.1 billion. This size of
company provides ample liquidity for an investor to accumulate a reasonable
investment, and to sell if and when appropriate.

September 2014

Effective Activism - 2014

6.

Cheap activism means higher net returns

The estimated average 42% discount to target price is one way to think about the
potential return on investment. Of course, we estimate the potential average 72%
return on an investment in the 31 companies before expenses, including the
expenses associated with the activism needed to achieve that return. Effective,
cheap activism makes that potential 72% return possible.

The problem with activism, for fund investors and portfolio managers alike, is that
the costs of an activist program consume all of the fees that a fund manager would
earn on the investment. An exempt solicitation lowers dramatically the cost to the
manager, and makes the potential 72% return more likely than under a
conventional approach.

We estimate the net impact of the costs of activism under a conventional and an
exempt solicitation, using a few simple assumptions:
Investment of 3% of market capitalization, comfortably under the 5% SEC
reporting threshold
Fee structure of 1% of assets under management and 10% of profits.
Activism costs of $1 million for a conventional approach and $100,000 for an
exempt solicitation.

Compare the two approaches (figures in $millions):

Exhibit 1 Activist Approaches

conventional exempt
investment
3%
11.0
11.0
appreciation
72%
7.9
7.9
value to
manager administration 1%
0.1
0.1

profit 10%
0.8
0.8



0.9
0.9

activism cost

(1.0)
(0.1)

net fees

(0.1)
0.8

The average investment is about $11 million (3% of the average market
capitalization of $368 million). The cost of a conventional activist strategy
overwhelms the additional fees that the manager would earn from the investment.
In this example, it generates nothing to the manager. Its no surprise that most
managers eschew an activist approach.

But, the much lower cost of an exempt solicitation leaves reasonable fees for the
manager. In this example, the manager earns $800,000 after the costs of activism.

September 2014

Effective Activism - 2014

7.

The Activist Investor

Resources and Advisory Services

The Activist Investor serves as a comprehensive resource for equity investors that
seek to enhance returns of poorly performing portfolio companies. We provide a
range of professional services to assist investors with their activist efforts.

For further information, or to discuss a specific turnaround situation, please contact:

Michael R. Levin
m.levin@theactivistinvestor.com
847.830.1479
www.theactivistinvestor.com

We base this information in this document on data from sources we consider to be reliable. We do not guarantee the
accuracy or completeness of this information. We do not intend anyone to use this information as the sole or primary
basis of investment decisions. Because of individual requirements of specific investors, an investor should not interpret or
understand this information as advice designed to meet the particular investment needs of any investor. We do not
represent this information an offer to buy or sell any security. Further, a security described in this document may not be
eligible for solicitation in the states in which the investor resides. Any opinions expressed are subject to change. From
time to time, Michael R. Levin may own the securities mentioned and may purchase or sell those securities in the open
market or otherwise.

September 2014

Effective Activism - 2014

8.