Widespread value dislocations create opportunities for activist investor Legion Partners

kohls

A rebound in investor activism is expected in 2021, after market dislocations and a global economic slump put a lid on activist agendas last year.

Activists scaled back their plans in the face of supply-chain disruption and stock market volatility caused by the coronavirus pandemic, leading to a 13 per cent decline in global activist campaign launches for 2020, according to Lazard. 

The pandemic made it difficult for activists to push for change within company boards at a time when the majority were focusing on cash preservation and survival.

At the same time, the highest adoption of “poison pill” shareholder rights plans at companies in a decade, according to Insightia, helped ward off activist takeovers.

However, vaccine approvals led to a late surge of economic optimism and a “strong snap back” in activism in the fourth quarter of 2020. More is expected to come in 2021, after many activists have made use of low equity prices to set themselves up for a comeback year.

Legion Partners is a US-based activist investor with USD526 million of assets under management. Founded in 2012 with USD200 million in seed money from the California State Teachers’ Retirement System (CalSTRS), the asset manager is known for locking horns with firms including Bed Bath & Beyond, Barbie doll maker Mattel, and cloud communications provider Vonage.

“It might not be completely accurate to say that [investor activism] has simply slowed,” says Ted White, co-founder and managing director at Legion Partners. “In our case, we may have been less public in some instances in campaigns, but we're still working really closely with our portfolio companies. There's really a lot more that goes on behind the scenes than goes on in public.”

Last year, Legion successfully pushed for changes including to boards, management, and sales of non-core assets, at six of its portfolio companies. Legion Partners tends to hold between 10 and 12 names at a time.

White says the pandemic allowed the firm to take advantage of “some near-term opportunities created by the volatility” that hit equity markets in March 2020. In that month alone, the Russell 3000 index of US stocks plummeted by 24 per cent. 

Low asset prices made it easier for activists like Legion Partners to build up stakes in companies, allowing them then to challenge management and operations of a business with the aim of improving shareholder value. 

“Think of it this way, there were some really good companies that had great long-term prospects, and their stock price was severely impacted during the pandemic,” says White. “In a lot of instances, we added to existing investments, even though they were pretty severely dislocated from where we bought in.”

One of these investments was department store chain Kohl’s. Last month, Legion and three other activist investors with a combined 9.5 per cent stake in the company unveiled a plan to take control of the Kohl’s board and improve shareholder value.

“Part of what underlies that position is a view that apparel sales are pretty good, and then on top of that, there's a huge opportunity to fix the business and make it more profitable than it had been previously,” says Chris Kiper, co-founder and managing director.

When Legion launched its campaign against Kohl’s, it took aim at the department store’s flagging sales and sluggish inventory turnover, and pushed for sale-leasebacks of properties and share buybacks. The investor group says this could increase earnings per share by at least 25 per cent – and improve Kohl’s standing with investors.

Kohl’s has responded to their campaign, saying: "We reject the activists’ short-termism and their attempt to disrupt our momentum at this critical time.”

Activists have often been criticised for having a "short-term outlook", because they seek to reshape a company’s operations but then often sell the stock after a few years. This means that not all activists are mindful of their effect on a company's long-term future returns.

“What we do in activism is often labelled as short-term. I'll tell you, that is simply wrong, on the whole,” says White. “It's ludicrous because if you can set a company up to be appropriately valued in capital markets, then it has far better opportunity to get financing, to grow, to do the right things, to treat its employees well, and behave better as a corporate citizen.”

In its latest proxy fight at Kohl’s, Legion teamed up with Macellum Advisors and Ancora Holdings, the same activists it worked with on a successful campaign at Bed Bath & Beyond in 2019. 

That campaign involved replacing the CEO, selling non-core businesses, and building a 168-page operational plan to overhaul the business. Bed Bath & Beyond’s share price doubled in the two years after Legion Partners’ initial investment.

According to White, activism is controversial because it is “in human nature to want the status quo, particularly if you're sitting on a board of directors”. 

This can open up a “chasm” between a company’s shareholders, who are its real owners, and the board of directors, who run the show.

“This is a strategy that has some confrontation associated with it, and in some situations, it's upsetting somebody’s apple cart. There are constituencies that would prefer shareholders not to get involved, and it’s that constituency that wants to find this more short-term,” says White.  

Plans like the one Legion put in place at Bed Bath and Beyond helped markets to understand the company’s true value. This is important given that Legion’s clients are long-term investors like pension funds and endowments, which are “beholden to the efficiency of capital markets… in order to earn a return and deliver to their beneficiaries what they promised over decades”. 

“The way public markets tend to value companies can be really disconnected from fundamental realities, and can actually be out of touch for long periods of time. Those are kind of the situations that we like,” says White.

Legion favours small-cap value stocks that they believe are temporarily undervalued by the market. This style of investing suffered in the first half of 2020, as ultra-low interest rates and recessionary economic forces incentivised investment in ‘growth’ companies instead. 

Value investors have already seen a sharp turnaround with Russell 1000 Value Index to outperform the Growth Index by six percentage points in February. Legion Partners says there is reason to expect more upside for stocks like these in 2021. 

“You’re leaving a slowdown period with consumer balance sheets in great shape, and that’s generally not what happens when you come out of a slowdown in the economy,” says Kiper.

Government support for households, businesses, and markets allowed consumers to amass savings in 2020. Oxford Economics estimates that over the course of the crisis, US households saved USD1.6 trillion more than they would have done otherwise.

This is partly why Legion Partners is optimistic on apparel retailers like Kohl’s. “We think as people emerge from the pandemic – and want to go back and have weddings, bar mitzvahs, and birthday celebrations, and go back to the office and go back to school – they’re going to need to have clothing, since they can't just wear pyjamas and slippers anymore.”

At the same time, companies have also used the crisis to improve their efficiency, reducing the level of duplication of costs and getting rid of extra labour in a similar way as they did after the great financial crisis in 2008. 

Kiper gives the example of Kohl’s. The department store cut its shops’ opening hours after realising that certain times in the early-morning and late at night were not producing enough sales to be worth opening. Once hours were reduced, they found customers amended their shopping habits and visited the stores more during the hours that it was open. “Those store hours are, in some cases, never coming back,” says Kiper.

“I think you're going to see every business think about ways that they can do things to be more efficient coming out of a pandemic. And so, when we look across our portfolio, what we're seeing is a renewed sense of profitability, and profit margins probably much higher than what people had seen before the pandemic,” says Kiper.