Jaggu's World of Stock Investing

When Hedge Funds Attack

By Will Swarts Published: March 2, 2005

MILLIONAIRES AND BILLIONAIRES ARE rarely seen as the natural allies of the little guy. But ordinary investors who own shares in sagging companies sometimes see their fortunes linked to hedge-fund managers whose annual salaries can reach into eight figures.

Activist fund mangers who control millions or billions of dollars can be an individual investor's best friends when they agitate for change or improved performance. And managers of other funds that short stocks can sometimes provide much-needed warning signs that a company is headed for trouble. If you know where to look, your fellow shareholders can be a big help, doing the heavy lifting you can't.

Unlike mutual funds, many players in the $1 trillion hedge fund industry are secretive — some decline to reveal their holdings even to their investors, who often must plunk down a $1 million minimum to get into the fund, then pay 1% annual management fees, as well as 20% of annual profits. But when a money manager with strong opinions — and the financial clout to back them up — weighs in, it can be a boost all around. Ask shareholders of Kmart (KMRT), who saw the stock climb from $15 in May 2003, when the company emerged from bankruptcy protection under the leadership of hedge fund manager Edward Lampert, to close at $99.15 today.

More recently, Highfields Capital Management last month made a $3.25 billion, or $17 a share, unsolicited bid for electronics retailer Circuit City Stores (CC), which, even after the stock's subsequent runup, offers a 6.5% premium to its current price of $15.90.

Greater numbers of funds are willing to throw their weight around, and will agitate for change even before they own 5% of a company, the threshold at which they must notify the Securities and Exchange Commission of "beneficial ownership," which makes their stake part of the public record. George Van, chairman of Van Hedge Fund Advisors, a hedge fund investing and consulting firm in Nashville, Tenn., says this doesn't always happen with genteel diplomacy.

"What I've seen is very straightforward, with a hostile edge," he says. "It may be constructive, but the approach can be pretty hard. That letter to Circuit City — they were pretty rough."

"Obviously, you want an improvement in operations, and it affects all shareholders equally," says Daniel Loeb, chief executive of Third Point, a New York hedge fund known for its sometimes brutal letters (see here and here) to officers of companies it hopes to turn around. "We're trying to get management to do what the board should be getting them to do — to perform their job function and maximize value for shareholders."

Though they haven't seen it yet, shareholders in troubled budget airline Independence Air (FLYI) could see their stakes double if the partners of East Texas Capital get their way. Since hitting a Nov. 12 low of $1.04 a share, the beleaguered carrier has rebounded slightly, closing at $1.45 on Wednesday, though it's still well off its 52-week high of $7.93, which it soared to, briefly, on April 12.

The small but scrappy hedge fund, based in Center Valley, Pa., rarely has more than $20 million under management. But what it lacks in size it makes up for in gumption. Last Wednesday it urged Chairman Kerry Skeen to hire a financial adviser to find a buyer for the Dulles, Va.-based budget carrier. Last November, the Boston hedge fund Par Capital Management, which owns about 10% of the airline, wrote to the carrier and urged it to pursue a sale or secure regional flying contracts with larger airlines to keep from folding its tent.

East Texas's pitch was somewhat different from Loeb's high-and-inside fastballs — East Texas has about 1% of Independence Air's shares, and not nearly enough money to force the issue. Also, the hedge fund's managers actually like the company, which just completed a particularly difficult restructuring at a time when the fortunes of many carriers are effectively grounded.

"Your recent restructuring is laudable and our principals are impressed by your product and your employees," the letter said. "However, especially in view of the extremely difficult operating environment for airline companies, it is [our] desire that you quickly find a merger partner that can assist you in better utilizing the assets you manage and maximizing the return for your shareholders."

Bob Miller, who handles real-estate investments for the partnership, said East Texas — named for a Pennsylvania village a few miles west of Allentown — hasn't heard back from FLYI management, and doesn't expect to any time soon.

"It's our belief that the stock is currently trading at 40% to 50% of book value — I think that the stock is just grossly undervalued at this time," he says. "We've had to take these stances reluctantly. The management is really encumbered with their restructuring, and I know they're busy. Saving the company is one thing, increasing shareholder value is another."

Independence Air spokesman Rick DeLisi said the airline hadn't commented on either letter and declined to discuss any potential announcements in the future.

Short sellers don't bother with tough love. These funds borrow stock, usually from a big investment bank, and pay interest on it, hoping that it will drop in price. They then sell it back, and pocket the difference. Web sites such as SmartMoney.com display the short interest on particular companies, and investors can use those numbers to see if more big investors are betting against a company.

James Chanos, a well-known short seller, was the first investor to raise questions about Enron, sparking a line of inquiry that led to the unraveling of the Houston energy trading company's Byzantine — and illegal — financial structures.

"The activist shareholder and the guy who shorts a stock are sometimes selling to each other," says George Lucaci, managing director of Channel Capital, a New York firm that owns HedgeFund.net, a Web site for hedge fund news and information. "They add a lot of liquidity, and I believe it has also increased volatility."

While short selling and shareholder activism might each — or in combination — make a stock's price move more than normally, Lucaci says the end result can make companies better. "It has often woken management up," he says. "They realize they have to be more aware of what they are doing, and why."

posted by jagadish @ 6:08 PM