Huimin Chen, and Thomas Shohfi, both of the Lally School of Management, Rensselaer Polytechnic Institute, have written a fascinating article on the relationship of sell-side analysis and hedge fund activism.
Chen and Shohfi shed some light on the old question: where do hedge funds get their trading/investing ideas? They believe that “activism target selection, objectives [and] tactics” are derived, “at least in part, from sell-side analysts.”
A Proposed Dynamic
As a straightforward example, they adduce a letter written by Jeffrey Smith, of the hedge fund Starboard Value, in January 2014. Smith cited a memo that had been prepared by Mark Wilde, an analyst with Deutsche Bank, more than a year before, in which Wilde had said, “for nearly a decade, we’ve argued that Wausau ought to exit all paper operations and focus on its tissue business.”
So this was hardly a cutting edge analysis when Smith cited it. Rational expectations theory suggests that the market “should” have responded to Wilde’s insights over the intervening month, discounting Wausau’s value (if it in fact wasn’t taking such advice). That would have made the idea unhelpful to Starboard by 2014.
But Chen and Shohfi suggest that there is a more complicated dynamic at work. An analyst’s report citing concerns about a company (such as that its business model requires a high demand for paper at a time when business offices are going paperless) becomes public knowledge and leads to a drop in market price. An activist hedge fund notices this while the stock decline is underway and proposes a solution (a new focus for the operating company). The hedge fund goes long on the company, “investors recognize the problem-solving capacities of activist hedge funds,” and the price of its equity rises.
The Case of Yahoo
Another example suggesting much the same dynamic involves Yahoo. In June of 2011, an influential sell-side analyst with Piper Jaffray prepared a sum-of-the-parts analysis of Yahoo that led to a valuation of just above $20 a share. Three months later in September, Third Point’s Dan Loeb said in a letter to the Yahoo board, stating that Yahoo’s then stock price of $13.60 a share, was “far below the Company’s intrinsic value, which we currently place in excess of $20 per share.”
Given the hypothesis that this is the dynamic at work—that the analysts suggest targets of opportunity to the activist hedge funds—one can make the following predictions: (1) that sell-side analysts are more active in reporting on a firm’s problems before hedge funds get involved and decrease their involvement thereafter; (2) that analyst reports reveal valuable information to investors; and (3) that the content of analyst reports contains information pertinent to and influential upon subsequent hedge fund activity.
Textual Analysis of Analyst Reports
The scholars at Rensselaer, in their testing of this hypothesis, engage in (or have their algorithms engage in) “textual analysis on activist reports.” That is, they count words, (or the parts of words that will cast the net widely despite, say, varying suffixes). They count, for example, the number of times “undervalue…” or “balance sheet” appear in an analyst report. This is language “related to activism,” because presumably activists want to own undervalued stocks which they can help push to the equilibrium value, and they will also often want to wrestle with the balance sheet in the course of their valuation.
It supports the above predictions then and thus it supports the proposed dynamic, that reports from sell-side analysts written about firms that—hindsight tells us—were soon going to be targeted by activist hedge funds have exhibited significantly higher rates of the use of such terms than do control firms. That difference fades and the rate of usage fades to the rate of usage for the control firms after the hedge fund intervention, suggesting a straightforward inference about who is influencing whom.
A Final Thought
The Rensselaer thesis raises some obvious questions, such as: what happens if sell-side research activities themselves decline, through such regulations as MiFID? If regulators induce the institutions that employ such analysts to shift their resources elsewhere, then will someone else pick up the task of idea generation? Or will the valuable functions that hedge fund activists perform in the markets go unperformed?