TAKEOUT BAIT.

“The way to maximize outcome is to focus on the process.”

Seth Klarman

Three months ago, I sheepishly wrote that the fund lagged its benchmark substantially in the second quarter, trailing the Russell 2000 by 14.3%. I mentioned being pleased with the fund’s 7% return, but given its style and my current risk appetite, thought it unlikely to keep pace in a frothy market (it was the 8th best quarter in the index’s history). I highlighted that small cap semiconductors rose 88% (the fund doesn’t own any) and April and May were the two best months for momentum on record (I’ve never been able to chase winners). For those not versed in factor investing, momentum is a measure of a stock’s tendency to rise simply because it has risen before. Think of them as the Kardashians of the investing world, famous for being famous.

In Nebraska we have a saying. ‘If you don’t like the weather, just wait a few minutes.’ As exceptional as the second quarter was, the third quarter reminded us that market leadership can change faster than you can say ‘AI token usage’. Tech fell 12% and energy was the only sector with a positive return, yet Epigram Capital Partners Fund I eked out a positive return. July and August were both down months for the index, during which the fund outperformed materially. While these results are unlikely to make anyone salivate, they do exhibit the ability to generate uncorrelated returns (rare in a long-only fund) and preserve capital during market turbulence.

One reason for this idiosyncrasy is that several holdings have been acquired, including two top-five holdings in July. Year to date, the fund has owned 71 securities and 12 have received offers. Last year was similar at seven out of 70. You can make a decent living trading on rumors, and while I do monitor them, I suspect I act on fewer than one in twenty. My goal is to never buy a stock I wouldn’t be comfortable holding should a transaction fail to materialize, something I pejoratively call ‘takeout bait’.

While predicting M&A may not seem like a repeatable skill, do it long enough and you’ll start to notice patterns. Like a star pitcher whose fastball has lost its zing, you can tell when a management team has given it their all. CEO schools are big on three-year Vision Plans, and midway through their second, management starts to feel their runway growing shorter. Invariably, they’ll face pressure to either explore a transaction or cast their burden onto younger shoulders. I imagine being a public company executive takes years off your life and once a CEO is in his or her 60s, retirement sounds more palatable than being grilled by dissatisfied analysts (many of whom are half their age). Every proxy details their pay package and what they’ll receive if they sell (known in industry parlance as a golden parachute). I’ve always found this term oxymoronic, since gold is heavy and the last thing I’d want when exiting a plane, but still. If you want to predict behavior, incentives are a good place to start.

I also monitor board membership. Boards gravitate towards candidates who’ve done right by shareholders in the past and have time on their hands, which usually means they sold themselves out of a job. All boards maintain a skills matrix, and if they’re seeking out an executive with M&A experience, it might be for good reason. Every time a board member leaves they must disclose if it was over a disagreement, and once in a blue moon, ‘strategic differences’ leak into the press release. This is board-speak for one person wanted to sell and another didn’t.

Lastly, I monitor shareholder dynamics and capital structure. You’d be amazed at how many funds have held a company for decades yet failed to generate a positive return. They know that to exit their stake would move prices, so they hold a subpar company indefinitely refusing to admit defeat. Activists know this too, which is why they focus exclusively on companies with disappointed constituencies, happy shareholders being notoriously hard to sway.

Speaking of activists, I’ve followed many of them long enough to know their typical playbook, whether their ideas are substantive or financial window dressing, and where their approach falls on the antagonist/constructive spectrum. 13 of the funds 36 holdings currently have an activist either as a holder or agitating for change. Six were purchased prior to the activists’ arrival.

As for capital structure, debt becomes current when it matures in the next twelve months. Companies refinancing now usually borrowed at trough interest rates in 2021, creating an earnings headwind all else being equal. If a management team is entertaining offers, they may postpone refinancing to take advantage of the acquirer’s cost of capital. The same is true of buybacks. Serial repurchasers are in the habit of re-upping their authorizations when they’re exhausted and failure to do so can signal a willingness to allow cash to accumulate to facilitate a transaction. You rarely see non-controlled companies allow cash to build on their balance sheet because it makes them susceptible to raiders who will finance their purchase with the company’s own cash. It’s the same reason companies acquire others as a takeover defense, deliberately inflecting stress on their balance sheet only to make it inhospitable to interlopers.

When asked to describe my process, predicting M&A or activist involvement rarely comes up. But I do look for companies that are misvalued or have misplayed their hand, both of which are fertile ground for transactions. ‘Someone might buy this’ can be said of any public company and isn’t the strongest of investment cases. But as long as I focus on companies with levers to create value, it’s not the worst thing in the world when someone else agrees.

Thanks for reading,

Dan Walker