Investor Essentials Daily

This activist investor’s shift in tone resulted in bad returns for its investors

June 16, 2023

Letter-based campaigns have been one of the most influential techniques in the world of activism.  

However, this technique is not only used by grassroots activists that want to push for political change, it’s also highly used in Wall Street.

One of the best appliers of it is the Third Point Management, founded and run by the famous Dan Loeb. 

Back in 2020, we talked about his tactics and mentioned he was getting softer with his activist campaigns as he got more experience and built a successful track record for himself.

Let’s revisit the fund to see how he reshaped the portfolio and how it has been holding up under the Uniform Accounting framework. 

In addition to examining the portfolio, we include a deeper look into the fund’s largest current holding, providing you with the current Uniform Accounting Performance and Valuation Tearsheet for that company.

Also below is a detailed Uniform Accounting tearsheet of the fund’s largest holding.

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Activist campaigns in the world of investment management have been rising since the 1980s with legendary names like Carl Icahn leading the way.

One of the best followers of this strategy in the last decades is Dan Loeb with his hedge fund Third Point Management.

Let’s remember his tactics and investment strategy from the original article we wrote back in November 2020. 

One of the favorite tactics among grassroots activist campaigns, particularly in politics, is a letter-writing campaign.

By flooding their representatives with personalized messages from constituents, these activists force elected officials to have to pay attention to their campaigns. Through these efforts, the activists hope to be able to change their representatives’ opinions and lead them to support the bills or issues that they find relevant.

This type of advocacy has helped people to have a stronger voice in their governments for centuries.

However, it is not just activists looking to impact government policy that turns to letter-writing campaigns. From time to time, various activist investing has also dabbled in writing letters to company management in hopes of eliciting change.

One of the great activist letter writers is Dan Loeb, founder and CEO of the hedge fund Third Point. In his early years as an activist at the firm, he was known to be a little more “rough around the edges,” bludgeoning unsuspecting company management teams with opinions on how to better drive shareholder value, or more specifically, how they were destroying it.

Many on Wall Street would wait with bated breath to see which executive was next on Loeb’s list to attack.

Loeb had tremendous success as an activist, enacting change by pushing management teams, at times with scathing letters, to take a deeper look at their business and implement changes that could ultimately lead to greater long-term value for the company and all shareholders.

As he has gained more experience with age, and as his incredible investment track record has become well-known, his tone has softened. Even so, his investment acumen has not diminished.

With the softened tone, Dan Loeb’s performance has actually been worse. In a good market of 2021, he managed to get 20%+ returns for his investors. 

But the last year has been a disaster for the fund as it even performed worse than the S&P 500 and lost around 24% in a challenging market.

Now, let’s have a look at his top holdings based on Third Point’s most recent 13-F and see how this shift in his tone reflected on his portfolio and if he is well-positioned for the year ahead.  

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.

It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.

See for yourself below.

A first glance at Third Point’s portfolio shows that the top holdings have been largely changed.

Looking at as-reported accounting numbers, investors would think that the well-regarded Dan Loeb invests in average, even below-average companies. 

On an as-reported basis, many of the companies in the fund are poor performers. The average as-reported ROA for the top 15 holdings of the fund is 9%, which is below the U.S. corporate average.

However, once we make Uniform Accounting adjustments to accurately calculate the earning power, we can see that the average return in Third Point’s top 15 holdings is actually 26%.

As the distortions from as-reported accounting are removed, we can see that Bath & Body Works Group (BBWI) isn’t a 15% return business. In fact, its Uniform ROA is 45%.

Meanwhile, Alibaba (BABA) seems like a below-cost of capital company with a 4% return, but this massive e-commerce company actually powers a 60% Uniform ROA.

That being said, to find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:

This chart shows four interesting data points:

  • The average Uniform ROA among Third Point’s top 15 holdings is actually 26% which is much better than the corporate average in the United States.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here are 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, the average Uniform P/E across the investing universe is roughly 20x.

Embedded Expectations Analysis of Third Point Management paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to remain at current levels with a slight decline in profitability. Just like analysts, the market thinks these companies’ profitability will be around the same levels going forward. 

Analysts forecast the portfolio holdings on average to see Uniform ROA slightly decrease to 24% over the next two years. At current valuations, the market’s expectations are in line with analysts and it expects a 27% Uniform ROA for the companies in the portfolio.

For instance, HCA Healthcare (HCA) returned 13% this year. Analysts think its returns will be around the same levels with a 14% return. At a 16.7x Uniform P/E, the market is pricing Uniform ROA to be around 12%.

Similarly, AMD’s (AMD) Uniform ROA is 32%. Analysts expect its returns will remain flat at 31%, the market thinks it’ll be around the same levels as well but it is slightly more pessimistic about the company’s long-term future and pricing its returns to be around 28%.

Looking at Third Point’s new portfolio, we can see that it’s composed of high-quality names that can provide strong returns to investors.

However, the portfolio-average Uniform P/E ratio is about 25 times. That’s higher than the market average of 20 times. Both analysts’ expectations and these companies’ current returns are in line with and at the same levels as market expectations.

This might limit the upside in the near term. After a disappointing performance in 2022, investors expect strong returns from Dan Loeb this year. With this fairly valued portfolio amid recession expectations in the near future, it seems like Third Point might have another challenging year.  

This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which has not been fully priced into their current prices.

It might take a big activist campaign to get the portfolio back on track. 

To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of Third Point’s largest holdings.

SUMMARY and PG&E Corporation Tearsheet

As one of Third Point’s largest individual stock holdings, we’re highlighting PG&E Corporation (PCG:USA) tearsheet today.

As the Uniform Accounting tearsheet for PG&E Corporation highlights, its Uniform P/E trades at 42.0x, which is above the global corporate average of 18.4x, and its historical average of 22.6x.

High P/Es require high EPS growth to sustain them. In the case of PG&E Corporation, the company has recently shown 55% Uniform EPS shrinkage.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, PG&E Corporation’s Wall Street analyst-driven forecast is for EPS to shrink by 163% in 2023 and grow by 12% in 2024.

Furthermore, the company’s return on assets was 1% in 2022, which is below the long-run corporate averages. Also, cash flows and cash on hand consistently exceed its total obligations—including debt maturities and CAPEX maintenance. Moreover, its intrinsic credit risk is 130bps above the risk-free rate. Together, these signal moderate operating risks and moderate credit risks.

Lastly, PG&E Corporation’s Uniform earnings growth is below peer averages, and in line with peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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