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Trading Alongside Activist Investors

Trading Alongside Activist Investors

Activist investors buy companies and demand change. They are individuals or hedge funds that buy a company’s stock so that they can demand changes they believe will increase share holder value. Some companies quickly respond to activist investors.

That was the case last month when activist investor Dan Loeb took a large position in Nestle. Loeb manages $18 billion through Third Point, a hedge fund. He disclosed that he had bought $3.5 billion worth of Nestle, an amount equal to just 1.3% of the company but almost 20% of the assets he manages.

Loeb wanted Nestle to sell its 23% stake in the French cosmetics company L’Oreal so that it could use the cash to buy back company stock. He also wanted the company to increase its profit margins from 15% to 18% to 20% by 2020.

Days later, Nestle announced that it will launch a 20 billion Swiss franchise share buy back program and focus its capital spending on high growth categories including coffee, pet care, infant nutrition and consumer healthcare.

Nestle didn’t mention Loeb when they made the announcement. Instead, the announcement noted the decisions were reached after a “comprehensive review of the company’s capital structure and priorities to support and enhance its ability to deliver on its value creation model.”

The company’s action boosted the stock price by about 2%. Loeb is most likely seeking more than that. His position seems to be aimed at breaking the stock out of its long term trading range.

Activists Don’t Always Get Results

Although Nestle shows that activist investors can achieve immediate results, there are times when activists fail miserably.

Bill Ackman’s Pershing Square Capital Management famously spent an estimated $5 billion investing in Valeant Pharmaceuticals International Inc. including shares of the companies and call options on the stock.

When the fund closed out its position, it was estimated that Pershing Square lost about $4.2 billion. This demonstrates that activist investors can be spectacularly wrong at times.

Source: Fortune

Knowing that, investors seeking to benefit from following activist investors should always manage risks. The chart above shows that it could also be beneficial to focus on short term trading strategies. Valeant did get a bounce after Ackman made his investment and short term strategies could have benefited from that.

There are several options strategies that can be used to manage risk. The right one to use depends on a variety of factors. In large part, the right strategy depends on the individual investor’s risk tolerance and the nature of the news.

A New Activist Investor Target

Last week, Hain Celestial Group Inc., (Nasdaq: HAIN) was in the news after an activist investor took a position in the company.

Hain makes a variety of organic products including Celestial Seasonings teas and Terra Chips. Sales topped $2.8 billion in the past twelve months.

Activist investor Glenn Welling of Engaged Capital LLC announced that he intended to force a share holder vote to change control of the board of directors. He also revealed he may push to force a sale of the company.

The news led to a rally in the stock.

The stock has been regularly setting new 52 week lows since last August when management announced that it would have to delay its earnings report. Management also revealed at that time that they were likely to miss their earlier sales and earnings guidance because of problems associated with recognizing revenue.

The company finally released that earning report in June of this year, after going 13 months without making any filings with the Securities and Exchange Commissions (SEC). Companies are required to file reports at least once every three months.

In the recent SEC filling, “the company corrected what it said we’re “immaterial errors” for prior-period financial statements.”

Now, Engaged Capital LLC has acquired a 9.9% stake in the company and revealed that it had discussions with the company’s board and held out the possibility of further discussions. But, at the same time, Welling intends to push his own slate of candidates to replace the existing board.

Over the past two years, Welling has recorded a number of wins. He has won similar elections after taking positions in Rent-a-Center, HeartWare International Inc., Outerwall Inc. (OUTR), MagnaChip Semiconductor Corp. and Benchmark Electronics Inc.

Press reports indicate that now, Welling is likely interested in pushing Hain to increase its revenue by focusing on a new approach to sales and marketing. As an alternative, Welling might want to force a sale of Hain to another packaged foods company.

Analysts noted there are a number of possible buyers that could be interested in Hain, either in whole or in part. Many established packaged foods companies are looking for ways to increase their sales in the organic foods space. That means well known names like PepsiCo. Inc., Campbell Soup Co., Hormel Foods Corp., General Mills Inc., Kraft Heinz Co., Nestle SA and Unilever NV could be interested in Hain.

Trading Alongside Welling

Hain Celestial’s stock price jumped on the news that Welling had acquired a stake in the company. But, the current price doesn’t fully reflect the gains that Welling is hoping to achieve on the position. That means further gains are possible.

To benefit from gains, an investor could buy shares of the company. This requires a significant amount of capital and exposes the investor to standard risks of owning a stock. If Welling is unsuccessful, the stock price could drop significantly.

There is also a risk that Hain has not put all of its problems behind it. The company went 13 months without making any SEC filings, an unusually long period of time. The company has not had a public share holder meeting in more than two years. It is, of course, possible the company faces ongoing problems.

To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options.

To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call.

This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership.

Both the potential profit and loss for the bull call spread are very limited and very well defined. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

Specific Trade Strategy

HAIN closed at $38.82. The July 21 $39 call can be bought for $1.27. To help lower the cost of the trade, the July 21 $43 call can be sold for $0.28. This will result in a debit of $0.99 to open the trade. This represents the maximum loss on the trade.

The maximum potential gain is equal to the difference in the strike price less the debit paid to open the trade. The difference between the strike prices is $4 ($43 – $39) and the maximum potential gain of $3.01 ($4 – $0.99).

Since each contract represents the 100 shares, the risk is $99 for a potential gain of $301.

If HAIN closed below $39 at expiration, both options are worthless and the loss is $99. If the stock closes above $43 at expiration, the gain is $301. Between $39 and $43, the payoff is between those amounts.

Overall, this trade carries low risk and a strong potential return given the small size of the risk.