The Daily Dose: Thinking Like an Activist Investor

 | Jun 09, 2014 | 9:00 AM EDT
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By the end of last week, I was damn near spent from stalking Wal-Mart's (WMT) annual meeting. I have to say that the new CEO of Wal-Mart, Doug McMillon, has left me so inspired to that I've had visions of him running for U.S. president. I wasn't inspired enough to even consider an upgrade on Wal-Mart shares -- but I am now confident that, if anyone appreciates this company's challenges and opportunities, it's McMillon.

In any case, following that annual Arkansas rave, news surfaced that Carl Icahn had amassed a 9.4% stake in struggling dollar store chain Family Dollar (FDO). There's no rest for the weary!

Allow me to explain: My firm initiated a Sell rating on this stock over a year ago -- and it's been a fine call so far, if I say so myself. The company's management team is blind and its board is ridiculously undermanned, filled with retired consultants. All of this, moreover, appears in the daily store operations and, ultimately, in the financials.

All this notwithstanding, shares of Family Dollar deservedly popped on news of Icahn's involvement, and they are likely to move higher still. Icahn has a real chance to overhaul the executive team and dismantle the board, and proceed to foster impactful ideas that can generate value for Family Dollar shareholders. I am not sure if Dollar General (DG) and Dollar Tree (DLTR) holders would be enthusiastic about joining forces with a fundamentally battered Family Dollar. But, either way, Family Dollar holders -- old and new -- have an opportunity to attain more wealth than they did prior to Icahn's disclosure.

So I am mildly upset with myself for failing to detect this breaking news. Family Dollar shares began to act well relative to the broader market in late May, and that should have been an indication that something was up, given the poor state of Family Dollar and money floating around shops focused on price-to-earnings ratios and activist investing.

Icahn did do a wonderful job of buying the stock "quietly," to paraphrase Gordon Gecko, as he started to amass his stake three days before the April 10 earnings bomb. Let's put aside the question of what Icahn knew about that earnings report -- that is, whether he knew it would be bad, thus opening an opportunity for him to get in at a low price. The reality is that, if Icahn began buying Family Dollar on April 7, his team had likely commenced a thorough company analysis weeks, if not months, in advance.

So the question for today is: Could the average investor have noticed any of this happening? While the masses are buying all sorts of richly valued companies right now, I think you should strap on your activist-investor hat and screen for companies that have fallen on hard times, but which play a crucial Family Dollar-like role in the economy that could be fleshed out with new ideas from outside investors.

Here are three things you should be seeking in the process:

Worsening sales growth, or outright year-over-year declines: The economy is improving, as suggested by nonfarm payroll gains of more than 200,000 for four consecutive months. In such an environment, a company should be growing sales by way of volume and pricing gains, or at least one of the two. If the company's sales are dropping, or slowing sharply -- as is the case with Family Dollar -- it could be a red flag on failed management initiatives.

New things are done, but they're not showing up in operating margins and return metrics: Family Dollar has been out of control when it comes to new store openings. That would be fine if this activity appeared favorably in operating margins and returns on asset and equity. But these metrics been down-trending at Family Dollar for the past three years and they are sufficiently below those for its rivals, Dollar General and Dollar Tree. This, in turn, points to weak management.

Tricks of the trade: In the land of retail analysis, a rising inventory-to-sales ratio and a falling profit constitute a recipe for share-price disaster. Outside of retail -- say, in industrials -- you need to track the trend in fixed assets. If fixed assets are declining amid impartment charges -- due, perhaps, to underperforming assets -- it could be a sign that management is failing shareholders.

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