By Paul Hodgson
FORTUNE -- Hedge fund activists often have very different strategies from each other, and very different opinions about a company's fortunes. Take William Ackman's shorting of Herbalife (HLF), while at the same time George Soros, Daniel Loeb, and Carl Icahn all took long positions in the stock. But one element underlies most if not all of their investments -- governance, and a belief that it makes a difference to a company's bottom line. To investigate this theory I will look at four recent transactions, two each for Ackman's Pershing Square and Loeb's Third Point.
Ackman's investments in Canadian Pacific Railway (CP) and Herbalife have been performing very differently from each other, until recently. Ackman's Pershing Square invested in Canadian Pacific in September 2011 and saw its investment more than triple by June last year when it started to sell off part of its holding.
In contrast, Pershing Square's $1 billion investment in Herbalife, a vitamin and supplement company, was doing less well last year. Ackman has shorted Herbalife, which is akin to borrowing the stock and selling it -- with the hope that the price will go down so it can be re-bought at a lower price, and then make a profit. Herbalife's stock price grew by 140% during 2013, the opposite of what Ackman wanted. This year, however, the stock has dropped 38%, and the Federal Trade Commission announced an investigation into the company's business practices; Ackman has long maintained that Herbalife is running a pyramid scheme where participants are paid primarily for enrolling other participants rather than supplying an actual product or service.
Like many activist hedge fund managers, most of Ackman's investments have a two-pronged approach -- financial performance and governance. At Canadian Pacific, the company was the worst-performing railroad in North America; investors had lost confidence in the CEO and finally in the board which was unwilling, or unable, or both, to fire him. Ackman launched a proxy contest there in 2012 when the board failed to respond to his overtures. Hours before the annual meeting, the CEO, the chairman, and a tranche of other directors resigned, clearing the board for the Pershing Square nominees. The effect on the stock price was electric, and it nearly tripled, from less than $50 to over $130.
At Herbalife, the situation is a little different. Ackman's bet was that although Herbalife was making money for shareholders -- the opposite to the situation at Canadian Pacific -- the company was running an illegal pyramid scheme and would eventually lose money for investors. If indeed the FTC determines that Ackman's accusations are true, then governance plays a very significant role in the investment because a board of directors that didn't realize the illegality of a company's business model, or who realized but did nothing, is culpable either way. Pershing Square would not comment on the record for this story. Herbalife has always maintained that it is a perfectly legal multi-level marketing company.
Not everyone agrees with Ackman about the company's long-term prospects, however, as I indicated earlier. Carl Icahn got another slate of three directors nominated, to add to the two already sitting on the board, though it was unclear why the three former directors were stepping down. Icahn is also Herbalife's largest single shareholder with nearly 17% of the stock, and others have aligned with him. Dan Loeb at Third Point also bought into Herbalife, so it is clear that the company's governance is not of universal concern.
While Loeb's position on Herbalife indicates that he has no concerns over the company's governance, many of his other holdings are focused on governance problems as well as underperformance. At FedEx (FDX), interestingly, even though Loeb has indicated that he supports current management and that he has invested in the firm because he believes the company will give him good returns, the reaction in the press was that there must be some governance problems at the company. Concerns focused on the concentration of power in chairman and CEO Fred Smith and the lack of any believable succession plan -- a "problem" that Loeb has said he doesn't agree with. On the other hand, Smith is 69 and has been CEO, president, and chairman for more than 40 years. Five other directors on the board have tenures of more than 10 years, and when directors have spent that much time with a CEO it begins to compromise their independence. FedEx directors are also very busy directors, with six of them sitting on three or more corporate boards, not counting any other non-corporate duties, or their actual jobs for those not retired.
While Loeb is working with Smith at FedEx, that is not the case at Sotheby's (BID) where he has nominated himself and two other directors to the board in order to improve what he refers to as the company's terrible operating margins. This slate is being rejected by the company, which has nominated two directors itself, vowing to buy back shares (something FedEx is also doing) and selling off assets to return cash to shareholders. The Sotheby's board presents similar issues to those at FedEx -- with some aging directors added to long tenures. Indeed, in a letter to the CEO that also asked him to resign, Loeb described Sotheby's as "on old master painting in need of restoration." Loeb has also been critical of executive pay at the firm. The firm was unspecific about its concerns, but mine would be that Sotheby's proxy statement spends way too much time explaining why it couldn't possibly disclose any of its performance targets -- even in retrospect -- because of potential competitive damage. The result is that no investor can see if the targets are difficult or a breeze.
Not only that, but Loeb has just launched a lawsuit to challenge the company's introduction of a poison pill in October last year. Poison pills can take many forms, but in this case the pill prevents any shareholder from owning more than 10% of the company's stock -- Loeb comes in just shy of that at 9.6%. Depending on which side you take, poison pills are typically introduced to give management time to consider their actions or to ring-fence directors from hostile activists.
Both Ackman and Loeb seem to see governance reform as an integral part of the activity of unlocking value. It is not an add-on, but sits on equal footing with other strategic actions such as stock buybacks, divestments, and efficiency programs. If fund managers who make this much money believe in governance, it's time others woke up to its value.
Despite the U.S. government's investigation of Herbalife, Pershing Square could lose its bet.
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