WRFH/Radio Free Hillsdale 101.7 FM - Wall Street Weekly: Hostile Takeovers and Activist Short Selling

Episode Date: February 16, 2024

Company takeovers can be friendly operations, but what happens when they turn hostile? And what is activist short selling? Can investment research firms singlehandedly dictate stock prices while making a profit for themselves? Join Patrick and George as they discuss these fascinating topics.

Welcome to Wall Street Weekly, a show where your hosts, George and Patrick, cut through the financial jargon to keep you educated and informed about the markets that affect our lives. Enjoy the show. You're listening to Radio Free Hillsdale 101.7 FM with a highly informing overperforming radio show. My name is George Ackler, joined alongside Patrick Scott, and we're going to get hostile on the show today. Hostile takeovers, baby. Let's go. I'm talking about the people who took down companies. or, as some would say, made them better and more profitable. It's a weird area of investing that there's many different strong opinions about,

and Patrick will get right into that after I disclaimed the show that anything you hear on this is not investment advice. It's for entertainment purposes only, as always, consult trusted financial representation before making any decision. Patrick, what is a hostile takeover and why is there such negative stigma around it? So a hostile takeover is when one company takes over another company against that company's wishes. And so we think about companies like mergers and acquisitions as when, oh, I want to buy George's company and George is willing to sell it to me at a certain price, the collection of all the shares. But what if George isn't willing to sell me his company? He very well might not be.

But there are still ways for me to get around that and still acquire his company. I think it gets a little nasty because it's not a transaction where every party is. is happy. And you come up with an example later of, I believe it's Anheuser-Busch and kind of what went down there in 2008. But for starters, what is the process of a hostile takeover? What does that look like? Yeah, we might think to acquire another company, doesn't that a company have to be, have to agree to want to be bought out? It seems like they should. Right, but not necessarily. So the process goes like this. Someone tries to take over a company. They're going to send a bid an offer to the company for a certain dollar amount.

If the price is right, the company will accept and yield to the offer, but sometimes they're not that receptive. And just for our listeners, who is the company? Who's making this decision? The board of directors. Which is appointed by the shareholders. So in that case, if the acquires still wants control over the company, they have three different options.

Their first option is to appeal to the shareholders, and those shareholders are going to vote people into the positions of board of directors. So they have that power. And the shareholders would vote people in who would accept a new offer from Company A, we'll say. Wouldn't they potentially accept the same offer or at the initial offering price? I suppose so, but yeah, same idea. People who are sympathetic to the cause. Right. Their second option is to try and acquire a majority stake with what's called a tender offer, which is buying shares directly from other shareholders. and often at a higher price than what the shares are currently worth. Their third option is to try and acquire any available stock in the open market.

However, this might not work because there might not be a whole lot of open shares in the market. For a tender offer, doesn't the company have to say that a tender offer is being offered? Pretty much, I think so. Yeah, they just proclaim it from the rooftops. Here's our offer. If any shareholders want to sell their shares for this extra larger price, then come to us. and buy them because we are willing to pay for them, but they have a set price. So how does this work with private companies? How do hostile takeovers work with private companies? Or do they? And the research that I've done, it is a little confusing because private companies can be everything

from a chick-fil-a at its beginning where one or two people own the entire company. Or it could be you have 150 share, like what we would consider shareholders that are owning the company. It's just not on any publicly traded markets. Right. The difference I would quantify with the private markets is, A, you have more smart money or institutional investors, but additionally, a lot of the valuation metrics, which we haven't really gone into on this show,

are used as the basis for what a company is worth. Whereas a publicly traded company, there's a price that's determined based on supply and demand. And if demand is really low, there might be bargain bin prices that a corporate raider, as a lot of these people doing hostile takeovers are called, can come in and liquidate the company and make much more money than it's currently trading at. But with private companies, there's not a set price based on supply and demand. And most of those shareholders aren't going to trade out a loss, knowing that someone's just going to take their shares, liquidate the assets, and sell it for more than it's worth. So there is kind of a set price, but it's not set by supply and demand. it's a more concrete representation of what each share is worth. That's my understanding, and I am by no means an expert in private hostile takeovers. So, yeah, that gets into my next point, which is takeovers are performed either as investments,

which is company one buying company two because they think that company two will do well in the future, sort of how we buy stocks normally, or they perform a takeover as activist investors. where they want to alter the course of the company, and they hope to make it more profitable in the future, like flipping houses or something. You know, you've got to renovate a little bit before it can make you money. And then a third option that isn't here is just to sell it right away. They think the assets are worth more than the selling price,

and they want to liquidate right away. Okay, yeah. So let's take a look at an example. InBev was trying to take over Anheuser-Busch, and these are brewing companies. and InBev made an offer at a 30% premium, which means that they were offering 30% more money for what each share was worth. But Anheuser-Bush's directors rejected that bid. And so then InBe appealed to Anheuser-Bush's shareholders to oust the board members and replace them.

That didn't end up working out. In-Bev made an even higher offer, which Anheuser-Bush then accepted under pressure from Warren Buffett, actually, who was invested in Anheuser-Busch. Why would the investors in Anheuser-Busch want the deal to go through? You know, we're talking about the acquire company that wants to buy it. How do they have any leverage over the shareholders? Aren't the shareholders on the team of the company they're invested in? But everyone has a price where they're willing to sell out and make money.

If I have a share worth $100 and I'm a short-term investor and you're going to offer me, you said, what, 30% premium? Right. You're going to offer me $130 for my share. you might not think it's worth that much. Yeah, I might not think it's worth $130 and be willing to sell out. And there's a price where every single investor will sell out. Even the most ardent supporter of Apple would sell out if it was a million dollars a share was the offer.

Right. Yeah, so this is what the tender offer is, that 30% extra, that they're just posting for everyone to see so that they can come and sell their shares too. In this case, in BIV. That way, shareholders can make a profit off of the tender offer. and equity in the company Anheuser-Busch goes to InBev. Now let's talk about a little bit about the ramifications of hostile takeovers. Let's talk about why some people don't like it. First, it's bad news for the workforce of the inquiry.

We talked about the two reasons why companies acquire each other. And the second reason was that a company wants to change the course of the other company. So oftentimes changing a company's direction means changing a company's leadership. So that board of directors that opposed the takeover initially, well, they probably had good reason to oppose it. They knew they were on the chopping block. The C-suite is in a risky position, too. The C-suite being CEO, C-I-O, C-F-O, anything with chief in front of it. And also, many of the jobs filled by average employees are no longer needed.

And so they will likely be let go as well, because the acquirer is going to prefer to keep their own employees over the employees that do the same job. at the acquiree company. And I think the worst example of this in the case of a company is if I own a company that's trading at $80 million as far as market cap goes, so that'd be shares times share price. That's what the company is worth. But I think in five years I can make a $1 billion company,

and my assets on the books are, we'll say, $120 million. So a company knows that if it comes in, buys my company for $100 million, it can then liquidate everything for $120 million and make a bunch of money off of that. If I'm CEO, I'm trying to convince everyone, no, if you just hold tight, if you don't take this short-term profit and wait for the long-term gains, we can be something much greater. Of course, the CEO also has incentive because they don't want to move towns. They don't want to lose their salary that they so generously receive every year.

But yeah, definitely a lot of different incentives at work. But that's also interesting because nowadays a lot of higher-ups are also compensated with stocks. So this would also benefit them in a way, too, though, wouldn't it? Yeah, it would depend on their stock comp plan. But either way, I'm not anti-CEO, but I think most of those guys are doing pretty well. It's also simply not a pleasant idea to think that another company could just come and take your business away from you without you being able to do much about it, especially at least if you're an unpopular boss. So it's just a very vulnerable position. Now let's talk about why it can be a good thing.

And I think the biggest reason is that it prevents the employees in company leadership from acting only in their own interests. And so in my financial management class, we talk about what is the main goal of a publicly traded company. And we determine that it is to maximize shareholder wealth, right? The threat of takeover motivates the company leadership to act for the benefit of the company's shareholders. because the shareholders have that power over the board of directors and therefore, you know, the C-suite, the CEO and the others, that they want to be on the shareholder's side.

So as long as the company leadership is working for the shareholders, they're safe. But if shareholders don't like the way the CEO is running the company, they can vote members onto the board of directors. And once again, yes, if you own a stock, you can vote to decide who is on the board of directors. The board can then replace the company leadership with people who will act in favor of the shareholders. Yeah, you could theoretically pack the board with people who are sympathetic towards selling the company if that's something you want to do. Or if the other company wants to almost bypass the shareholders, they can just try to buy a majority stake in the company and then they can control the voting. Which is very hard to do because I think it's once you get over 10% in a company, you have a publicly traded company. you have to a publicly traded company you have to start reporting every buy that you make so yeah people start

getting a little nervous if you're at 20% and they see you keep buying having an emergency meeting or something to write the ship well that was everything that we had on hostile takeovers but before we move to georgia segment we'd like to remind you that you're listening to wall street weekly on radio free hillsdale 101.7 fm as i said i just talked about hostile takeovers and how George is going to tell us about story time with George didn't expect this did you Patrick no I did not okay so picture this Patrick it's the Saturday before Super Bowl and the chiefs and the 49ers are equally favored to win 50% each way and many people are betting on both teams but you've been putting in 16 hours of research every single day you want to find

some bet that you can make to make money on the Super Bowl and after watching footage of Patrick Mahomes getting off the bus, you notice something interesting. One of his wristbands is actually a hospital band. You zoom in on the picture and spend hours of more research and you find that the numeric code and the doctor name can only signify one thing. Patrick Mahomes has had season-ending shoulder surgery and will not be playing during the Super Bowl. The only people who know this are you and the team, which obviously they're not allowed to gamble. So what do you do? You bet a million dollars the 49ers will win the Super Bowl, and because it's 50-50, you'll receive $2 million if they do. Then you release your research to the general public.

The NFL world goes crazy, and Patrick Mahomes confesses that he is, in fact, not going to be playing. This is going to change the odds, so instead of 2 to 1, the Chiefs are now 10-to-1 odds to win the Super Bowl. At this point, you could lock in profit by placing a $200,000 bet on the Kansas City Chiefs. No matter who wins, because remember the chiefs were 10 to 1 at this point, you'll win $2 million, and you've only had to spend $1.2 million to do so. Now, for all you smart investors out there, you might think, oh, there is probably better ways you could have made more money riskless, but we're not going to go into this because this isn't a show where we're trying to talk about sports betting or anything.

But this is essentially what a research short-selling firm actually does. So they'll go around looking for pictures, looking at it. everyone's wristbands seeing if they've had any surgeries recently. Okay, so not exactly that. They're not going to go for big targets either. So maybe the Kansas City Chiefs weren't the greatest example being one of the most notable professional sports team in the world. But here's what they're trying to do. They generally find smaller or foreign companies that no one's really taken a deep dive into. A perfect example of this would be Hindenberg's research into a company called EBICs. It was a U.S. traded company that was based in India that had grown to an $800 million market cap.

That's not huge, just to clarify, right? Yeah, so they're going for smaller targets. To be on the S&P 500, you have to be $12 billion is where the cutoff is right now. A pretty small company. Okay. And their business model was issuing prepaid gift cards. It was a lot like Visa, except more specific. For example, if I wanted to give you the gift of a weekend getaway,

I could give you a gift card that can only be used on Airbnb.com and at, certain restaurants. And that's what that company was selling? That's what that company was doing. Okay. After doing some research, Hindenberg found a story about EBICS auditor, RSM. They had resigned because EBICS wouldn't provide evidence regarding quote-unquote unusual transactions related to the company's gift card business in India. This was all public information and being that it was just one small-ish issue, investors weren't super concerned. There was about, 20 things and 20 steps that Hindenberg took that ultimately led to EBCS's share price decline. I think the most interesting, though, that shows how many resources Hindenberg has is that they

found that EBCS cash listed 970 vendors that were independent distributors of this product called EBCS cash. And Hindenberg Research called each and every one of those 970 distributors. and they found that 403 didn't pick up, 527 told us that they didn't sell EBCs cards, and 40, only 40, which is 7% of those who picked up, told us that they sold the EBIX cards. And then, contrary to Ebyx's claim, many said that they were selling many less gift cards than they had pre-pandemic. The long and the short of it was that Hindenberg was able to uncover, I think what we would consider fraud on the financial reporting for EBCs.

The price went down 40% immediately, and now it's down 96% from when EBCs or from when Hindenberg released its report. Would they have shorted the company before they did this to make money? Just like we bet on the San Francisco 49ers before the Super Bowl, before we released the Patrick Mahomes information. Yes, what they're going to do is they're going to short the stock and then reveal the research so they can make money off of it. Patrick, I'm going to pose this question to you, though. And it's a question that comes up a lot in the investing community. Do you think research firms do investors a service or a disservice? Just the average ordinary investor.

Are they doing us a service? Oh, the average investor? Well, they're not exactly taking away from the investor by releasing this information after that they have shorted it in this case, after they've made their profit. Yeah, and I think that's what most people would say, because at face value, it's pretty obvious that exposing fraud in the market and reducing information asymmetry, which is what we'd call in economics, the fact that I know something that you don't know, they're reducing that gap. Even if I lose 30% in a stock, if they're doing fraudulent things, that's probably information

that I want to know. Right. And if they're doing fraudulent things, then most likely the stock's going to go down at some point anyways. And investors aren't forced to act on the information they receive. And in fact, if they think Hindenberg or another firm called Muddy Waters research is wrong, they can just buy more of the stock when it plummets inevitably. Right.

Also, I want to bring up the point that not just any company can release this research. So the only reason that the two big firms, Muddy Waters and Hindenberg Research, which will look at are large firms with huge research capabilities, is because they've been successful even when they weren't huge. You start out small, you get a reputation of being really good at what you do, and then you can grow and keep on doing it at a higher and a higher level. If you actually look back at their track record, it's pretty incredible how many companies have lost 30, 50, 70% of their value because of the information that they're able to uncover.

So it definitely doesn't seem like these research firms are enemies to investors, but it definitely seems like they're enemies to companies. Even companies that are quote-unquote acting ethically have argued that they can be hurt by this, that it's a self-fulfilling prophecy. Smaller companies might rely on a stable share price to get things like debt financing, and if their share price craters, they might struggle. The analogy that I would use is even a well-run bank. Still, if there wasn't FDIC insurance, would still be susceptible to a bank run just because of the nature of the business. If everyone tries to sell or, you know, get their deposits back

at once, they're probably going to go under. And I see it as a similar thing. If everyone starts selling at the same time for a small company, their share price might crater, causing them to lay off people in the business, contract their operations. ultimately fail. It's uncertain how many times this has happened, but based on all the small firms that Muddy Waters and Hindenburg has gone after, I would think it's pretty likely that it's a non-zero number. Finally, I'll put my tinfoil hat on because investors have long speculated that there could be ulterior motives at play. And this is not something that I necessarily believe, but in the case of Muddywater's research, last week they released a short report on Fairfax Financial, causing its share price

to tank 12% in the matter of a day. This was a strangely big company at $20 billion, which was odd compared to what the firm had done in the past. Fairfax Financial has been on an upward trajectory for the better part of the last six months, and some people, mostly retail investors, the quote-unquote dumb money, have speculated that Muddy Waters was colluding with short sellers

who wanted to exit their positions. So the idea is that we talked about how do short-sellers lose, money. Okay, they lose money when the stock goes up in price. Right. And if I keep on losing money and I'm like, oh, it keeps going up. I have no place where I can sell. The theory goes, I call up my friends at Muddy Waters and say, hey, can you dig up some dirt on this company? Because quite frankly, every company has some dirt to be dug up on it. Right. Causing its share break to tank temporarily. And then you can get out. Then you can get out. Remember to exit your short positions. Oh, wow. You have to buy shares of the stock. That's interesting.

Again, I think that in the case of like Muddy Waters in Hindenburg, if I'm being 100% honest, I think the odds of this happening are probably near 0%. However, with the success of research firms, they've had massive popularity over the past couple of years and the democratization of the investment process where more people could theoretically do this type of work. As more firms enter the market, I think it would become much more likely. that people would be potentially willing to sacrifice their reputation as a research firm to make money on the side helping out short sellers. Again, kind of a far out there conspiracy theory, but to give fair treatment to what research short sellers do, I thought I shouldn't just make it all one-sided. Well, I think that's all the time we have for today. We hope you have enjoyed this episode. To that point, we have a great slate of episodes coming on in the next few weeks. I know we have an interview coming up. I don't know if it'll be directly on our show feed, but we'll make sure to put that at Wall Street pod on Twitter so you don't miss that. We're going to be talking about

Bitcoin next week with a student at the college who has dabbled in the field to say the least. Yes, not the same one we had first season. We'll call it season one. Season one, not our friend Ian Schlegel, but we're going to have another buddy from our investment club come in and talk to us. So that should be good as well. Absolutely. Well, we thank you so much for tuning in this week and hope you'll join us next week as we come to you with another episode of Wall Street Weekly on Radio Free Hillsdale 101.7 FM.