Shareholder activism is a loaded concept that often evokes negative emotions and summons images of corporate raiders and barbarians. This perception is seldom challenged.
What we rarely read about are entrenched chief executive officers and directors who have forgotten their role as stewards of shareholders’ investments. Sometimes, these shareholder representatives own little stock themselves. When a shareholder questions the status quo, these new views are often rejected out of hand. This “insider-versus-outsider” mindset threatens both the spirit of corporate democracy and the fiduciary duty that boards of directors owe their shareholders.
In Canada, there are two major trends that are creating the need for more activist investors.
The first is the rise of index investing. The trend toward low-cost, passive investing continues to accelerate and the investment management industry is becoming dominated by index funds. The philosophy behind indexing is that markets are efficient because all possible information and insights are always priced into stocks. Most index funds allocate capital according to company size, with the largest, most liquid companies getting the largest allocations and small companies getting only the crumbs.
The second trend is consolidation among investment management firms, which are merging to create scale in order to combat pressure on their fees from exchange-traded funds. As investment companies come to manage increasingly larger pools of capital, fewer of them are focused on investing in small and mid-sized companies in Canada.
Both trends are pushing capital toward the biggest, most liquid Toronto Stock Exchange-listed securities. This is creating a rise in the number of orphaned companies in Canada – companies that are without controlling shareholders, are neglected by investment banks, receive limited analyst coverage and have small insider ownership.
To evaluate this phenomenon, we ran a screen to find Canadian companies with a market capitalization of $50-million to $1-billion. We found 206 companies that had all of the following characteristics: no single shareholder with more than 10-per-cent ownership, two or fewer sell-side analysts covering the stock, and less than 10-per-cent ownership by the board and management (in aggregate). These are Canada’s corporate orphans. And there is an increasingly large gap between the public and private market valuations for these orphans. That’s where smart activist investing can help.
Consider the premiums paid in change-of-control transactions that my firm, Ewing Morris & Co., has been involved with. One example was ZCL Composites Inc., a $225-million Edmonton-based company that makes underground fibreglass storage tanks for gas stations. I joined the company as a director in 2016 when it was covered by two sell-side analysts and had limited insider ownership. During my time on the board, we exited a money-losing division and returned excess cash to shareholders through a series of special dividends; recently the company completed a sale of the business to Shawcor Ltd. for a 46-per-cent premium. Shawcor’s ownership will allow ZCL to leverage its advanced composite technology and global presence and I’m confident the company has now found a better, permanent home.
Another example is AlarmForce Industries Inc. My partner, Lee Matheson, was the chairman of AlarmForce when the business was acquired for a 72-per-cent premium by BCE Inc. AlarmForce had languished as an orphan on the TSX for years before the deal. The company is now much better positioned to grow and service customers within the infrastructure of a much larger parent. In both cases, these were strategic acquisitions designed to help small, orphaned Canadian companies grow.
Many investment firms are unwilling or unable to engage in this manner. But in our experience, the ability to influence outcomes often closes the price-to-value gap much more quickly than waiting passively. Activist investing is often ugly, but it does not need to be. Our goal is to always be constructive rather than antagonistic and behave in a respectful manner. We’ve found that CEOs, on seeing that our views have merit and will benefit all shareholders, begin to trust, and even welcome, our advice.
There is no shortage of examples of activist investors behaving in disreputable, self-serving ways. But when practised constructively, activist investors can help ensure that shareholder views are represented and shareholder value is realized. With the growing class of corporate orphans, we think activism has never been more valuable.
Darcy Morris is the co-founder and CEO of Ewing Morris & Co. Investment Partners.