As I was looking over Friend of the Blog Ron Bobman’s latest activist letter pressing for change at Argo, I had a unique thought. Why are there only activists who press for change to make stocks go higher? Why aren’t there activist short sellers?
Now, maybe this seems crazy. Who would want to short a stock and then press the board to make changes to make it better? No, no, you’re not getting it. An activist short seller would press the board to make changes to make a company worse!
OK, now you probably really think I’m crazy! What board is going to listen to ideas to make the company worse? Well, if you put it that way, then nobody. But, what if I made a small modification?
What if the activist short strategy is to encourage the company to keep doing what they’re doing? There are plenty of poorly run companies out there. The biggest risk to shorting them is that they will realize their mistakes and make changes.
The activist short would prevent that from happening by telling the company they are on the exact right path and should keep doing what they’re doing!
The brilliant aspect of this, of course, is that is exactly what most managements and boards want to hear! It’s hard as an activist to convince a company to do something they don’t want to do.
But to convince them to keep doing what they’re already doing? That’s pretty easy! If it happens to be value destructive, then you, the activist short, will benefit!
Furthermore, by going public with your short thesis – that the company should continue on its current path and keep destroying value – you may catalyze others to sell the stock as they will realize they were probably wrong to ignore all the flaws in the current strategy.
Finding the Target
All we need to do now is figure out who is the right target. The good news is there are plenty of poorly run companies out there to choose from…and many have entrenched, stubborn managements likely to agree with our demand not to change.
Of course, I’m not going to pick on anyone specifically. However, I thought I could write a hypothetical letter to an activist short target. Fortunately, a couple of years ago I invented a fake insurance company – the Eastern & Southern. If you remember them, you truly are a loyal reader!
I was planning to write more about them and had some good background notes on their story, but, well, sometimes you get distracted and start writing about other things and the Eastern & Southern ended up in limbo. Luckily for me, I found those old notes, so can give you a little bit of background before we write our letter demanding no change.
The Eastern & Southern Insurance Company of North America
For the non-obsessive readers of the blog, the E&S was formed (in my imagination) by the 1988 merger of Eastern Accident & Fire and Southern Indemnity Company. They were two very different companies (Eastern focused on complex risks for F500 companies while Southern wrote small substandard risks in the Southeast) and the combination didn’t work very well.
Underwriting problems arose (primarily from concentrated cat exposure) and cultures clashed. The solution was always to try something new – expand into new lines or geographies and attempt to convince investors they were ahead of the curve. They rarely were.
Brokers played the E&S like a fiddle using them to take risks they couldn’t place elsewhere or to fill out towers to keep lead markets from pushing too hard on price.
The E&S is led by Pickett Lowe, the unfortunately named grandson of the Southern’s founder Harrison Lowe. Pickett may not be a skilled underwriter or manager or strategist or, well, anything, but he does know how to survive and he was able to wrest control back from the Eastern’s more patrician leadership after one too many underwriting failures led the board to give up and let Pickett have a try.
The Stock Setup
The E&S stock (ticker: EAS) has languished for years. Book value has grown at a low single digits CAGR over the last ten years with a 6% ROE. The stock trades above book, at 1.33X, due to speculation somebody will eventually take it out as it is one of the only “pure play specialty” companies still public. Absent M&A speculation, it would trade on the merits at no higher than book and probably below.
Given the unlikelihood Pickett will sell the family legacy, as well as his determination to restore its good name, the M&A premium seems foolish.
While the company promotes to investors its plan to reach a 10% ROE in two years (it’s been two years away for twelve years running), the odds of succeeding are low. More likely is that even the 6% is unsustainable given the aggressive growth and optimistic reserving.
Also worth mentioning is that, while E&S still has its A rating, it has been on negative watch for some time now. They have also “opportunistically” raised debt over the years to fund stock repurchase when the valuation was apparently “cheap” (though in hindsight more expensive than it is today) leaving them at 28% D/C, so any bad news would require an equity offering to preserve the rating.
A traditional activist would certainly focus on the potential to put the company in play and force Pickett to sell out for 1.5-2X BV. Our newly created short activist has a different point of view which you can read below.
If our activist can convince Pickett to continue following foolish strategies, eventually the bad underwriting results will emerge, the stock will fall to book, and EAS will have to raise equity at the bottom to keep its Best rating.
The Letter
September 15, 2021
Mr. Pickett Lowe, CEO & Chairman
Eastern & Southern Insurance Company of North America
400 North Boulevard
Baton Rouge, LA 70802
Dear Chairman Lowe:
I represent Active Acceptance, the first activist investment firm that works with companies to continue with their chosen strategy rather than listen to outside investors who don’t understand your company but purport to be able to run it better. We have taken a large investment position in EAS stock.1
I am writing to encourage you to remain focused on achieving your 10% ROE goal by 2023. While skeptical investors may feel this goal is unachievable given past failures to meet it by prior management, I am convinced that with your leadership, E&S is well on its way to finally turning the corner.
I believe the reason EAS stock trades at an elevated P/E ratio (22X) reflects investors confidence in you meeting your goal since your P/E would only be 13X ’23 EPS2, placing it more in line with the peer group. Failure to achieve the ROE goal would likely produce a significant drop in the stock.
It is also important that you meet the ROE goal by producing a 10% ROE for the full calendar year, rather than moving the goalpost to something like “we expect to exit the year at a run rate 10% ROE”. Investors would understandably view that as a failure.
The biggest risk for the company is the negative outlook it has with A.M. Best and S&P.3 A downgrade to A- would be extremely harmful to the company as either E&S would lose access to good business or it would have to raise capital at unattractive terms to preserve the rating.
The best way to defend the rating is to meet the objectives the rating agencies have laid out, primarily an improvement in the combined ratio. Since improving the combined ratio also improves the ROE, there is perfect alignment between keeping the A rating and achieving the 10% ROE4.
While some may suggest helping the rating by buying more reinsurance or derisking the investment portfolio, these actions would be counterproductive. They would pressure the expense ratio and investment income, both of which would make the ROE goal harder to achieve.5
As long as the Federal Reserve is backstopping credit, it makes sense for the E&S to target lower rated investments to improve the portfolio yield.6
Similarly, while the rating agencies would prefer you to bring down your debt levels towards a low 20s D/C, if you successfully execute on your growth plans, you will be able to service the current debt load. Using your earnings to buy back stock, rather than pay down debt, lowers your equity and thus improves the denominator in the ROE calculation.7
Continuing on your current growth expansion plans will allow E&S to leverage its high fixed expenses and improve the expense ratio while also allowing for more operating leverage through diversification benefits.8 I am particularly excited about you recent expansion into cyber!9
Finally, I want to highlight that we believe the E&S should remain independent. While selling the company may appease short term shareholders, the E&S has a long and storied heritage10 with a brand name that resonates in the market. If the company successfully executes on its plan, there is far more value for shareholders in remaining independent for the long term.11
While I am not asking for any board representation at this time, I would like to be granted observer status so I can make sure the Board is committed to its current strategy and doesn’t acquiesce to pressure from more short sighted shareholders who may try to interfere with the company’s direction.
Sincerely,
Izzy Short
Founder, Active Acceptance Management, L.P.
Footnotes & Conclusion
OK, as you can see, I added some footnotes that wouldn’t go in the real letter, but for the edification of you the reader!
Footnote 1: “large investment position” doesn’t mean it is a long position! Will Pickett figure that out?
Footnote 2: Subtle way of pointing out the stock is substantially overvalued!
Footnote 3: This alerts EAS shareholders that they have not paid enough attention to this risk.
Footnote 4: And now we have created doubt that keeping the A is possible given achieving the 10% ROE is not a given.
Footnote 5: We don’t want to encourage the company to start acting responsibly! Play to the fear of missing the ROE goal.
Footnote 6: Carefully worded, since, for as long as the Fed refuses to allow credit losses, this will be true. But what happens when that is no longer true?
Footnote 7: We don’t want to give Pickett any crazy ideas to reduce the balance sheet risk by paying down debt. Recall, the goal of the short is to see E&S stumble and have to raise equity to keep its A rating.
Footnote 8: Another common trap = writing bad business to “arbitrage” the capital model. If business can’t be written at a profit, it doesn’t matter what the capital charge is!
Footnote 9 : Excited to see what a disaster it becomes!
Footnote 10: playing to Pickett’s ego!
Footnote 11: remember, we earlier alluded to the fact that the market has built in achieving the ROE goal based on the ’23 valuation but Pickett surely doesn’t recognize this.
So there you have it. I have created the template for an activist to convince poorly run companies to continue underperforming. This works better when there is a reason to believe management’s current path is steering them straight for the cliff, such as a ratings watch, a rotting acquisition likely to produce a reserve charge, or growth in a challenged line of business facing difficult external pressures.
If anyone wants to put this method to practice with a real company, I am willing to license the IP I have created for you if you share 10% of the proceeds of a successful campaign. Thanks and much appreciated!