Empirical Finance Newsletter, September 2009 (plus Stock Screen Results)

September 1, 2009 Volume 2, Issue 8

Empirical Finance Newsletter Turning academic insight into investment performance Editor’s Note: The Empirical Finance, LLC team has been synthesizing, cataloguing, and writing empirical finance research for many years. Our investment programs integrate many of the research insights highlighted in the Empirical Finance Research Newsletter, but not all of them. This newsletter is meant to highlight ideas we look for and consider when developing our investment technologies.

Hedge Fund Activism, Corporate Governance, and Firm Performance Alon Brav, Wei Jiang, Randall Thomas and Frank Partnoy Journal of Finance Vol. 63 No. 4. August 2008

Abstract: Using a large hand-collected dataset of hedge fund activism in the U.S. over the period 2001 through 2005, we find that activist hedge funds act both as value investors and shareholder advocates. They target undervalued firms, and propose an array of strategic, operational, and financial remedies. Most tactics are non-confrontational, and attain success or partial success in two-thirds of the cases. However, hedge funds seldom seek control of target companies. The market reacts favorably to hedge fund activism, as the abnormal return upon announcement of potential activism is in the range of 5-7 percent, with no apparent reversal in the subsequent year. We show that this positive market reaction does not reflect anticipated wealth transfers from creditors to shareholders, but instead reflects anticipated improvement in performance. Indeed, target firms see moderate improvement in operational performance and considerably higher CEO turnover after activism. Our analysis provides important new evidence on the mechanisms and effects of informed shareholder monitoring.

Empirical Finance, LLC 16192 Coastal Hwy. Lewes, DE 19958 T: +1.773.230.4727 F: +1.888.517.5529 http://empiricalfinancellc.com

Data Sources:

Discussion:

The authors examine a sample of all SEC Schedule 13-D filings between 2001 and 2006. In total they analyze 11,602 filings and then systematically find those filings associated with bona fide hedge funds via internet searches, phone calls, etc. In the end, after various filters, the authors create a database of 236 hedge funds who file 13-D filings at some point between 2001 and 2006 on regular corporations. The total number of events analyzed is 1,032.

Hedge fund managers (as opposed to mutual fund managers, fund of funds, etc) have the greatest incentive to create shareholder value through shareholder activism. Hedge fund managers' pay is strongly tied to good performance, they can lock money down for longer periods (1+ year lock-ups), and they do not have to deal with many of the regulations the rest of the money management industry must endure (Investment Company Act of 1940, SEC more generally, state regulators, etc).

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Hedge Fund Activism, Corporate Governance and Firm Performance The sample examined in the paper includes both hostile and friendly activism, and the authors find that friendly activism is far more common than hostile action. They go on to conjecture that the reason for CEO opposition to hedge fund activism is possibly due to the likely impact it will have on CEO pay. Figure 1 displays a column chart of the returns for the period of twenty days prior to the 13-D filing through 20 days after the filing. Abnormal returns are positive 3.2% in the twenty days before the filing (consistent with the activist establishing a position) but are also positive after the filing. The day of and the day after the filing combine for a 2.0% abnormal return and by day 20 the cumulative abnormal return reaches 7.2%. This indicates that simply buying on the second day after a 13-D filing can produce a 2% abnormal return over four weeks. Buying even earlier after an announcement can make this return even larger. After decomposing the sample, the authors further find that announcements of activism that focus on liquidation or sales of business segments result in the highest abnormal returns—more than 8% over the post-13-D four week period on average. This indicates hedge funds can indeed create value when they identify inefficiency with regards to the allocation of the firm’s resources

Empirical Finance, LLC 16192 Coastal Hwy.

The authors also point out that the average holding period in their sample is about one year, contradicting the notion that activist hedge funds are short-term traders trying to quickly extract value from existing shareholders.

Finally the authors confirm that the abnormal returns around announcements are not simply T: +1.773.230.4727 representative of a wealth transfer from F: +1.888.517.5529 creditors to shareholders. In fact, those target firms without debt actually experience larger http://empiricalfinancellc.com abnormal returns than those with debt. Lewes, DE 19958

Investment Strategy: 1.

Focus on small companies.

2. Watch for activists who are entering companies at the same time mutual funds are dumping (watch for 13-Gs filed concurrently with 13-Ds). This way you can buy at cheap prices while the mutual funds are putting pressure on the stock. Eventually, the selling pressure is gone and you have an activist presence to ensure the ship is sailing straight ahead. 3. Call the company in question and assess how ―open‖ they are. Sometimes even the best activist campaign can't beat an overly entrenched and crooked management. 4. Call the activist and get a feel for what they want to do with the company. In my experience, activist investors are usually class-act capitalists and may give you hints as to the direction they want to take a company. 5. Do your own due diligence and determine where the hidden value is located. If you have an assessment of exactly what the activist is after, you may be able to determine how successful they will be in their attempts to unlock this value.

Conclusions: The contribution of this paper is to show that activist hedge funds are good for corporations, shareholders and the economy generally: They are not short term traders, they encourage the efficient allocation of capital, they generate higher returns for shareholders and do not harm creditors in the process. In light of this evidence, it is difficult to understand the enmity shown by politicians and the media towards the activist hedge fund industry. Of course, it is less difficult to understand why an entrenched CEO who has successfully extracted wealth from the corporation at the expense of other stakeholders might show such enmity. And therein lies a possible explanation as to why activist hedge funds often get such a bad rap. Page 2

Empirical Finance LLC Current Stock Screens

Empirical Screen #1 Piotroski F-Score and signaling factors This table highlights all companies that have the highest score possible on the Piotroski F-Score fundamental analysis screen (slightly augmented). We screen for small-cap companies that have book/price ratios in the top 20% of all companies traded on the NYSE/AMEX/NASDAQ. We add information on CEO ownership to signify ―skin in the game.‖ Finally, we highlight any open market repurchase activity that has taken place in the last 6 months (signals that shares are cheap). Ideas generated in this screen are not meant to be short-term trades, but represent long-term opportunities that, on average, have outperformed the general market by great margins. (Screened on August 31, 2009).

Company Name, Exchange, Ticker Comfort Systems USA Inc. (NYSE:FIX) MYR Group, Inc. (NasdaqGM:MYRG) Pike Electric Corporation (NYSE:PIKE) M&F Worldwide Corp. (NYSE:MFW) Apogee Enterprises Inc. (NasdaqGS:APOG) Advance America, Cash Advance Centers Inc. (NYSE:AEA) Republic Airways Holdings Inc. (NasdaqGS:RJET) Matrix Service Co. (NasdaqGS:MTRX) DHT Maritime, Inc. (NYSE:DHT) Asset Acceptance Capital Corp. (NasdaqGS:AACC) International Shipholding Corp. (NYSE:ISH) Preformed Line Products Co. (NasdaqGS:PLPC) Young Innovations Inc. (NasdaqGS:YDNT) Spartan Motors Inc. (NasdaqGS:SPAR) Frisch's Restaurants Inc. (AMEX:FRS) Spectrum Control Inc. (NasdaqGS:SPEC) Empirical Finance, LLC 16192 Coastal Hwy. Lewes, DE 19958 T: +1.773.230.4727 F: +1.888.517.5529 http://empiricalfinancellc.com

Mkt. Cap. ($mm)

Book/ Price

Recent CEO % Buybacks ownership

428.7

0.65

-

1.03

399.9

0.40

-

0.827

369.5

0.68

-

5.72

363.5

1.24

-

0.026

354.7

0.87

-

1.45

342.2

0.53

-

0.785

297.3

1.56

0.574

273.2

0.59

02/04/2009 Buyback

245.2

0.71

-

0.129

216.5

0.65

-

0.375

205.7

1.01

-

6.19

194.0

0.75

15.14

179.0

0.61

168.7

1.01

07/20/2009 Buyback 07/24/2009 Buyback

140.9

0.79

-

6.33

114.0

0.93

-

1.22

0.46

1.41 2.14

Screening Criteria: ►Market Value between $100mm and $500mm ►Book Value / Market Value less than 3 ►LTM Net Income greater than 0 ►LTM Cash from Operations (CFO) greater than 0►LTM Return on Assets % greater than 5% ►LTM CFO greater than LTM Net Income ►LTM LT Debt / Capital greater than LTM-1 LT Debt/Capital ►LTM Current Ratio greater than LTM-1 Current Ratio ►LTM Shares Outstanding less than LTM –1 Shares Outstanding ►LTM Gross Margin greater than LTM-1 Gross Margin ►LTM Asset Turnover greater than LTM-1 Asset Turnover.

*Please Note: This newsletter is published by Empirical Finance, LLC, which serves as the general partner for various investment vehicles. Empirical Finance, LLC may purchase or sell securities and financial instruments discussed in this newsletter on behalf of its clients. Empirical Finance, LLC is not an investment, legal, or tax advisor, and none of the information available through the newsletter is intended to provide tax, legal or investment advice. Nothing provided through this report constitutes a solicitation by Empirical Finance, LLC for the purchase or sale of securities.

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Empirical Finance LLC Current Stock Screens

Empirical Screen #2 Top 10 Long/Short Net Operating Asset companies These tables highlight the companies with the lowest net operating assets and the highest net operating assets. We screen for small-cap companies having 8+ years of operating performance. Low NOA ideas generated in this screen are not meant to be short-term trades, but represent longterm opportunities that, on average, have outperformed the general market by great margins. High NOA companies are good short-sell candidates. (Screened on August 31, 2009).

Long: Company Name, Exchange, Ticker Zion Oil & Gas Inc. (AMEX:ZN) Insmed Incorporated (NasdaqCM:INSM) Energy Recovery, Inc. (NasdaqGM:ERII) Hemispherx Biopharma, Inc. (AMEX:HEB) ATA, Inc. (NasdaqGM:ATAI) China Mass Media Corp. (NYSE:CMM) BioSpecifics Technologies Corp. (NasdaqGM:BSTC) Agria Corporation (NYSE:GRO) Maxygen, Inc. (NasdaqGM:MAXY) China Distance Education Holdings Limited (NYSE:DL)

Mkt. Cap. ($mm)

NOA

CEO % Ownership

167.8

-3.17

2.27

108.7

-2.99

-

254.3

-2.36

1.04

265.1

-2.33

0.36

159.9

-2.15

0.10

104.1

-1.59

-

156.7

-1.56

23.45

115.7

-1.53

-

272.5

-1.21

1.51

253.6

-1.10

-

Short: Company Name, Exchange, Ticker

Empirical Finance, LLC 16192 Coastal Hwy. Lewes, DE 19958 T: +1.773.230.4727 F: +1.888.517.5529 http://empiricalfinancellc.com

Domino’s Pizza, Inc. (NYSE:DPZ) JMP Group Inc. (NYSE:JMP) NPS Pharmaceuticals, Inc. (NasdaqGM:NPSP) Crown Media Holdings Inc. (NasdaqGM:CRWN) KapStone Paper and Packaging Corp (NasdaqGM:KPPC) Valence Technology Inc. (NasdaqCM:VLNC) Revlon, Inc. (NYSE:REV) Raser Technologies, Inc. (NYSE:RZ) Dynex Capital Inc. (NYSE:DX) Cheniere Energy, Inc. (AMEX:LNG)

Mkt. Cap. ($mm)

NOA

CEO % Ownership

451.6

3.43

0.79

199.2

1.83

14.97

197.8

1.61

0.26

171.9

1.59

-

188.1

1.48

9.30

191.6

1.43

0.00

224.3

1.42

0.05

145.9

1.28

0.00

112.3

1.24

4.68

145.8

1.03

0.76

Screening Criteria: ►Market Value between $100mm and $500mm ►NOA=[(Total Assets -Cash and Equivalents)-(Total Assets—Total Debt)]/Total Assets year prior) *Please Note: This newsletter is published by Empirical Finance, LLC, which serves as the general partner for various investment vehicles. Empirical Finance, LLC may purchase or sell securities and financial instruments discussed in this newsletter on behalf of its clients. Empirical Finance, LLC is not an investment, legal, or tax advisor, and none of the information available through the newsletter is intended to provide tax, legal or investment advice. Nothing provided through this report constitutes a solicitation by Empirical Finance, LLC for the purchase or sale of securities.

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