There are two main stock market strategies where reading schedule 13D filings is essential to success: portfolio cloning and deep value investing.
In this post we’ll talk about what a schedule 13D is and why it is useful for those two strategies, by tackling the following:
- The Basics of the Schedule 13D Filing (vs the 13G)
- How the Schedule 13D Can Help the Average Investor
- Vanilla 13D Filing Example: CEO and Chairman of the Board
- Schedule 13D Filings: Examples of Shots Fired
- Investor Takeaway
If you’re buying stocks in turnaround situations (especially smaller ones), and you don’t know about the schedule 13D and how to read it, you’re seriously crippling your chances of success (and even finding them in the first place). So let’s get started.
The Basics of the Schedule 13D Filing (vs the 13G)
Essentially, a Schedule 13D Filing is a required document which must be filed to the SEC by any investor or entity which acquires more than 5% of a company’s ownership stake and intends to use their position to influence management.
In the goal of providing transparency of changes to the ownership structure of public corporations, this document clues investors in to the major owners of the companies they invest in.
Shareholders with large stakes in a business can sometimes affect how the businesses are run. This is because of the voting power associated with share ownership.
The following is a small sampling of the types of things that are voted on by shareholders:
- Board of Directors elections
- Executive compensation
- Mergers and acquisitions
The shareholders who push to influence management—through proxy (voting) wars or otherwise—are also known known as activist investors.
The filing of a Schedule 13D can signify that one of those major company changes are about to happen, and that an activist investor is about to enforce it.
The 13D itself is a somewhat of a harbinger on its own because a more passive investor (i.e. not an activist) generally has the option to file a Schedule 13G instead of a 13D, as long as they’re keeping ownership between 5%- 20% and will not embark on a takeover.
The investor.gov website defines both schedules 13D and 13G as “beneficial ownership reports”, where the 13D filing must be completed within 10 days of the acquisition of 5%+ ownership.
Since a 13D is “often filed with a tender offer”, which is a large acquisition of shares of stock or debt by a large investor, the 13D can signify big change is about to happen (or already has).
If the schedule 13 filings signify major ownership changes, the “D” in 13D signifies an activist with an intent to influence management, while the “G” signifies a large investor who does not.
How the 13D Can Help the Average Investor
Again the power of large ownership stakes comes down to the ability to influence major company decisions. These can lead to big moves in a stock.
For most average investors, it’s not so much the voting power of the individual shares we own which are important—the total shares owned by most average investors total shares are a drop in the bucket compared to an entire public corporation’s.
However, by learning which shares have voting power and which person or entity owns a significant block of those shares, we can make investment decisions and/or observe what’s going on in a business with that context in mind.
It can be very beneficial to read the schedule 13D’s filed for companies, and watch how these major owners (especially if they are well-known activists) interact, or keep in mind what they’re likely to do.
For example if you know a particular activist investor has a reputation for pushing management to clean up a company’s operations, this could be a good investment opportunity as you “ride the coattails” of an influential activist investor.
And as we’ll see later in this post, some activist investors have used their 13D filings to grab the attention of companies’ top managements and publicly push for the changes they’d like to see, for the benefit of shareholders.
First off, let’s define the basics of portfolio cloning and deep value investing, so we can understand the type of investing strategy that is most likely to find great benefit from analyzing a schedule 13D.
Portfolio (or Investor) Cloning
The idea of cloning is one popularized by the great investor Mohnish Pabrai.
It’s a pretty simple idea; copy the ideas of the investors who you respect and believe in the most. Since an investment idea can benefit anybody no matter if you came up with the idea yourself or copied it from someone else, cloning can be a powerful way to profit from other people’s hard work and research.
Because 13D filings are required to be filed by the SEC, we can use them to discover some of an investor’s biggest bets in the market, as they will have to file a 13D as they buy a significant stake in a stock.
Remember that a 13D is required if an investor owns more than 5% of a company, so you’ll tend to see more of them filed in smaller companies where less capital is needed for a 5% stake.
Though you might not get the exact same results of a major activist investor since the schedule 13D is filed on a short delay (10 days or less), if you’re following investors who are notorious for very long term holding periods that delay might not make a big difference over the life of a great stock.
You might find better results in looking for Schedule 13G’s rather than 13D’s if you truly want to clone ideas for the very long term, but sometimes takeover situations can occur where activists have a longer time horizon rather than the typical short term, turnaround situation.
Deep Value Investing
Most deep value strategies involve buying stocks that are beaten down, in the hopes of catching an inevitable rebound in the stock price.
Since the market is emotional (see: Exhibit Mr. Market), many stocks tend to be priced more pessimistically than they should as perceptions often divorce from the reality.
But since the reality is that stocks will be beaten up because expectations are low, this approach will lead an investor to some really bad businesses and situations—which is why wide diversification is highly recommended for a deep value strategy.
Additionally, since beaten up stocks usually involve beaten up, flawed, and/or declining businesses, these usually don’t tend to be great long term investments and are bought and sold quickly for the quick profit from the stock price rebound.
So, deep value stocks tend to be fertile ground for an activist investor, because with their capital (and Schedule 13D filings) they can quickly influence a company and nurse it back to health.
It’s often management incompetence which leads to businesses that struggle, and sometimes you need an outside authority to whip management back into shape.
By using their influence from 13D filings, and even using the 13D filing directly as its own tool, activist investors can be that authority to shake up a company and its decision making, and thus boost the stock as the business heals.
The average investor can simply follow activist investors into these kinds of opportunities just like you would when portfolio cloning, and benefit from those investors’ efforts.
In fact, that’s exactly what Warren Buffett did early in his investing career, with a strategy he called “coattail riding”.
You can see that there’s several ways to make money by following Schedule 13D filings, so let’s dig-in to a couple so you can wield this power for yourself.
Vanilla 13D Filing Example: CEO and Chairman of the Board
To find a company’s 13D filings, go to sec.gov and search for the company’s public filings using their name or ticker symbol.
Once there, you’re going to want to look (or filter) for a form called SC 13D.
Since most companies don’t have activist investors looking to inflict change most of the time, you probably won’t find a 13D for most of the companies you look at.
You can use a website such as sec.report to search for some of the latest 13D filings as a source of investment ideas for a deep value approach.
Here’s one I found from a company called Hudson Technologies, Inc. The investor is an “activist” because he actively influences management in his role as CEO and Chairman of the Board. Obviously in this case, there’s probably not the same type of imminent changes to the way the company is run as you might see from an outside activist investor.
Still, this gives us a good sense of what a regular, non-eventful 13D filing looks like.
Here’s a screenshot of what the document looks like when you first open it (I used the version on sec.report for these screenshots):
You’ll notice there’s a few key sections of the Schedule 13D to be aware of. Here’s some additional notes on what to expect and the contents of this one from Hudson Technologies:
- Item 1: Security and Issuer
- Name of the activist and which securities are being acquired (usually common stock)
- Item 2: Identify and Background
- Who the activist works for or represents, in this case it’s CEO Brian Coleman
- Additional information included about Coleman were related to criminal background and citizenship
- Item 3: Source and Amount of Funds or Others Consideration
- How the activist purchased the securities. In this case it was Coleman’s personal funds, but sometimes you’ll see debt funding such as when there’s a leveraged buyout
- Item 4: Purpose of Transaction
- Here’s where it can get juicy and the activist can clear the air on intentions or frustrations. In this case there was nothing special, just “investment purposes”. More on this section later.
- Item 5: Interest in Securities of the Issuer
- How many shares the activist will own and what voting power this represents
- Item 6: Contracts, Arrangements, Understandings or Relationships With Respect to Securities of the Issuer
- Sometimes you might see voting rights transferred to another entity in this section, such as with trusts and other related vehicles
- Item 7: Material to Be Filed as Exhibits
- Another place for potentially juicy content and public requests. Nothing here for Hudson Tech.
All of this information has the potential to provide good context on a major ownership change as revealed from a Schedule 13D. As you will see, items 4 and 7 is where activists can publicly air their grievances.
But even just simple information such as an activist’s name from item 1 can provide foreboding warnings on what’s to come based on the activist’s reputation and track record.
Schedule 13D Filings: Examples of Shots Fired
Now that we’ve covered the basics, let’s get into a juicy 13D. Here’s one from the notorious Robert Chapman, who was a major investor who took delight in stirring the pot with managements in the companies he would take major ownership stakes in.
Taking this from his 13D filed with a company called Sunterra, Chapman went on a tirade from which I’ll share some of the bolded highlights:
- “Sunterra Europe is a malignant cancer ulcerating at Sunterra’s healthy North American business; accordingly, Chapman Capital demands that, at a minimum, this division be sold to the highest bidder.
- Chapman Capital further demands that Sunterra, in parallel with the auction of Sunterra Europe, explore the full scale auction of the Company in its entirety, which we estimate to be worth in excess of $14.00 per share in a private market transaction involving a strategic or financial buyer.
- Mr. Benson’s compensation as CEO of Sunterra and former head of flailing Sunterra Europe Group Holdings seems to have no material relationship to this meretricious stewardship of Sunterra’s scare resources.”
The entirety of this letter from Chapman to the company’s chairman David Gubbay can be found in the 13D filing, and was scathing to say the least.
By reading the Item 4 of the 13D, you would’ve found this line, “On June 28, 2006, Mr. Chapman sent a critical letter to Mr. Gubby and the Board of Directors of the Company. The correspondence, dated June 28, 2006, is attached hereto as Exhibit B.”
Which led to the juicy flaying that followed.
Let’s do one more example; this one is more recent and more concise.
In a 13D filed by J. Carlo Cannell from Cannell Capital, Cannell threatens management with the following actions if the company doesn’t respond his letter (attached as “Exhibit 99”):
“CC hopes to work collaboratively with REI in order to produce positive change, which change may include (i) reconstitution of the BOD; (ii) enhancement of the Company’s capital structure; and possibly a (iii) merger into, or with, other companies to enjoy greater scale and expertise. All of these changes are aimed to help injured shareholders…
If positive changes are not able to be affected through “friendlism” then CC reserves the right to (i) form a group(s) with other parties; (ii) call a special meeting; and/or (iii) take other extraordinary actions for the benefit of aggrieved shareholders.”
The letter with Cannell’s grievances was short, here’s a screenshot (from bamsec.com):
Who says that you can’t find drama in boring legal documents?
While obviously some of the juicy filings were extreme examples, it is a fact of the matter that businesses get taken over and shaken up all of the time.
A filing such as Schedule 13D can indicate a situation like that which is about to happen.
Sometimes in struggling companies it takes radical action to unlock suppressed value for shareholders, which is the land where deep value investors feast.
By simply following along with the drama—eating popcorn along the way—investors can position themselves to profit as the changes unfold, and sometimes on a very quick timeline.
If you are truly interested in learning more about succeeding with a deep value approach, may I recommend reading the following post as well.