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Top Undervalued Companies Owned by Activist Investors, Part 1

While activist investors, like investors in general, aim to buy low and sell high, their investments may not all look good from a purely value investing standpoint. Activist investors focus on taking large stakes in companies that have high potential to create value for shareholders, then using their large stake to influence said company's decisions. Even their smaller holdings are typically meant to take advantage of upcoming events that they expect to cause significant improvements in a stock's price.


Since there is a good deal of overlap in activist investing and value investing, the following companies may be worth keeping an eye on, since they are owned by activist investors and have many qualities that make them attractive from a value investing standpoint.

Jeff Ubben and Alliance Data Systems

Jeff Ubben (Trades, Portfolio) is the co-founder, CEO and chief investment officer of ValueAct Capital. The firm's activist investing strategy focuses on investing for the long term in high-quality companies in which they are able to establish communicative relationships with management. The equity portfolio for ValueAct was valued at $9.27 billion as of Dec. 12 and consisted of holdings in 22 stocks.

According to the discounted cash flow model and other factors, ValueAct's most undervalued holding is Alliance Data Systems Corp. (NYSE:ADS). The firm owns 3,707,646 shares of the stock after reducing its position by 28.8% (1,500,000 shares) in the second quarter, making up 6.94% of Alliance's total shares outstanding.

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Ubben originally bought Alliance in the first quarter of 2016, during which shares traded at an average price of $219.63. As of Dec. 12, shares of Alliance are trading at $105, which represents a 67.41% discount to the company's earnings-based DCF of $337.45. The stock is also undervalued according to the Peter Lynch chart.

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There are a few reasons why Alliance often trades at a steep discount, but as Steven Gorelik said, "The fact that it took over 1,300 words to explain all the different parts of ADS and how they fit together is one of the reasons why the company is persistently undervalued by the market."

In other words, it is difficult to understand exactly how the company operates and makes itself profitable. Alliance Data Systems is a provider of customer loyalty programs, private label credit cards and direct and indirect marketing, which it launches through the capture and analysis of transaction-rich data. In essence, it makes its money from the loyalty programs you see at your favorite stores, but the way it profits from its operations makes it difficult for analysts to accurately predict what its earnings will be each quarter.

Wall Street thrives on fast reactions to quarterly earnings, so it's no surprise that a company that rarely matches predictions has a hard time keeping the value of its shares. This trend has been compounded by Alliance's drop in net income for the past year; by quarter, the company had a net income of $149 million in the first quarter, $139 million in the second quarter and a net loss of $107 million in the third quarter.

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Alliance has a GuruFocus financial strength score of 4 out of 10 and a profitability score of 9 out of 10. As of Dec. 12, it has a price-earnings ratio of 12.99, a cash-debt ratio of 0.45, a price-sales ratio of 0.76, a return on capital of 213.1% and a three-year revenue growth rate of 11%.

In terms of ownership, 17.4% of Alliance's stock is owned by institutional investors, while 7.33% is owned by insiders, making it particularly vulnerable to market sentiment. While the company is undeniably undervalued in terms of its earnings and potential, those factors are useless to shareholders if the market never translates them to the stock price.

There is also the U.S. Federal Reserve's loosening of monetary policy to consider. The lowering of the prime interest rate has had negative effects on the value of credit card receivable portfolios and positive effects on the ability of consumers to pay off their credit cards before interest compounds. This translates to lower profits for a heavily credit-based company like Alliance. Analysts are estimating a massive drop in Alliance's revenue, predicting $5.2 billion for 2020 and $5.3 billion for 2021.

Thus, while Alliance may be worth keeping an eye on, it may not necessarily be a good buy at the moment. The results for the fourth quarter will give a more solid picture of what the company is able to earn after its recent setbacks and provide the final outlook before the beginning of fiscal 2020.

Daniel Loeb and Centene

Daniel Loeb (Trades, Portfolio) is the founder and CEO of Third Point LLC. Third Point's investment strategy is based on value and events, seeking to identify and push situations that will create value for its investments. As of Dec. 12, the firm's equity portfolio was valued at $8.42 billion and consisted of positions in 40 stocks.

According to factors such as the DCF model, Third Point's most undervalued holding is Centene Corp. (NYSE:CNC). Third Point owns 2,400,000 shares of Centene after reducing the position by 4% (100,000) shares in the third quarter, making up 0.78% of the company's total shares outstanding.

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Centene is a major intermediary for both government-sponsored and privately insured health care programs in the U.S. Instead of a traditional activist play, this position is more likely to have been established to take advantage of specific events affecting the profitability of health insurance - or, in this case, events that were expected to negatively affect health insurance companies but ended up not doing so. Loeb established a position in the company in the second quarter, and while the price kept free-falling for a while after that, it has now spiked back up past his initial buying price.

As you can see in the chart below, it was not a drop in revenue or earnings that caused Centene's sudden drop into undervaluation. Despite maintaining consistent growth, the company's Dec. 12 price of $57.69 is trading at a 37.26% discount to its earnings-based DCF of $91.95. The stock's Peter Lynch fair value is in the middle at $78.66.

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As a major provider of government health insurance in the U.S., Centene's stock price was a victim of a federal judge ruling the Affordable Care Act "unconstitutional" in December 2018. After a months-long court case, U.S. District Court Judge Reed O'Connor of Texas declared that key portions of the legislation were unconstitutional.

As a result of the ruling, the market began factoring in speculative losses for health insurance providers, especially ones affiliated with government health insurance programs. Centene's stock price, which peaked at $73.14 per share in late September 2018, began to fall in October due to the court battle. Once the ruling hit the news, the stock continued to fall to a low of $42.41 in late September 2019.

Contrary to investors' fears, Centene's revenue did not suffer a company-crushing decline. The Affordable Care Act had not translated to profitability for health insurance providers at the time of the court ruling, and the actual application of the law in terms of what came to be and what did not turned out to be unpredictable in many ways. The important thing for Centene was that it did not profit significantly from the Affordable Care Act or suffer financially from portions of it being counteracted.

On paper, Centene looks good; GuruFocus has assigned it a financial strength score of 6 out of 10 and a profitability score of 8 out of 10. The company has a price-earnings ratio of 17.87, a cash-debt ratio of 1, a price-book ratio of 1.96 and a three-year revenue growth rate of 17.7%.

At the end of the quarter ended Sept. 30, Centene provided full-year 2019 revenue guidance of $73.6 billion to $74.2 billion. Analysts predict Centene's revenue will grow 0.67% to $74.4 billion in 2020 and another 6.99% to $79.6 billion in 2021. However, Centene recently announced that due to the delay of a large contract, its fiscal 2020 revenue will take a $500 million hit, which will most likely bring it below analyst expectations and total fiscal 2019 revenue.

Disclosure: Author owns no shares in any of the stocks mentioned.

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This article first appeared on GuruFocus.