If you enjoy the finer things in life, then you’ll love the action taking place in the specialty retail market. Great paintings, sculptures and fine jewelry are not only to be appreciated, but they can make for great investments as well.#-ad_banner-#

We’ve already seen one shake-up in the specialty retail industry this year. Billionaire John Paulson is taking famous piano maker Steinway Musical Instruments private for $512 million. The bidding war between Paulson, private equity firm Kohlberg & Co. and Samick Musical Instruments has driven Steinway’s stock up 90% this year.

While Paulson is a fan of pianos, it’s no secret that billionaire and activist investor Daniel Loeb loves art. He is said to have various pieces of art hanging in his Park Avenue office and enjoys going to art shows.

Loeb and his Third Point hedge fund are coming off one of their biggest wins after helping turn around Yahoo (Nasdaq: YHOO). Loeb sold two-thirds of his position back in July when the stock was trading around $25, locking in a cool half-billion dollars in profits.

Now Loeb’s looking to put that capital to work in other markets, with the art market being a perfect candidate. Loeb and his Third Point hedge fund have started their latest activist campaign with leading auction house Sotheby’s (NYSE: BID). Loeb joins fellow activist investor Marcato Capital in the stock.

Marcato now owns 6.6% of the company, and Third Point owns 5.7%. Third Point and Marcato join billionaire and notable activist investor Nelson Peltz’s Trian Fund Management, which owned 3% of Sotheby’s as of the end of the second quarter.

	Wikipedia/Jim Henderson
	Sotheby’s headquarters in New York City.

So what are these billionaires and activists expecting to get out of Sotheby’s? Are they after the real estate value? Is the company grossly undervalued? Are they playing the expected rebound in art sales? Will they push the company to boost shareholder returns?

The hedge funds involved have kept their public statements vague, and while none of the activists involved has outlined his plans for the stock, it’s safe to say there is value in the company that needs unlocking.

Part of Sotheby’s moat is its unrivaled name recognition. For those who don’t know, Sotheby’s is an auctioneer of specialty retail items, which includes fine art, antiques, jewelry and other collectible items. Its roots date to 1744, when it was founded in London.

With the industry being niche, and the fact that Sotheby’s is the only major publicly traded auction house, relative valuation is next to impossible. However, from a historical valuation perspective, Sotheby’s does not look all that appealing. The stock is trading at near-decade highs on price-to-earnings (P/E), price-to-sales and price-to-book bases.

Thus, there will need to be a catalyst to drive the stock higher. Here are a few possibilities these activist investors could be looking at to unlock value.

Economic Expansion
Sothebys took quite a nasty spill along with the broader economy back in 2008, trading below $9 per share before rebounding to the over $45 it trades at today. As income levels rise and the broader economy strengthens, the demand for the finer things in life, such as art, should also rebound. The company’s underlying reliance on the economy is exhibited by the stock’s 2.7 beta.

Although the expected boost in sales and earnings, due to a rebounding economy, will likely boost the share price, that’s not the sole reason for the activists’ investing. Activists generally get involved for something more than market-moving events. They look to generate their own alpha through management shakeups, strategy realignment, balance sheet restructuring, and so on.

Real Estate 
The big news of late, in addition to the activist campaigns, is that Sotheby’s is planning to sell its New York headquarters. Stifel Nicolaus has said that those real estate properties could hold unrealized value for Sotheby’s, noting that the New York and London properties might be worth $300 million more than is carried on the balance sheet.

It’s no secret that one of the activists involved in Sotheby’s, Marcato Capital, specializes in real estate investments. That firm may be looking to get its hands on any profits from Sotheby’s real estate and return them to shareholders.

Margin Expansion
Loeb and his activist buddies may believe Sotheby’s can expand its margins to historic levels. The company’s trailing 12-month margin on earnings before taxes (EBT) is 18.4%, while in previous years it has had margins between 27% and 30%. If we think about where earnings would be if the EBT margin were 27%, there is definitely upside here. With a 27% EBT margin, earnings could easily be nearly 50% higher than current levels; assuming Sotheby’s keeps its premium 31 P/E multiple, the price target would be $68.

Boosting Shareholder Value
The activists could also be looking at Sotheby’s cash on hand. The company has more than $10 in cash per share and could increase its modest 0.8% dividend yield or boost share repurchases. Its debt-to-equity ratio is down to 0.5 as of last quarter, compared with 0.9 in 2009. Sotheby’s recently said it was exploring new ways to boost shareholder value, which could include a higher dividend or share buybacks.

Whatever the reasoning behind Loeb’s investment, you’d better believe the upside will be realized in a short period. Loeb isn’t necessary a long-term investor, rather an opportunist. So the question remains whether he’ll treat this like a short-term investment, as was the case with Yahoo, or an ultra-short-term investment, like his stake in Herbalife (NYSE: HLF). 

Sotheby’s has only five analysts following it — compared with the 48 following Apple (Nasdaq: AAPL) — so it can be tough to get information on the company. But investors can use this to their advantage: Despite the fact that Sotheby’s has three activist investors collectively owning 15% of the company, the stock is flat since Loeb’s involvement. 

Sotheby’s also offers investors downside protection given its inherent moat as the only major publicly traded auction house. The other major player in the $8 billion art dealership industry, Christie’s International, is private. Sotheby’s other moatlike characteristics include its cash-generating capabilities and strong liquidity. Over the trailing 12 months, Sotheby’s managed to generate $237 million in free cash flow. That’s $6.50 a share, or an 8.7% free cash flow yield.

Risks to consider: The biggest risk is another pullback in the economy. Investors should also consider the risk that the activist investors announce a sound strategy for unlocking value, sending the stock surging, but ultimately their plans fail, sending the stock plunging.

Action to take –> Get into Sotheby’s before the real bidding process begins. If the activists get their way, there could easily be more than 50% upside to the stock over the next couple of years. The stock has a solid moat and business model that makes the downside limited. The company’s balance sheet and free cash flow are both relatively solid.

P.S. — Activist investing is a bit different from buy and hold, and isn’t suitable for every investor. Owning “Forever” stocks is, however, for everyone. These companies have large moats that allow them to dominate their industries and as a result, you can add them to your portfolio and simply forget about them. To learn the names and ticker symbols of these stocks — click here.