Special Situations Investing: An Integral Part of Value Investing

Sometimes you have to make an exception.

A value investor is someone who looks to buy stocks when they are trading at a discount.

But what if there’s an opportunity that’s too good to pass up? An opportunity that exists outside of your usual paradigm?

Jim Rogers often talks about simplifying his thinking. He sits there and will not make a move until there’s money lying on the floor, waiting for him to pick it up.

What if there were money on the floor – would you make an exception then?

That’s what investing in special situations is all about – buying a security based on a specific event or situation that has the potential to affect share prices, rather than the underlying fundamentals of the stock itself.

What is Special Situations Investing?

Special situations indicate events that do not occur regularly. As fundamentals investors, we are used to looking at various business indicators and valuation ratios to arrive at an “intrinsic value” of the stock. The typical investment cycle goes like this:

Find an undervalued stock
Assess the risk in the stock
Decide how much to allocate if the stock is attractive
Decide on the sale price, and purchase the stock
Hold and adjust if necessary, and finally,
Sell the stock when it reaches the pre-determined sale price (or any of the 1 of the 9 reasons to sell a stock)

But some times, this process falls apart due to unusual circumstances surrounding a stock (or a business).

Most investors are not equipped to handle anything out of ordinary and will avoid these situations. An investor experienced in special situations investing however knows that there is a lot of money to be made by looking out for interesting scenarios and finding ways to profit from them. In some cases, valuation thesis can be made while in some other cases the opportunity can be fleeting and quick action is necessary.

Special situations fall into a number of different categories:

See also: What is the book value

Cash Payouts/Acquisitions

Imagine you owned shares in a company like Tesla, trading at around $300 a share as of May 7, 2017. Unbeknownst to you, General Motors has been cooking up a plan to acquire Tesla in order to shore up the electric vehicle market as well as give themselves an edge in the driverless car race.

This may never happen in reality but when a company is acquired in this manner, current shareholders may be given an opportunity to sell their stock at prices above market value (i.e a premium paid above the market price), i.e. General Motors will offer you $350 per share.

If you happen to own Tesla stock at the prevailing market price you could lock in a 17% return ($50/$300) on your investment. These sorts of opportunities present themselves in company acquisitions and mergers.

It is pretty much impossible to get the stock at the low price once an acquisition deal is announced. The markets react and adjust almost instantly. However, there is another way you can participate in acquisitions.

Can I buy stocks without a broker?

A large number of companies that remain undervalued for long periods are eventually acquired for a premium by a competitor or other industry player. This stands to reason as the acquiring company is perhaps the most informed and sophisticated investor in the market for this sector. A significantly large number of Value Stock Guide investments have been acquired resulting in significant profits for us and our members.

This may not happen to every stock in your portfolio. It is not possible to reliably predict which companies will be acquired and when. However, by positioning your portfolio to include undervalued businesses,you increase the odds significantly that you exit your investments with nice profits as some of your holdings are acquired.

Company Breakups and Spinoffs

A spinoff is a part of a larger company that is broken off and made to stand on its own as a corporate entity. Sometimes the spinoff is a profitable company on its own right and can be a fine investment.

Spinoffs can be lucrative because of several reasons.

Opacity: There’s often not a lot of data available on spinoffs right away. This makes it hard for the market to properly value spinoffs and their share prices tend to stay low while the market catches up.
Strong selling pressure drives prices down: When a spinoff occurs many investors are automatically given shares in the company by virtue of shareholder status in the parent company. Retail investors often dump their shares, either because they don’t want to take the time to understand the new business or because they feel like they were saddled with something they didn’t ask for. Larger, institutional investors may ditch their shares because they have rules on minimum amounts they must invest and the spinoffs don’t meet those thresholds. They would rather sell than hold and take the time to understand the new company. Index funds will sell the spun off equity as the spun off company is very likely not part of the index they track

If the spinoff is actually valuable then the market will eventually wake up to its value but until then smart investors can make a good return by searching for promising spinoffs.

Investing in spinoffs can be tricky at times. If you know the intimate details of the business inside and out, you may have an edge over other investors and can come to a better valuation of the spun off company rather quickly. In most other cases, a reasonable profit can be generated by just acknowledging the fact that the stock of the spun off entity will be sold off mercilessly when the spinoff occurs, for no fundamental reason, and a contrarian investment in the stock will in most cases generate some nice profits in a reasonably short time frame (3 months – 1 year).

Litigation

There are a few occasions when the value of a stock depends on the outcome of litigation. The market tends to undervalue litigated assets, allowing investors to buy the stock at a discount and realize fantastic returns once the lawsuit goes away.

Sometimes bankruptcy falls under this umbrella – and savvy investors should know to look for situations when solvent companies, firms with valuable assets, file for bankruptcy. In these cases, shareholders tend to do pretty well.

Republic Airlines filed for bankruptcy in early 2016; at the time they listed $2.97 billion in liabilities and $3.56 billion in assets, leaving the company with positive net assets. The company was actually trading for less than the amount of cash they had on hand, per share.

While the company had decent financials, at the same time Delta Airlines had a lawsuit against Republic seeking $1 billion in damages, liquidity issues and a pilot shortage among other things. Obviously if the court ruled in favor of Delta it would make life extremely difficult for Republic Airlines but if Republic got a positive ruling then a shareholder could reasonably expect to do well – especially considering that the company resolved a lot of their issues in the first month after filing for Chapter 11.

Think about how valuable it would be to have the ability to understand and forecast how this scenario would likely play out. Eventually Delta settled for $170 million dollars and also agreed to provide Republic with up to $75 million to help with their liquidity issues.

Extreme Case of Special Situations Investing: Distressed Debt Investing

An extreme example of buying valuable assets for pennies on the dollar arises when a business is being liquidated or under bankruptcy reorganization. Often, the equity holders are wiped out, but the bond holders may not yet know how much of the value still exists in the business assets that they are likely to receive. Recall, bonds are senior claims on business assets compared to equity. Even among bonds, some bonds may be more senior than others, and some debt may have assets backing up the debt while others may be unsecured. The dueling claims and counter claims of the lenders are often resolved in courts. The uncertainty of the final outcome forces these debt instruments to sell at significant discount to their real values.

An intrepid investor with solid grounding in valuing assets and an ability to wait for the proceedings to pay out, can reap significant rewards by picking out some particularly distressed debt with otherwise solid values. Most times, the risk lies in the wait and understanding of the legal due process, not necessarily in the actual investment itself. However, you should invest in distressed debt only once you are confident you know what you are doing.

Temporary Distress in Otherwise Healthy Business

The idea of mean reversion plays heavily in this theme and an investor can either invest in a distressed stock or a distressed, or declining industry as a whole.

Now there’s obviously a difference between investing in a distressed industry that is experiencing a cyclical decline versus an industry that is going extinct. Once the issues that are plaguing the sector work themselves out, for example: high interest rates creating a shortage of readily available capital, then the industry will bounce back.

(Actually, investing in a cyclical stock is much more nuanced but you can find investments that can reliably generate nice consistent profits year after year)

Other times a firm suffers a reputational hit that also punishes their stock price. For instance, British Petroleum suffered greatly, and rightly so, when news of the oil spill in the Gulf of Mexico broke – an event that saw millions of barrels of oil deposited into the waters of the Gulf. In the months following the spill, British Petroleum saw its share price cut in half, dropping from $60 a share to under $30.

Except nothing had changed in their fundamentals. Yes, they had perpetrated an economic disaster but an experienced distressed stock investor might look at the situation and realize that while their reputation and brand might be tarnished, their ability to make money remained. An investor would need to look hard at this situation and ask themselves if they believed economic forces would lift BP’s share price back to where it was within a reasonable time frame.

The value investing mindset is a wonderful method of operating when operating within the financial markets, but it is also important to have the flexibility and ability to recognize when other opportunities arise, occasions when money is simply waiting to be picked up off the floor.

All you have to do is stop and pick it up.

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