Special Situation Overview, Part 1

I just finished Joel Greenblatt’s book, “You Can Be A Stock Market Genius.” I found it to be filled with interesting ideas about event-driven trading strategies.  The title is horrible.  Either  Mr. Greenblatt is dumb like a fox and didn’t want “serious” investors reading his book, or he let the publisher’s marketing department choose the title.

While I may not be interested in trading special situations or augmenting my event-driven strategies, it’s always important to know what your competitors are doing.  Reading the book has prompted me to think about these situations from a different perspective.  I’ll always take some additional time when reading about new deals to see where someone like Mr. Greenblatt will be looking for an edge.

I’m going to review some of the principals and lessons I found in the book, chapter by chapter.

On the basics:

– There are no shortcuts in investing if you want to do well.  Always do your own research and due diligence.

– EMH is mostly an academic exercise because there are traders who achieve superior returns year after year.

– Smaller funds have an advantage over the investing giants because they can participate in transactions that are not suitable for a large institution.

– Do not trust the opinion of others.  The odds of someone presenting you with a worthwhile investment is practically zero.  Analysts and other street professionals will often overlook special situation opportunities because they are out of their area of expertise.  Special situations are not profitable for analyst firms to cover because they do not generate enough revenues (read: commissions) from institutions and clients.

– You do not have to be invested all the time.  You will be more successful if you pick your spots carefully and act as a specialist in a few deals.

– There are only a few ways to make money in the market:

  • Participate in the growth of innovate companies.
  • Purchase great companies at good prices and hold for the long term.
  • Look for asset mispricings.  Special situations are focused on this area.

Spinoffs, Partial Spinoffs and Rights Offerings

– “Spinoffs can take many forms but the end result is usually the same: A corporation takes a subsidiary, division, or part of its business and separates it from the parent company by creating a new, independent, free-standing company.  In most cases, shares of the new “spinoff” company are sold to the parent company’s existing shareholders.”

– Studies find that spinoffs outperform the market by approximately 10%: Patrick J. Cusatis, James A. Miles and J.Randall Woolridge “Restructuring through spinoffs: The stock market evidence” Journal of Financial Economics.

– Spinoffs can take time to realize value, often one to two years.

– Reasons for spinoffs:

  • An unrelated business that stops the market from realizing the value of the core business.
  • Getting out of a “bad” business.
  • Getting shareholder value for a business that cannot easily be sold.
  • Tax considerations make spinoff more attractive than a sale.
  • Spinoff solves a strategic, anti-trust or regulatory issue.

– Key points to look for in an outstanding spinoff opportunity:

  • Institutions don’t want it.  Not because it isn’t good investment, but because it doesn’t fit their obectives.
  • Insiders want it.
  • A previously hidden investment opportunity is created or revealed.

– If a spinoff creates an entity that the media or analysts feel is a weak investment, it may be worth a second look.  Carefully analyzing a spinoff company that at first glance appears to be a toxic dumping ground for the parent company can be a good contrarian play because it can turn out to be an overlooked and oversold opportunity.

Case studies from the book:

  • Host Marriott/Marriott International
  • Strattec Security/Briggs & Stratton
  • American Express/Lehman Brothers
  • Sears/Allstate/Dean Witter
  • Liberty Media/Tele-Communications

A key theme of the book is to follow the insiders and align yourself with their incentives.  If they are truly looking to unlock value for shareholders, then they should have a significant portion of their career and/or net worth at risk in the deal.

Recent Spinoff examples:

  • EnCana Corporation/Cenovus Energy Inc.
  • eBay Inc./Skype
  • Time Warner Inc./AOL, Inc.
  • Verizon Communications Inc./Frontier Communications Corporation
  • Motorola Inc./Mobile phone spinoff

Continued in Part 2: Risk Arbitrage and Merger Securities…

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