Special situation investing
Joel Greenblatt’s book “You Can Be a Stock Market Genius…” beautifully explains event-driven investing also called Special situation investing. The core idea of special situation investing is not valuation but an event that drives the share price.
Special situations have a clear and often a catalyst, so the outcome is often binary i.e., either it works out as expected or it doesn’t. Most of these situations revolve around the transactional aspects of a corporate event. Due to time sensitivity, these investment situations are quick and not like typical value-based investing. An announcement by the company is not an opportunity unless there is a higher probability of closure. The investor’s task is to understand this probability. Merger arbitrage In a merger, one company takes over another one by paying a certain sum in cash, stock, or a mix of both. There can be a gap between the offer price and the market price. This gap is usually due to regulatory approvals, shareholder approval, fake offer, etc. The more uncertainty, the more may be the gap. Unlike a value-based investing approach, here an investor should avoid being contrarian. For example, regulatory approval is pending, and you decide to invest. Eventually, when the regulatory approval comes (HDFC Bank and HDFC limited), sure you will make a good return but if the regulator poses a challenge (IHH and Fortis), you may incur losses. Therefore, reduce the probability of loss as much as possible. The potential return reduces but the probability of success increases. The time frame for these transactions to close is 3 months to 12 months, depending on how complex the transaction is. During the merger process, the spread can be quite volatile and driven by the flow of news/rumors. This might present more than one opportunity to enter/exit the trade. The opportunity has to be evaluated at both target’s and the acquirer’s end especially if there is a stock-based transaction. At the time of the HDFC and HDFC Bank merger, an arbitrage opportunity (~2%) existed to buy HDFC limited and short HDFC Bank due to the difference in the transaction. Spin-offs In a spin-off situation, the company is divesting part of its business into another company. The company also distributes its shares in the spin-off on a pro-rata basis to the current shareholders. Reliance plans to separate its retail, telecom, and oil business. The shareholders will be given shares as per the value assigned by the company to each of the businesses. But where can an investor make money? In case the spin-off business is small, most of the institutional investors will sell their stake in the small business. The logic of the sale is not value, but institutional investors are not allowed to hold. The size of institutional investors' funds often becomes a very high portion in the small company, and these investors don’t want to participate as a majority shareholder in a small company. This creates significant selling pressure right before/after the transaction. This might offer a chance to play on the eventual rebound. Another key to look at is the senior management allocation in small businesses. If the promoter is keeping a significant stake in the smaller entity, there is a high chance of spin-off success. Buyback A buyback offer is announced when a company intends to buy a part of its outstanding shares. This can be done for various reasons, such as capital return to shareholders or maybe management simply thinking that shares are very cheap now. Usually, the consideration comes in cash, and to incentivize participation, the offer is done at a premium to the share market price. Participation is often high when the offer price is at a premium, making the investment proposition weak. If you buy shares intending to tender but eventually the company does not accept due to the size of bidding, the share price can drop. The probability of success depends upon the acceptance by the company. Lesser participation in the offer indicates a higher likelihood that upper limit prices may be reached. Asset sale Often companies own land or buildings on their books. Accounting rules require these assets to be shown at their cost price, which may be quite low. A ballpark assessment of the value of land/building can indicate a fair value of the asset. Many companies trade at a significant discount to its sum of the parts valuation and have their assets undervalued by the market. In such cases, an asset sale could become a catalyst for the share price increase as when the assets eventually get exchanged into cash, the market is much more likely to start recognizing that value. Rights offering The rights offering is a way of raising equity while giving the priority to current shareholders. Each shareholder is allowed to acquire a certain amount of shares and to incentivize participation, new shares are offered at a discount to the market price. Participation by the top management is a positive indicator. Rights offering should be of reasonable size and not a very large portion of the overall market cap. Warrants A warrant is giving the holder the right but not the obligation to buy the stock at a certain price, quantity, and future time. Warrants need to be exercised before the pre-fixed date. If you don't exercise warrants before the pre-fixed date, then the warrants lapse. The special situation investment opportunity in these instruments arises when it is much more profitable to buy the warrants of a company rather than buying the underlying shares.