Special situations in investing are potentially lucrative, aming to seize short term opportunities for outsized gains, but not always easy to identify. This week we take a look at three types of these situations.
When you hear value investing you probably think Warren Buffet and Berkshire Hathaway; growth investing might conjure the more recent example of Cathie Wood and her ARK Innovation (ARKK.NYSE) fund and on the more exotic end, quant investing may bring to mind Jim Simons and the Renaissance Technologies’ Medallion fund.
There is, however, another breed of lesser discussed investor; the special situations investor. These investors look to profit, in the short term, from opportunities that present themselves. There are myriad opportunities but we will examine three common ones.
Merger Arbitrage
This is a classic special situation; one company makes an offer for another and the target’s share price rises but trades below the offer price. The opportunity is in buying the target, riding the price up till the deal closes and harvesting the difference. Typically, as conditions to close (successful due diligence by the acquirer; approval from shareholders of the acquiree; regulatory approval if required etc) are ticked off the market price will converge to the deal price.
The acquisition of TAMIM holding Uniti Group Limited (UWL.ASX) was a text book merger arbitrage opportunity. A telecommunications and digital infrastructure entity holding infrastructure assets that have been in demand with several similar entities acquired in 2021.
The below chart shows the share price (SP) movement from $4.12, when UWL first mentioned discussions with parties in relation to a takeover, to $4.99 after a binding scheme implementation deed was signed, a 21% gain in just under three months.
Not all mergers are created equal. On the other end of the scale is Elon Musk’s bid for Twitter (TWTR.NYSE). When he emerged as the largest shareholder the price was $49 and a merger agreement was subsequently signed for $54.20. Musk has since sought to terminate the deal and the SP is currently in the mid $30s. A world of pain (so far) for those who tried to arbitrage to $54.20 but is it NOW a great merger arbitrage opportunity? Plenty to play out still and a lot for any investor to ponder in that trade.
Geopolitical Events
Large scale global events can have material effects on markets and particular companies. Let’s take the current war in Ukraine as an example.
On 10 November 2021, the United States reported an unusual movement of Russian troops near the border of Ukraine. By 28 November, Ukraine had reported a build-up of 92,000 Russian troops.
On 7 December, US President Joe Biden warned President of Russia, Vladimir Putin of “strong economic and other measures” if Russia attacked Ukraine. This signalled the willingness of the United States to assist, potentially militarily through supplying weaponry. This was bullish for American defence contractors with Lockheed Martin (LMT.NYSE): and Raytheon Technologies (RTX.NYSE) two of the leading firms in the space.
The chart below shows the SP performance of the two entities with the eventuation of the invasion on 24 February 2022, providing a good exit with returns dependent on how early (brave) you entered the trade. This trade was also counter to prevailing market conditions, providing an even greater relative return.
Product/Service Specific
Sometimes a particular product or service can be impacted by supply and/or demand dynamics which create an opportunity. Earlier in 2022 an infant formula shortage gripped the United States. This provided an opportunity for other nations/companies to assist in filling the void. The two best known infant formula (IF) companies on the ASX are The a2 Milk Company (A2M.ASX) and Bubs Australia (BUB.ASX).
The shortage was due to the compounding of a number of issues:
Historical import restrictions
Supply chain disruptions due to Covid-19 (2021)
Large scale recall and shut down of a factory of one of the three major US producers, Abbott Laboratories (ABT.NYSE), in February 2022
The recall would have had some special situation investors taking notice as that took things from difficult to crisis point.
Out of stock rates for IF are normally 10% but by the end of April had risen to ~30%; mid-May to 43% and 70% by the end of May. On 30 May 2022 BUB announced it had been granted immediate permission to import infant formula into the USA and had an agreement with the Biden administration to provide at least 1.25m tins. The share price rose 40% that day, providing an exit.
Note however, that A2M was in a down trend all year (also dealing with issues like a covid-exposed reliance on the Chinese market and Diagou trade and class action lawsuits) and by the end of June was 30% down from the start of the year. Special situations are certainly not risk free.
In 2021, a similar trade (based on demand of a service) was buying Australian Clinical Labs (ACL.ASX) as COVID intensified in Australia and demand for (government subsidised) PCR testing skyrocketed.
Summary
As we have seen, special situations come in many forms. The intention is to profit in the short term which can deliver outsized returns, sometimes counter to the market trend. That said, there are risks involved both idiosyncratic (i.e. the company you invest in may have issues specific to itself that derail the investment) and systematic (i.e. prevailing market conditions increase the likelihood of failure e.g. A2M).
Finally, it’s important to keep in mind your thesis and realise your gains when the special situation plays out or, if it doesn’t, cut your losses.
Disclaimer: UWL is currently held in TAMIM portfolios.
When it comes to investing, many know the value in identifying stocks with a big moat. Giants like Buffett and Munger maintain that this has been a crucial part of their success, but how can we identify one of these moats in the making?
In the wake of the ruins brought by World War 1, the French government vowed to protect its vulnerable northeast border with Germany from any future attacks. With horrid memories of fighting and living in open-air trenches, the French spent a decade building a 482-kilometre series of fortifications that would be both impenetrable and comfortable to live in.
The monumental concrete glory, known as the “Maginot Line”, included 142 large artillery forts, 352 fortified gun emplacements and 5,000 smaller bunkers (or pillboxes). Behind the imposing line of fixed defensive positions, tank traps and high concrete walls were fully equipped subterranean bases complete with mess halls, hospitals, recreation facilities and railway lines.
The Maginot Line was thought to be impenetrable and would prevent any WW1-style infantry and artillery attack. At the beginning of World War II, however, it wasn’t able to stop the Nazi war machine from quickly overwhelming and occupying France. The Germans quickly abandoned older tactics for a far more mobile and manoeuvrable attack that disrupted and dismantled the French defensive strategy.
The Oracle of Omaha: Warren Buffett
For decades, Warren Buffett and Charlie Munger have taught all who will listen that a crucial ingredient to their investing success has been finding companies with a big “moat”. An economic moat is the same concept as a moat around a mediaeval castle. It is about protection and long-term survival, preventing other businesses from stealing away a company’s profit margins or market share. Moats can come in different forms: network effects, real assets (e.g. property or infrastructure), intangible assets (such as brands or intellectual property), distribution, switching costs, price advantages and culture.
It’s not hard to see how a huge defensive wall around a business to protect it from competitors might create a very attractive investment. But by focusing only on the size of the moat, investors can miss the opportunity to invest in smaller businesses disrupting the status quo: either globally, like Amazon (AMZN.NASDAQ) or Google (GOOG.NASDAQ), or locally, like REA Group (REA.ASX) or Jumbo Interactive (JIN.ASX). Competition is a potent force in capitalist societies, and mature businesses that once had seemingly “impenetrable” moats have been overrun by the forces of ‘creative destruction’ – think Kodak and Blockbuster.
Instead of focusing only on those mature companies with an existing moat, finding companies that are in the process of building their competitive advantage could be a boon to your portfolio. Beyond the clear-cut growth indicators like compounding revenue and increasing market share, here are some other barometers of an emerging moat:
Management reinvest capital into the business effectively
Jeff Bezos once said:
“Friends congratulate me after a quarterly-earnings announcement and say, ‘Good job, great quarter.’ And I’ll say, ‘Thank you, but that quarter was baked three years ago.’”
Amazon’s growth has been fuelled by continuous reinvestment into innovating and optimising its services. Many of its financial decisions are characterised by a preference for long-term growth instead of short-term profit chasing. Even as the company’s stock price continued to climb through the 2000s, Amazon was and continues to be known for spending big on what some investors considered bad bets, like branching into web hosting. The payoff has been a steep trajectory from a small moonshot company into a trillion dollar megacap.
Reinvestment usually comes in various forms, e.g. research and development; capital expenditure to increase capacity, enhance reliability or boost quality of product or service; and marketing to reinforce branding or gain larger mind share amongst customers. What’s important is to find a company that can continually reinvest funds and earn a high rate of return – the longer this runway, the better.
Destination focussed, avoiding the pursuit of short-term goals
Costco’s (COST.NASDAQ) retail concept is simple: customers pay an annual membership fee which provides entry to the stores for a year, and in exchange Costco operates an every-day-low-pricing strategy by marking up its goods significantly less than competitors (branded goods by only 14% and private label goods by 15%). By sticking to a standard mark-up, savings achieved through purchasing or scale are returned to the customer in the form of lower prices, which in turn encourages more consumers to sign up and buy more products, and extends the scale advantages. This is retail’s version of perpetual motion.
To appreciate the long term focus of building this flywheel, consider this story of Costco founder Jim Sinegal, recounted by well-known investor, Nick Sleep in 2002.
When the opportunity arose to take a higher gross margin than usual on a US$2 million shipment of designer jeans from an exporter (i.e. more than the standard 14%), Sinegal firmly insisted on refusing to break the contract with Costco’s customer, arguing with the exporter that if “I let you do it this time, you will do it again”.
Sticking to the long term destination focus of customer loyalty and footprint expansion has resulted in a 10x return on an investment in Costco from 2002 to today. The focus has firmed the brand, the stickiness of its suppliers and customers – an upward trajectory of its moat.
Alternatively, companies that either damage customer loyalty with operational pivots or reduce investment needs in order to boost short term profits are mortgaging their moats, especially if competition is spending heavily to take over its market share.
The Bottom Line
There are very few companies that last a hundred years. It is vital to evaluate where a company is in the business life-cycle and the direction of its competitive advantage. Disruptive companies can have innovative technologies or operations that are more efficient and make the old way of doing business obsolete. These companies have the potential to change or entirely displace existing businesses and industries. Like David toppling Goliath, finding a wonderful business with a growing moat could provide outstanding returns.
This week we take a look at the factors contributing to the global food shortage and why prices will likely remain elevated for the foreseeable future.
The Food and Agriculture Organization of the United Nations (FAO) Food Price Index – a global benchmark for food prices – is up 22.8% above the same corresponding month in 2021 due to a global agriculture supply shortage.
But you don’t need us to tell you that. A short stroll through the local fresh food section will give you a fair indication of the havoc. $12 lettuces. $17 green beans. $10 for a punnet of strawberries!
Food prices have been on the rise since late 2020, largely due to supply-side factors. Output by farmers has been hindered by the rising cost and availability of key inputs such as fertilisers and chemicals. This has been caused by a sharp increase in global energy prices that has made some fertiliser production uneconomical in addition to adding to fuel costs. The impacts are more pronounced in developing regions. In North America, fertiliser accounts for 10% of inputs costs, whereas in West Africa this increases to 56%.
Supply had been also been impacted by an unusual combination of weather events. La Niña reduced yields in the Southern Hemisphere leading to drier conditions. Flooding in China impacted rice harvests while heat waves in India limited wheat output. Add in pandemic-induced shipping bottlenecks in addition to labour constraints and the scene was set for a global supply shortage and thus more expensive food.
Then Russia invaded Ukraine, making a bad situation worse.
The two warring nations provide 28% of the world’s wheat and 69% of the global sunflower oil supply. Concerns over Russia blocking grain exports out of the Black Sea led to a price spike. Bans on Russia and Belarus, which account for 20% of fertiliser exports, have only worsened supply issues. Further sanctions by the EU and US on oil and gas have had a similar impact. With food security front and centre, nations such as India, Argentina and Malaysia have withheld exports to bolster domestic supply. The shortages have created a vicious cycle, with the United Nations estimating that 1.7bn people could fall into hunger and poverty.
Is the food shortage turning a corner?
The positive news is that prices look to be turning a corner. In May the FAO Food Price Index fell, albeit modestly, for the second consecutive month. Prices for fertiliser are off 30% while shipping rates and energy prices are also beginning to cool down. Certain food commodity prices, like fish and meat, remain elevated. But overall the old adage – the cure for higher prices is higher prices – is starting to take effect.
On Friday Russia withdrew from Snake Island, reopening shipping lanes for grain exports out of Ukraine. While only a small concession, this will put downwards pressure on wheat and other commodity prices.
Markets are also beginning to price a correction. The BetaShares Global Agriculture Companies ETF (FOOD.ASX) has fallen 18% in the past three months. Moreover, most futures curves are in backwardation (when the future price is lower than the current price), implying that abnormal food prices should revert over time.
Interestingly, this hasn’t quelled investor interest. Salmon producer Tassal Group (TGR.ASX) received a takeover bid last week. Fortescue Metals (FMG.ASX) founder Andrew Forrest also purchased a 17.4% stake in cattle and beef producer Australian Agricultural Company (AAC.ASX).
Agriculture is a cyclical industry, prone to peaks and troughs. It’s hard to imagine conditions getting any worse, but that doesn’t mean they won’t persist. Despite energy prices moderating, it will take time for decreases to flow through. Moreover, future-proofing supply chains will be a longer-term project given it takes two to five years to develop new fertiliser plants and oil refineries. Reducing dependency on Russia will also be no easy (or cheap) task. While markets are pricing in falling agriculture prices, it’s likely they will remain above historical levels for the time being.
Disclaimer: Tassal Group (TGR.ASX) and Fortescue Metals (FMG.ASX) are both currently held in TAMIM portfolios.
Inflation is at highs not seen in decades with Australians facing soaring prices for everything from fuel to energy, construction and food. So, what about Consumer Staples?
To combat cost of living pressures, curb inflation and wind back its pandemic related monetary support, the RBA lifted the cash rate for a third month in a row on Tuesday.
This latest 50 basis point rise takes the cash rate target to 1.35%, following a 25bps rise in May – the Reserve Bank’s first rate rise in eleven years – and a further 50bps lift in June.
The RBA concedes that there’s no quick fix to reining in inflation and it could take some time to get back down to the 2-3% target band from the 5.1% annual inflation rate seen in the March quarter.
RBA governor Philip Lowe says inflation could reach 7% by the end of the year before easing early next year. That said, Lowe also stated (last year) that interest rates would be maintained at ultra-low levels until at least 2024. So, it’s really all quite unknown.
What we do know is that higher food prices are hitting hip pockets at the supermarket.
The impact of the east coast flooding, combined with rising transport and fertiliser costs — due to the war in Ukraine and high fuel and labour costs, can be seen on supermarket shelves across the country.
And while we know this is bad news for shoppers, what does it mean for retailers?
When it comes to discretionary spending, rising inflation and subsequent interest rate rises have resulted in a pullback of spending — clearly negative for restaurants, cafes, and retailers of higher priced goods and services.
On the other hand, Consumer Staples — and supermarkets in particular — are known to benefit in times of high inflation.
As consumers stay in and eat at home, supermarkets including Woolworths (WOW.ASX) and Coles (COL.ASX) – which take two-third of Australia’s grocery sales – as well as Metcash (MTS.ASX; supplier to IGA, Foodworks and Drakes Supermarket) are experiencing increased sales.
Each of these businesses reported solid results for the last quarter thanks to higher in-home consumption and rising food inflation.
As they dominate such a large share of the market, these retailers have no trouble passing on higher costs from manufacturers, who are facing higher production costs themselves.
Further, since these supermarkets are not as affected by higher costs they can better compete on price as compared to their smaller competitors.
Coles and Woolworths have raised prices in response to “rising supply chain cost pressures”, according to research by UBS. Woolworths lifted prices by 4.3% in the March quarter, compared to 1.4% in the previous quarter. At Coles, food prices were 3.2% higher in the three months to 30 March after rising 1% in the December quarter.
Coles reported that March quarter sales at its Supermarkets division saw a near +4% jump from last year. Woolworths, meanwhile, saw a +4.4% jump in food sales from a year earlier.
As for Metcash, it says nearly two-thirds of its suppliers have raised prices. But with the company recording record sales growth over the full year to 30 April (revenue up +6.4%, including particularly strong sales in the more recent quarter), it appears that those costs have also been passed on to shoppers.
Other Consumer Staples businesses, including large manufacturers of food, beverages and household items, also tend to do well in times of high inflation. This includes primary producers and agricultural businesses such as GrainCorp (GNC.ASX), Elders (ELD.ASX), and Costa Group (CGC.ASX). These names have each proved to be robust performers in recent months amid the wider market pain.
And while their share prices have suffered in recent months, JB Hi-Fi (JBH.ASX) and Wesfarmers (WES.ASX), with its Bunnings and Kmart stores, could also perform relatively well in this ongoing inflationary environment. While they are, strictly speaking, Consumer Discretionary businesses, their everyday electronics and home improvement products can more or less be considered staples.
Wesfarmers CEO Rob Scott pointed to Kmart’s significant economies of scale and sourcing capabilities, viewing “inflation as an opportunity”, in which, “we are seeking to minimise cost pressures, deliver productivity improvements, while also competing for the share of wallet for more value-conscious consumers.”
It is in times like these that Consumer Staples should prove their worth in investors’ portfolios. And, as a defensive sector, dividends tend to be more sustainable and earnings less cyclical.
Recession. If you feel like this word is everywhere at the moment and everyone is talking about it, you would be right. Google searches for the term have spiked and every finance program and publication is covering it. So, let’s take a look.
So, what exactly is a recession?
There is no single definition of recession. The most common definition used in the media and textbooks is a ‘technical recession’, in which there have been two consecutive quarters of negative growth in real gross domestic product (GDP).
This is a somewhat arbitrary and abstract definition with the oxymoron of “negative growth” thrown in for fun. What tends to happen during a recession is the more important factor to consider.
Let’s start with what “real GDP” is. Real GDP is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given period of time. Two consecutive quarters in which real GDP decreases reflects an economy going backwards by producing fewer goods and services than before. Following this through, if fewer goods and services are being produced then this generally implies there is reduced demand for them. If businesses are experiencing less demand and therefore producing/supplying less, they require less labour to do so. This manifests in workers receiving fewer hours or being laid off and therefore higher underemployment and unemployment. This is a key characteristic of recessions alongside depressed levels of household spending and business investment.
What causes recessions?
Recessions have many different causes. For example, the 1974-75 recession was caused by, among other things, the global oil price shock which saw prices approximately quadruple. This resulted in significant increases in the cost of production, leading to increased prices and reduced consumer demand which fed back to reduced output.
Crude Oil Nominal Price (USD)
The 1991-92 recession (the recession Australia famously “had to have” and our last technical recession) was caused by high interest rates which were put in place to reduce speculative behaviour in the commercial property market and address high levels of inflation. Elevated interest rates (cash rate of 17.5% in 1990) flowed through to increased mortgage and business loan repayments which reduced consumer disposable income and business investment. This led to reduced demand in the economy for goods and services and thus reduced output.
Finally, if we go by gross GDP, the most recent recession was caused by the arrival of Covid-19; gross GDP falling -0.3% and -7.0% respectively in the March and June 2020 quarters. Management of the public health crisis resulted in governments mandating suspension of large swathes of the economy for prolonged periods of time which prevented them from producing goods and services, leading to a reduction in output. In fact, the June 2020 quarter falling by -7% is the largest quarterly decline since records have been kept.
How long do they typically last?
Over time in Australia recessions have tended to last for shorter periods of time and be less severe as can be seen in the charts below. Many factors have contributed to this and the Australian economy’s increased resilience, including; avoiding recession during the Asian Financial Crisis of the late 90s; the tech wreck of the early 2000s and of course the Global Financial Crisis of 2008. Some of these factors include floating of the dollar (1983); banking sector reform; labour market reform and more transparent conduct of monetary policy.
Note the dates above.
How do they affect the share market?
There is no sugar coating it, recessions are negative for the share market. Reduced demand leads to reduced profits and profitability. In turn this results in a decrease in share prices. As this tends to be economy wide, recessions are usually associated with bear markets, a term used to describe a decline in a share market index of at least 20% or more from its most recent peak.
Of course, within the overall decline there can be opportunities which see individual companies experience increasing share prices. The most important takeaway from the below charts tracking the share market across various recessions since 1875 is that it has always recovered to a new high subsequently. EVERY. SINGLE. TIME. Recessions are temporary; the wealth creating effect of the market is enduring.
So, are we headed for recession in 2022/2023?
The short answer? We don’t know and neither does anyone else for that matter. The pandemic resulted in disruptions to supply chains as manufacturing and transportation around the world was affected by differing government policies and restrictions in addition to workforce issues resulting from illness and/or fear of the virus.
This had the expected effect of reducing the supply of goods and services. Simultaneously governments, particularly in the western world, unleashed a torrent of short-term direct stimulus which in many cases fully replaced (and them some) the income of workers affected by closure of parts of the economy. Longer term stimulus was also enacted, think the Home Builder Grant. The twin effects of reduced supply and increased demand have resulted in inflation not seen in decades (see below).
This has been exacerbated by the war in Ukraine which has led to higher energy prices. Central banks likely assumed that as the pandemic came under control, supply would normalise to meet demand and inflation would slow down. This has not proven to be the case and central banks around the world are now “behind the curve” in controlling inflation (USA 2% target vs 8% currently and Aust. 2-3% target vs 5% currently) resulting in them increasing interest rates aggressively. A war that affects global energy and food prices was the last thing needed. As mentioned above, high interest rates were partly the cause of the early 1990s recession and an oil price shock the cause of the 1970s recession. The fear is that history will repeat. Central banks are hopeful they can increase rates enough to dampen demand and reduce inflation without causing a recession (i.e. a soft landing).
Will they succeed? Only time will tell but history suggests they have their work cut out for them.
