Special Situation Investing

Special Situation Investing

11 May, 2023 | Investment Philosophy, Stock Insight

In this week’s article, we will explore a distinctive investment approach that has the potential to serve as a viable pathway for maintaining overall portfolio returns, regardless of the broader market conditions…

​This approach is known as special situation investing. Special situation investing involves identifying and capitalising on specific, one-time occurrences that influence the valuation of a stock or other investable asset. Before delving deeper into the reasons why this strategy is worth considering, and why now may be a particularly opportune time to do so, it is important to first establish a clear understanding of what exactly special situation investing entails.

Special Situation: What is it?

Every active investor wants a sustainable edge—a system that produces strong returns and is repeatable. Some investors look for the cheapest stocks. Others look for growth. Still, others focus on exploiting trading arbitrage. There are many ways to try to earn a return.

One unique area of investing is that of special situations. Special situations are a niche area because they require a lot of extra work, and the reward isn’t always there.

A special situation is a particular circumstance that has affected or could affect the value of a company’s stock. Oftentimes, the underlying fundamentals of the stock might not pass the typical value investing criteria but the special situation itself provides a nice opportunity for investors to profit from the situation. These events or situations can vary greatly, but they are often related to corporate events such as mergers, spinoffs, restructurings, or distress within an industry.

When it comes to special situation investing, there are four broad categories that investors can consider.

  1. Market inefficiency is based on the idea that markets are voting machines in the short run and weighing machines in the long run. This means that a security may be mispriced in relation to its peers on a multiple basis (e.g. price-to-earnings (P/E), enterprise value-to-operating earnings EV/EBIT) or similar based on the sector the company operates in) basis. Market inefficiencies can take the form of both overvalued and undervalued securities.
  2. Fallen angels are the second category of special situation investing. This strategy involves investing in companies that have experienced temporary setbacks, causing the market to overreact and undervalue their stock. This category can be particularly relevant in a rising interest rate environment, as companies with strong underlying investment theses may experience short-term turbulence due to rate hikes.
  3. The third category of special situation investing is banker-led opportunities. This category includes corporate events such as mergers, acquisitions, restructurings, and spinoffs, which are led by investment bankers. In these events, the investment banker acts as a catalyst for change, which can result in an undervalued security becoming more valuable.
  4. Finally, distressed industries or companies. This category involves investing in companies or industries that are facing significant headwinds due to market or economic cycles. These securities can be purchased at a discount, and investors can realise exceptional returns by waiting for the cycle to normalise. However, this strategy requires a high degree of conviction with a contrarian approach as well as a sound understanding for accounting and valuation.

It’s important to note that special situation investing is not without risks. Investing in companies undergoing restructuring or distress can result in significant losses if the company fails to recover. Additionally, some situations may not be as special as they seem, and investors may find themselves caught up in a value trap.

Having established an understanding of the various types of special situations investing, it is now crucial to examine the current investing environment and its potential impact on portfolio allocation. By delving into the broader market dynamics, we can better appreciate the unique opportunities and challenges that lie ahead and make informed decisions.

Why Now?

​While it is true that special situation investing can function irrespective of market, the current economic environment provides a unique set of opportunities for this investment strategy. Focusing on company-specific or corporate events insulates returns from broader market sentiment and macro factors, but the abundance of opportunities available can be impacted by the macro environment. The current rising interest rate environment is an example of this.

Interest Rates & Special Situations

​As interest rates rise, special situation investing can be both a challenge and an opportunity. The decline in liquidity across the markets will result in corporate events such as mergers, spinoffs, restructurings, and even bankruptcies. The excesses created by central banks and the zombification of companies are reversing, with the cost of capital being the single most important factor to consider.

The rising cost of capital can have a two-fold impact. Firstly, we will see the gradual decline of concept companies or those with excessively lazy balance sheets. Secondly, it will create increasing opportunities for those with access to capital or better balance sheets. This may include more acquisitive corporates consolidating their space or institutional investors, such as private equity, taking advantage of discounted securities. This is already being seen on the ASX with lowball takeovers from private equity players on the rise.

For the discerning investor, this economic environment presents an immense amount of opportunity. The current economic environment has opened up a range of opportunities for special situation investing that should not be ignored like allocations towards attractive targets for acquisition or for distressed debt investors to acquire attractive assets at a bargain.

We are already seeing an uptick in M&A activity within our Australian Equity portfolios. Our portfolio manager, Ron Shamgar, has seen a number of takeover offers cause share prices to rise steeply in the last two months. Since taing over the portfolio two of the more interesting takeovers we have seen relate to Silk Laser Australia (SLA.ASX) and Amaysim (AYS.ASX).

Silk Laser Australia (SLA.AX)

​The profitable, founder-led business had seen its share price sold off as a result of the broader market sentiment. For one thing, the business is classified as consumer discretionary with the primary product being hair removal and as such recession fears had exacerbated what was already a broad trend toward multiple compression despite continued revenue and EPS growth. The share price fell from a peak of 5.20 AUD to circa. 2 AUD.

What was interesting for us was Silk’s market share (i.e. 33% and in the top 2) and ongoing industry consolidation. This particular security looked like a prime takeover target. This illustrates that sometimes markets can be rather inefficient in distinguishing between industry categories and that certain segments actually perform well in spite of broader market conditions.
It was thus not perhaps all too surprising to us then that SLK promptly got a bid given the tremendous undervaluation and indeed at a bid of 3.15 AUD Wesfarmers still walks away with a bargain under its belt.

Note – TAMIM bought SLK at an average price of 1.75 AUD.

Amaysim (AYS.AX)

Amaysim, taken over in 2020, is a classic example of distressed play where the company operates in a clearly consolidated market with high levels of margin and competitive pressures. Amaysim was an MVNO (Mobile Virtual Network Operator) within the broader telco space. These are effectively marketing plays that don’t actually own any of the underlying infrastructure. So, what made it attractive?

The business was a turnaround in progress after making a few historically bad decisions. It was also growing revenue and profitability which led to a strategic position of 5% market share in a clearly consolidated industry. Moreover, the company had a longer-term contract with Optus (the eventual acquirer) that was due for renewal. Thus what we saw was a pool of one million subscribers with the leverage of contract renegotiation in an industry with low subscriber growth and a global landscape where MVNO’s typically have a history of being bought out by incumbents once critical scale is reached. We also simply didn’t see a scenario where Optus would choose to lose 11% of their subscibers to a competitor.

The security was bought by us at 63c and acquired at 84c.

Before we conclude our discussion on special situations investing, let’s take a look at a few notable success stories that illustrate the potential for strong returns in this investment strategy.

Joel Greenblatt and an 836,000% return

​Joel Greenblatt’s investment returns are legendary. In 1985, at the young age of 27, he founded Gotham Capital and launched a hedge fund with assets of around US$7 million. In its first ten years, the fund compounded average returns of approximately 50% per year (after expenses but before fees). Over twenty years, it averaged a staggering 40% a year. At that rate, $1 million grows to $836 million.

Over the subsequent decade, Greenblatt and his partner Robert Goldstein, returned capital to their investors so they could have more freedom to pursue other interests. While continuing to invest, Greeblatt has kept busy as a talented writer, educator, philanthropist and family man.

His first book, humorously titled You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits introduced many to the idea of special situations investing – methods in which Greenblatt says are what drove his incredible investing performance.  The book’s content by far outperforms its cheesy title and while intended for a general audience, became a bible for hedge fund managers in search for an edge. Subsequently, Greentblatt has taught “Value and Special Situations Investment” at Colombia Business School since 1996.

Workouts and the Buffett Partnership

​In 1959, Warren Buffett started an investment partnership. The Buffett Partnership Ltd had an immensely successful existence until Buffett chose to wind it down in 1969 and concentrate his wealth in the funds biggest investment, Berkshire Hathaway.

In the early years of the partnership, Buffett would break the Buffett Partnership portfolio into two separate categories, Generals and Workouts. In the Generals category were stocks that traded at a deep discount to what Buffett estimated to be their intrinsic value (value investing).

Workouts, on the other hand, were stocks whose financial results depend on corporate
action rather than supply and demand factors created by buyers and sellers of those equities. In a letter to his partners from 1957, Buffett writes:

Perhaps an explanation of the term “work-out” is in order. A work-out is an investment which is dependent on a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued situations. Work-outs come about through: sales, mergers, liquidations, tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally.

​For the Buffett Partnership, Workouts were also a way of being concentrated and diversified at the same time. As the return of the workouts was not dependent on the gyrations of the stock market, the risk profile of each category differed. If the stock market were to fall drastically, resources dedicated to workouts would be ploughed into Generals. Conversely, if there was a lack of opportunities in the general market due to high valuations, resources could be deployed to Workouts.

The TAMIM Takeaway

​In conclusion, special situation investing is a unique approach to investing that has the potential to offer significant rewards when executed well. It involves identifying specific events or circumstances that affect the value of a stock. Special situation investing can be complex, requiring a high degree of conviction with a sound understanding of accounting and valuation. While there are risks associated with special situation investing, the current economic environment offers an excellent opportunity to implement this strategy. With the decline in liquidity across the markets, corporate events such as mergers, spinoffs, restructurings, and bankruptcies are becoming more prevalent. It is times like these when some unique investors have an edge and special situations fall within their circle of competence.

Disclaimer: SLA.AX is currently held in TAMIM portfolios.

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