Extra Credit: Investing In Special Situations

Do you remember extra credit from school?  Extra credit was the ‘bonus points’ awarded for doing just a little extra homework or answering a few extra questions on an exam.  It was easily one of my favorite parts of school.

Why?  For a little bit of extra effort I could boost my scores from ‘normal’ to ‘excellent’.  Extra credit was one of those incredible “can’t lose” situations — get the question right and you get the bonus points, get the question wrong and you lose absolutely nothing.

As it turns out, extra credit actually exists in the real world.  For people willing to do some extra work, there’s thousands of side hustles that are the financial equivalent of ‘extra credit’.  Often this real-world “extra credit” only requires being in the right place at the right time to capture the opportunity.

Today’s post is about one of my favorite forms of “extra credit” in the real world — Investing in special situations.

What Is A Special Situation?

Special situations are investing opportunities that arise when irregular business activities occur.  These irregular activities include mergers, spinoffs, bankruptcies, investor activism, tender offers, restructurings, litigation, turnarounds, capital allocation policy changes, and a host of other possibilities.

By investing in these unique situations, investors can sometimes realize incredible profits.

Despite the use of the words ‘irregular’ and ‘special’, these situations do happen fairly frequently in the investing world.  There’s always something happening in the business world.

For astute investors willing to do a little ‘extra credit’, special situations can be an incredible way to boost your investing returns.

Please note:  Special situations are usually not for beginner investors.  As I said, extra credit requires extra work.  Consider yourself warned.

Spinoffs

Spinoffs are one of the easiest special situations to take advantage of, and they happen all the time.  They’re also a good place to get started for investors new to special situation investing.

Spinoffs happen when a large company decides to sell or “spinoff” a smaller division of the larger company.  Typically spinoffs happen because the smaller division doesn’t ‘fit’ within the larger company and it’s true market value isn’t realized as part of the larger conglomerate.

Spinoffs can also be a way for management to separate a ‘bad’ business from a ‘good’ business.  While words like ‘bad’ and ‘good’ sound pretty scary, it’s a well studied fact that spinoffs (even the ‘bad’ ones) can perform very well once they’re freestanding entities.

It makes perfect sense when you think about it — by shedding the inefficient bureaucracies of large corporations, entrepreneurial forces become unleashed and ‘average’ businesses can become above average investments.

Typically you invest in spinoffs in two ways — By purchasing shares of the parent before the spinoff, OR by purchasing freshly spun-off shares in the open market.

Not all spinoffs are going to be successful investments of course, but many are.  Studies like this one from Purdue have shown that most spinoffs do quite well — frequently beating the market.

Interested finding some spinoffs to invest in?  Check out this list of upcoming stock spinoffs.

Bankruptcies

Yes, bankruptcies can be special situations!  While the bankruptcy of a public company is not a common sight, it does happen from time-to-time.

How do you ‘invest’ in a bankruptcy?

Well, it’s a little tricky — First, existing equity shareholders are typically wiped-out during a bankruptcy, that’s almost a given.  However, bondholders often end-up with equity (shares) in the newly reorganized company.  The idea is to buy-up debt (bonds) for pennies on the dollar which is then converted to shares in the new company.  Pennies become dollars.

The result is often very large gains, even when the ‘stench’ of bankruptcy is still wafting around the reorganized company.

Yes, I said ‘stench’.  Never mind that debt levels are usually reduced to reasonable levels — Investors frequently treat companies that have emerged from bankruptcy like they’ve been swimming in raw sewage.  The shares often trade very cheaply when compared to similar firms.

This is the second way to invest in a bankruptcy — buy shares in the newly reorganized company after they’ve been re-listed.  Usually they’re dirt cheap.  If you can manage to hold your nose for a few years (until the smell of bankruptcy wears off), some very good gains can be realized.

Acquisitions & Mergers

When two companies merge together, the acquiring company usually pays a premium over market value.  This premium is a boon to existing investors because it often means quick profits.

Astute individuals might imagine they could purchase shares in the acquired company (at less than the offer price) and realize a profit…

Unfortunately, it’s not so easy.  Being able to jump-in on a merger after the deal is announced is almost never possible.  Professional investors in this field called “risk arbitrage” quickly acquire every share they can.  The market price for the acquired company’s jumps to the purchase price almost immediately.

Let me use a real world example to illustrate the difficulty here — One of my current favorite investments, LyondellBasell (LYB) is attempting to acquire A.Schulman (SHLM) for $42 per share in cash.

The deal was announced in a press release before markets opened on February 15th.  On February 14th, A. Schulman’s shares closed at $38.65.  By the time markets opened on February 15th, the shares traded at $43.20.  Yes, that’s above the deal price.

You would have needed to hold shares before the deal was announced to realize that 15% profit.

Fortunately for small investors, mergers often take years to resolve.  There wasn’t an opportunity to profit on February 15th, but there could be one in the future.  Deal prices can change, and market values are always fluctuating.  It pays to pay attention.

There are also special securities (preferred shares, warrants, bonds, etc) that get issued during mergers.  These esoteric securities frequently get ignored by investors, but can often make for great investments.  (For the curious, I’ve written about my successes with preferred shares in the past.)

If you’re interested in learning more about how to profit from mergers, I recommend Joel Greenblatt’s book which covers the topic, and Risk Arbitrage by Guy-Wyser Pratte.  Both these texts go into a good amount of detail on mergers.

Investor Activism

One of my favorite forms of special situations today is Investor Activism.  You’ve probably read about it in the  news — Typically, a hedge fund manager acquires a controlling interest in a troubled (or poorly run) company and then pushes management for change.

The great part of these deals is that anyone can join in.  If you agree with the thesis of the activist investor, you can actively purchase shares and vote in the proxy battles.

Sometimes these deals work out great — In the case of Cracker Barrel (CRBL), activist investor Sardar Biglari purchased 18% of the company back in 2012 and proceeded to bully Cracker Barrel’s executives for years to see improvements.  Investors did very well.

Shares of CRBL went from $60 per share in 2012 to $157 per share, trouncing the S&P 500.  Dividends quadrupled in the span of 5 years, going from $1.15 per share to $4.65 today.

The best part of this special situation?  Anybody could have taken part.  All the documents were published and available to the public.  As it turned out Biglari was right, and investors that followed along profited handsomely.

Sometimes activist investors fail miserably too — The most famous case being Bill Ackman losing about 90% of his initial investment on a bad investment in Valeant.  It was quite the disaster.

As with all investments, tread carefully.

Final Thoughts

This post was just a sample of the many special situations that can arise when investing.  There are many more I didn’t discuss here!

Over the years I’ve personally invested in many special situations — spinoffs, mergers, activist situations, and even companies recovering from bankruptcy.

Sometimes I was simply in the right place at the right time, buying cheap stocks when the bigger sharks were circling.  I’ve also followed activist investors into poor companies and done well when changes were implemented.  Other times I’ve held my nose and invested in companies emerging from bankruptcy.  All of these situations worked out great.

Right now, I’m only invested in two special situations — The upcoming DowDupont (DWDP) spinoff, and a company recently emerged from bankruptcy (LyondellBasell).  These two situations comprise about 20% of our portfolio.  While it’s possible that either of these special situations could turn into losers, I’m betting not.

Only time will tell.

If you’d like to learn more about the topic of investing in special situations, I highly recommend Joel Greenblatt’s book “You can be a Stock Market Genius”.  Yes, the title of the book is terrible — but it’s actually a really excellent book on special situations; filled to the brim with interesting case studies.

Of course, most investors don’t need to look for special situations to realize good returns.  A well diversified portfolio of index funds can provide sufficient return to reach financial independence.  You don’t need to touch a single special situation in order to do OK.

That said, the extra credit is out there for people willing to do the extra work… just like in school.  Some people actually enjoy investing — For those willing few, investing in special situations can be an incredible source of ‘extra credit’ for your investing portfolio.

Good luck!

[Image Credit: Flickr1, Flickr2, Flickr3 ]