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- First, What is a Special Situation?
- Warren Buffett Loves Special Situations
- Warren Buffett – The King of Special Situations
- Now Back to NuPathe (PATH)
- Getting into NuPathe’s Special Situation
- The Juicy Risk vs Reward
- Example Scenario For this Special Situation Workout
- Finally, Some Important Points
- What is Old School Value?
Did you notice the market drops the past few trading days?
It’s been a while since the market fell like this.
Feels like rain after a long drought.
One company that isn’t taking notice of what the market is doing is NuPathe (PATH).
When the market “fell” 2% last Friday, here’s what it did instead.
So what gives? A reader saw my post about NuPathe on facebook and asked what my reason for buying was.
NuPathe is a special situations play.
After 2 years of being passive on the special situation side, I’m actively looking for more special situations to participate in this year.
Let me go over what special situations are about, and how to profit off NuPathe.
First, What is a Special Situation?
There are various forms of special situations. I have already written about the most common ones.
- risk arbitrage special situation
- going private transactions
- odd-lot tenders
- equity stubs
- investing in bankrupt stocks
You can see that it’s not your typical going long or short.
Warren Buffett Loves Special Situations
Here’s what Buffett said about workouts (or special situations) in his 1969 letter.
Theses are securities with a timetable. They arise from corporate activity – sell outs, mergers, reorganizations, spinoffs etc. In this category we are not talking about rumors or “inside information” pertaining to such developments, but publicly announced activities of this sort. We wait until we can read it in the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the apple-cart so that the expected development does not materialize. Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc.
The gross profits in many workouts appear quite small. It’s a little like looking for parking meters with some time left on them. however, the predictability coupled with a short holding period produces quite decent average annual rates of return after allowance for the occasional substantial loss. This category produces more steady absolute profits from year to year than generals do. In years of market decline it should usually pile up a big edge for us; during bull market it will probably be a drag on performance. on the long term basis, I expect the workouts to achieve the same sort of margin over the Dow attained by generals.
By taking advantage of workouts, Warren Buffett was able to make money in any market.
Simply put, special situations brought stability and outperformance to his portfolio as it works independently to the market.
A basic example is a merger.
Say Coca Cola is buying out a new energy drink company EnRG for $20/share. Since the market is confident of KO’s due diligence and ability to pay up, EnRG is going to trade close to $20/share on the news. The next day, even if the entire market fell 3%, EnRG is going to trade close to $20.
Because the value has already been set and it would be foolish for anyone to sell their shares at $18 when you know it’s going to close at $20.
That’s the beauty of special situations.
The value and time are given so there is more predictability.
Warren Buffett – The King of Special Situations
In fact, one of Warren Buffett’s cornerstone strategy was to invest in special situations.
In 1969, this is how Warren Buffett built his portfolio. Buffett always called it workouts, but you can see that he dedicated 23% of his portfolio to it.
Now Back to NuPathe (PATH)
Teva Pharmaceutical (TEVA) is buying NuPathe (PATH) for Zecuity, which is the world’s first migraine treatment patch.
- Buyout price of $3.65 per share in cash
- NuPathe shareholders will receive rights to get additional cash payments of up to $3.15 per share if sales milestones of Zecuity is achieved
NuPathe has a maximum of 9 years to meet the goal and sales must come in four consecutive quarters.
- If net sales of Zecuity is between $100m to $300m, shareholders receive $2.15 in cash first
- If net sales of Zeucity is greater than $300m, shareholders receive the remaining $1.00 cash payment
Getting into NuPathe’s Special Situation
I’ll base the scenario off the latest closing price of $4.10.
- If Zecuity sales is less than $100m, no cash payment received
- If Zecuity sales is between $100m and $300m, $2.15 is received
- If Zeucity sales is greater than $300m, an additional $1.00 is received
Stock purchase price: $4.10
Initial cash payment: $3.65
Immediately, I’m starting down $0.45 ($4.10-$3.65=$0.45).
If Zecuity is a complete flop, then I get no payment and I lose $0.45 which is an 11% loss.
But even if that is the case, there is still 9 years for this investment to work out.
Plus, there are a few things going for this deal.
- Zecuity is the first ever migraine treatment patch. Already approved by the FDA and patent protected of course.
- Zecuity solves the problem with side effects that occur with migraine pills and prescriptions.
- Huge market size. More than 37 million suffer from migraines.
NuPathe didn’t have the funds to market and commercialize Zecuity which is why they were looking for a partner.
Now that TEVA has solved its cash problem, I’m guesstimating a scenario of 2-3 years to receive the first payment of $2.15.
Don’t take my word on this, but I’m going to just bet that it won’t take more than 5 years to achieve $300m in sales.
The Juicy Risk vs Reward
When it comes to special situation deals like this, always calculate the percentage of loss versus reward to understand what you are getting yourself into.
I got lucky with my INFU downside estimate so let’s see if I can get lucky with this one too.
Here’s the breakdown of the downside vs upside.
The “total invested amount” is the money that you really end up tying up to this special situation. It’s not $4.10 because you get back $3.65 once the deal closes.
So to make this worthwhile, a large upfront purchase is required.
Example Scenario For this Special Situation Workout
Say you buy 1,000 shares @ $4.10.
The total upfront cost is $4,100 but once the deal closes you get $3,650 back so you really only end up spending $450.
The most you’ll lose is $450, which is a maximum of 11%.
The first milestone scenario will net you 280% on your $450 investment.
And the best scenario is a 500% return on your $450.
I’ve never seen such low risk, high returns before. The time frame is much longer compared to a regular workout, but a possible 280% – 500% over a 5 year span is phenomenal.
But $450 is chump change for a lot of you.
So if you have a $100k portfolio and you want the final allocation of this workout to be 3% of your portfolio, you will need to buy about 6,500 shares for a total initial cost of $26,650.
That way, when you get back the $3.65 per share, you are left with about $3k invested for the remaining cash rights.
Finally, Some Important Points
- Special situations can boost your portfolio in volatile and difficult markets. Keep your eyes open for the various types that you can partake in.
- Don’t make my mistake of buying too little at first and then having to buy more.
- Don’t chase the price too much. Set a limit of how much you are willing to lose. At $4.10, max loss is 11%.
- Don’t expect to see your final invested amount for at least 5 years.
Download the spreadsheet below and test the scenarios for yourself.
Next time, I’ll show you how I found this opportunity and how you can do the same thing.
In the meantime, got any special situations that you have an eye on? Let me know in comments.
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