The TRUE Father of Special Situations


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Jae Jun

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As I continue to make my way through The Snowball: Warren Buffett and the Business of Life, there’s an extraordinary amount of details into how Buffett’s early partnership started, the original investments and the outcomes.

Following Ben Graham’s deep value background, Buffett spent most of this early days as an active investor.

Before Munger was able to convince him that buying compounding businesses at a reasonable price was the way to go, Buffett ran a special situation segment of his portfolio.

During his partnership years, this is what his allocation looked like.

Buffett’s Partnership Portfolio Allocation

Buffett called them workouts – because there was somebody before him that invested in “special situations”.

Workouts did so well for him that he kept a large portion of his portfolio during good and bad times. It’s what helped him achieve ridiculous gains when the market and everything else was crashing around him.

And it worked superbly.

He generated a staggering compounded annual growth rate of 25%.

buffett-partnership-returns-25pct

Buffett Partnership Returns 25%

If you aren’t familiar with special situations, here’s a quick definition:

“The essence of a special situation is an expected corporate (not market) development, within a time period estimable in the light of past experience”

So who is the real father of special situations?

Benjamin Graham of course.

He laid it out clearly in Security Analysis, but an easier read is from an old 1941 article written for the Analyst’s Journal.

Here we go~

The Meaning of Special Situations

the-meaning

In the broader sense, a special situation is one in which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance. In the narrow sense, you do not have a real ―special situation unless the particular development is already under way.

The example he gives is that a preferred stock with very large back dividends could be an interesting possibility, but it isn’t a special situation until the buyer knew that a plan of repayment has or will be announced.

The reason for narrowing the definition of a special situation to an event that is under way is for the expected annual return.

Originally when I got into special situations, it was all about the annual return. 26% annual return for a month of holding sounded like a grand plan.

Until I misjudged a few special situations.

Then I realized that an annual return is just a vanity metric. With special situations, it’s the absolute return that has to be worth it.

No point in investing for a 26% annual return, only to realize that after fees and taxes, the true return is 2%.

In any case, if you find the right special situation with the right odds – pounce.

How to Calculate Indicated Annual Return

return-to-me

Graham makes it easy to determine the attractiveness of a special situation. Figure out what the indicated annual return is.

There’s assumptions involved, but here’s a general formula.

Let G be the expected gain in points in the event of success;

L be the expected loss in points in the event of failure;

C be the expected chance of success, expressed as a percentage;

Y be the expected time of holding, in years;

P be the current price of the security.

using these assumptions and probability scenarios

Indicated annual return = GC – L(100% – C)/YP

We may take as a current example the Metropolitan West Side Elevated 5s selling at 23. It is proposed to sell the property to the City of Chicago on terms expected to yield in cash about 35 for the bonds. For illustrative purposes only (and without responsibility) let us assume (a) that if the plan fails the bonds will be worth 16; (b) that the chances of success are two out of three—i.e., 67% (c) that the holding period will average one year.

Then by the formula: Indicated annual return = 12 x 67% – 7 x 33%/1 x 23 = 24.7%

Note that the formula allows for the chance and the amount of possible loss. If only possible gain were considered, the indicated annual return would be 34.5%.

Classes of Special Situations

There are two main categories of special situations:

  1. Security exchanges or distributions
  2. Cash payouts

But a more conventional classification is:

  • Class A. Standard Arbitrages, Based on a Reorganization, Recapitalization or Merger Plan.
  • Class B. Cash Payout, in Recapitalization or Mergers
  • Class C. Cash Payments on Sale or Liquidation
  • Class D. Litigated Matters
  • Class E. Public Utility Breakups

Class A. Standard Arbitrages, Based on a Reorganization, Recapitalization or Merger Plan.

…one pleasing aspect of the special situation operation, which is that if your deal works out you are sure to make profits, but if it doesn’t, you may still make a profit. The hazards of arbitraging increase as the general market level rises, because your chances of loss in the event of the plan’s failure become correspondingly greater.

…In the recent Raytheon-Submarine Signal merger, one could buy Submarine Signal and sell Raytheon on announcement at an indicated spread of about 18%. That arbitrage was successfully consummated within sixty days.

But special situations are not guaranteed.

sfxe-month-down

I dodged a -69% bullet by deciding not to play an arbitrage based on my special situations checklist.

There are, of course, various hazards involved in all these arbitrages. They include possible rejection by stockholders; possible legal action by minority holders; possible disapproval by the S.E.C, etc. The experienced operator does not ignore these hazards, but attempts to measure them carefully in the particular circumstances of each case.

Here’s an easy checklist I use for Class A special situations.

  1. Make sure both parties have done their due diligence
  2. Check management of both parties are trustworthy
  3. Financing and regulator approval is complete
  4. Get preliminary shareholder sentiment or controlling shareholder approval
  5. Obtain regulator (SEC, FCC, any and all) approval
  6. Get final shareholder approval at a meeting called for that purpose
  7. Check to see that insiders are continually vesting or buying shares
  8. Verify upside and downside risk is asymmetric by assigning potential upside to downside returns

It will be noted that the industrial, utility and rail arbitrages fall respectively into three distinct classed with regards to the time element. One might almost say that the first is usually a matter of weeks, the second of months, and the third of years.

Class B. Cash Payout, in Recapitalization or Mergers

A recent example of this type is Central and Southwestern Utilities 2nd Preferred. Under a recapitalization and merger plan, presented to the SEC on Feb 5, 1946, the holders were given the option of taking the full redemption value in cash or the equivalent in new common stock at the syndicate offering price. The current redemption value was $220 per share, against the market price of 185. Thus the expected profit would be 19%, plus interest at about 3% per annum for the duration of the operation.

The hurdles to be surmounted here in include:

(a) SEC approval;

(b) Court approval.;

(c) Ability to secure underwriting of new common stock at a specified minimum price;

(d) Miscellaneous delays, most frequently caused by litigation.

If the plan should fail, the buyer risks a fall in the price; but contrariwise in the typical preferred stock or bond pay-out, there is virtually no chance of getting more than the redemption value accorded under the plan. We must recognize here an inherent weakness in this type of operation. (Sequel: The plan was carried out, and the preferred holders who asked for cash received $233 in February 1947.)

Class C. Cash Payments on Sale or Liquidation

Class C is what I prefer in a special situation because it involves less variables.

In most cases where a company sells out its business to another or merely liquidates its assets piecemeal, the ultimate amount received by the security holder exceeds the market price at the time the sale or liquidation is proposed.

You don’t see company liquidations as much. Depending on market conditions, a financial disaster will uncover who has been swimming naked and that could lead to distressed opportunities. A factor to consider is that for these liquidation style special situations, cash burn, taxes and feeds the company pays in order to process the liquidation factors into your margin of safety.

Originally if you thought you were going to get $2/share, after all the expenses and cash burn, it could easily be $1/share.

Class D. Litigated Matters

There are fairly numerous cases in which the value of a security depends largely on the outcome of litigation.

This may involve a damage or subordination suit (e.g., International Hydro Electric, Inland Gas Co.); disputed income tax liability (e.g., Gold and Stock Telegraph, Pittsburgh Incline Plane); an appeal from a reorganization plan wiping out stock issues (e.g., St Louis Southwestern Ry., New Haven R.R.). In general, the market undervalues a litigated claim as an asset and overvalues it as a liability. Hence the students of these situations often have an opportunity to buy into them at less than their true value, to realize attractive profits—on the average—when the litigation is disposed of.

Class E. Public Utility Breakups

Remember that this article is from 1941.

In today’s terms, this is like spinoffs.

…principle that a holding company is worth more dead than alive—i.e., that it’s separate assets, net, will sell for more than the parent company securities.

Spinoffs

Before going onto Class F, here’s some info on spinoffs.

Spinoffs can take many forms but a simple definition can be defined as a corporation taking one of its subsidiary or business division and then separating it to create a new company. A spinoff usually occurs because the company wants the public to fully recognize the underlying assets of the division and to get a better valuation of the whole company. The newly created company is then valued by the market independently.

Here are some characteristics that can point to an exceptional spin-off opportunity.

  1. Institutions don’t want it. Institutions have a to abide to rules such as not owning more than a certain percentage. They end up selling without even looking at the business and investment merits.
  2. Insiders are incentivized and want the spin-off to succeed. Will they be receiving stock, options or preferred stock as compensation? Analyze management compensation plans, actions and motives. Insiders should have a vested and active interest in the new company with a large incentive.
  3. Previous hidden investment opportunity is uncovered.
  4. Keeping an eye on the parent company can also pay off.

You can also do this on your own, but back in 2011, I tracked how past spin-offs performed.

spinoff performance

I love spin-offs.

Not for Everyone

Some love chocolate ice-cream. I always go for strawberry.

It’s not for everybody.

Special situations, as we define them appeal mightily to one class of temperament for the very reason that they leave other people cold. They lack industrial glamour, speculative dynamite, or more sober growth prospects. But they do afford the analyst an opportunity to deal with security values very much as the merchant deals with his inventory, calculating in advance his average profits and his average holding period. In this sense they occupy an interesting middle ground between security purchases for ordinary speculation or investment and security purchases for resale in syndicate or dealership operations.

Just remember:

The essence of a special situation is an expected corporate (not market) development, within a time period estimable in the light of past experience.

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