I’ve always wanted to read “You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits” by Joel Greenblatt since I knew about the book some years back, yet have somehow never managed to do so. Well, I finally dug in and I’m glad that I did.
This is an excellent book, written in a humorous, straight-forward, easy-to-read style that is great reading.
Books on special situation investing are rare. Martin Whitman has books on bankruptcy investing, Guy Wyser-Pratte has a book on Risk Arbitrage. Greenblatt goes through a few areas: spinoffs, mergers, restructuring, options, etc. and explains why these are good hunting grounds for bargains due simply to their very nature.
It also reminds me about David Einhorn’s investment philosophy that they look at where something might be cheap, and then analyse the situation to determine if it is indeed a bargain.
Overall a very good read, highly recommended.
- After purchasing 6 or 8 stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small.
- Overall market risk will not be eliminated merely by adding more stocks to your portfolio.
On Buying and Selling
- It’s relatively cheap
- There’s limited downside
- It’s undiscovered
- Insiders are incentivized
- You have an edge
- No one else wants it
When to Sell
- For special situations, trigger to sell may be a substantial increase in the stock price, or a change in the company’s fundamentals (e.g. company is doing worse than you thought).
- When you make a bargain purchase because of a corporate event, determine what kind of company you’re buying. If the company is an average company in a difficult industry, sell once the stock’s attributes become more widely known. If the company is a good company, you can hold for the long-term.
Why Invest in Spinoffs
- A study done by Penn State covered a 25-year period ending in 1988, and found that stocks of spinoff companies outperformed their industry peers and the S&P500 by 10% per year in their first 3 years of independence. The parent companies outperformed the companies in their industry by more than 6% per year during the same 3 year period. [“Restructuring Through Spinoffs,” Journal of Financial Economics 33 (1993). Patrick J. Cusatis, James A. Miles, and J. Randall Woolridge.]
- The largest stock gains took place in the 2nd year after the spinoff. This is likely due to 2 reasons: it takes some time for the selling pressure to wear off, and it takes a year for the entrepreneurial changes and initiatives to kick in.
- With the market averages returning ~10% per year historically over the long-run, spinoffs can return ~20% per year.
- The management of the spinoff is freed from a corporate parent, and has more accountability, responsibility, and direct incentives (e.g. stock options).
- The whole motivation behind a spinoff is to increase shareholder value.
Why Do Spinoffs Occur
- Unrelated businesses can be separated so that each can be better valued by the market. The valuation metrics used for each unrelated business can be different, hence is the combined entity may not be appropriately valued.
- Separate out a ‘bad’ business so that a ‘good’ business can show through. Establishing a more focused management team for each entity is better for both.
- Give value to shareholders for a business that can’t be easily sold. The division may be in an unpopular but cash-generating business. In that case, debt can be loaded onto the spinoff to create more value to the parent.
- Tax considerations favour a spinoff rather than a sale. Under certain conditions, a spinoff can be a tax-free transaction, compared to a sale where the gains are taxed and dividends are taxed again.
- A spinoff may solve a strategic, antitrust, or regulatory issue, allowing other transactions to occur. E.g. a parent holding a division in a highly regulated industry may have problems getting itself acquired.
Why Are Spinoffs Sold Down
- Shareholders mostly were invested for the parent’s business.
- Spinoffs are much smaller than the parent, which is too small for an institutional portfolio.
- Many funds can only own S&P500 companies. A spinoff from an S&P500 company will be sold.
- Insiders prefer a low initial price because their stock options are set based on the stock price after a day of trading, a week, a month or more. Do check the SEC filings for when the mangement’s stock options will be set.
Buying Before or After the Spinoff
- In general, if institutional investors are interested in a parent company because an undesirable business is being spun off, they will wait until the spinoff is completed before buying the parent.
- This removes the risk of the spinoff transaction not being completed, and the need to sell the unwanted spinoff.
- It has the tendency to drive up the price of the parent’s stock immediately after a spinoff.
- Hence it is usually worthwhile for you to buy stock in the parent before the spinoff takes place.
Spinoff Example #1: Marriott
- Announcement date: October 1992.
- Marriott Corporation to be split into Host Marriott and Marriott International.
- Host Marriott will hold the unsalable hotel properties with almost all of the debt.
- Marriott International will hold the hotel management service business with the huge income stream.
- Stephen Bollenbach (the CFO that came up with the plan, and who turned around Donald Trump’s gambling empire) will be CEO of Host Marriott.
- Marriott International will extend a $600M line of credit to host Marriott.
- The Marriott family will hold 25% stakes in both companies.
- Institutions would not want it. Host Marriott looked so awful that few institutions would do further research.It is small (10-15% of the original $2B market cap) and highly leveraged. It is in a different business compared to what they were mainly investing in.
- Stephen Bollenbach is going over to Host Marriott, not Marriott International.
- Host Marriott had $20-25 per share of debt, with $3-5 per share of equity. A 15% move on the asset side can double the stock.
- Host Marriott has a lifeline of $600M from Marriott International.
- How it played out
- SEC filings: June/July 1993.
- Spinoff date: End September 1993.
- Insiders had huge vested interest with 20% of Host Marriott’s stock.
- Host Marriott tripled in 4 months from spinoff.
Spinoff Example #2: Briggs & Stratton
- Announcement date: May 1994.
- Briggs & Stratton (small gas-powered engines used in outdoor power equipment) to spinoff off Strattec Security (automotive-lock division).
- Strattec was less than 10% of Briggs & Stratton’s total sales and earnings. Briggs & Stratton is a S&P500 company.
- Insiders will hold 12% of the new company.
- Comparables for Strattec are at P/E of 9 to 13 based on Value Line’s “Auto Parts (Original Equipment)” group. Earnings seem to be going 10% higher.
- Strattec is the largest supplier of locks to GM, supplies almost all the locks to Chrysler, and may supply locks to Ford. The Ford opportunity can increase sales by more than 16%.
- Strattec seemed to have a strong niche with quality products at competitive prices.
- How it played out
- SEC filings: November 1994, January 1995 (more details)
- Spinoff date: 27 Feb 1995.
- Form 10 filed. Did not require a shareholder vote.
- Traded at $10.50 to $12, the low-end of the industry P/E range for several months, and the price did not take into account (1) the Ford business, (2) Strattec’s market niche, (3)
- upcoming 10% profit increase.
- Traded to $18 before the end of 1995, a 50%+ gain.
Spinoff Example #3: Home Shopping Network (HSN)
- Announcement date: April 1992 (Smart Money magazine)
- To spinoff Silver King Communications to hold its 12 UHF TV broadcast stations.
- HSN management believed that the broadcast stations should be valued on a cash flow basis, while HSN being a retail company should be valued on an earnings basis. The high amortization each year on the broadcast stations was hurting the overall earnings of HSN.
- Silver King’s operating earnings was ~$4M, cash flow was ~$26M, free cash flow was ~$23M.
- HSN will shift $140M of debt to Silver King and be relieved of $12.6M in annual interest costs. HSN’s reported earnings will go up by $8.6M ($12.6M of interest saved – loss of Silver King’s operating earnings).
- Stock price was just over $5 despite being a high flyer in the 1980s.
- The value of the spinoff was small (every 10 shares in HSN will receive 1 share of Silver King), yet it has a ton of cash.
- Spinning off Silver King (broadcast is regulated) makes HSN more saleable.
- How it played out
- SEC filings: August 1992
- Spinoff date: January 1993
- Silver King traded at $5, less than 5x cash flow, for a few months. Traded at $10-$20 over the next year due to speculation that it will join with others to form a 5th TV network.
- HSN went up instead of going down on the day of the spinoff, leading to a one-day gain of 12% for HSN shareholders.
- Another HSN spinoff Precision Systems traded below $1 for several months, went to $5 within a year, and $10 over the next 2 years.
- HSN and its rival QVC Network both doubled in the next year.
Spinoff Example #4: American Express
- Announcement date: Jan 1994
- To spinoff Lehman Brothers to remove volatile earnings.
- Amex will be left with 2 businesses, the travel related business (charge card, travel agency, traveler’s check) business and Amex Advisors business (financial planners, annuities, mutual funds).
- Lehman is estimated to be worth $3 to $5 per Amex share (at $29)
- Amex would earn $2.65 per share in 1994 without Lehman Brothers, so the post-spinoff Amex can be bought for less than 10x earnings at $24-$26.
- Amex comparables have P/E in the low teens.
- Amex Advisors was growing at 20% for almost 10 years.
- How it played out
- Amex rose $1.60 the first day after the spinoff.
- Amex went to $36 in the first year after the spinoff, for a 40%+ gain.
- Warren Buffett bought 10% of Amex 6 months after the spinoff.
Why Do Partial Spinoffs Occur
- To get the market to value a particular division independently, while still retaining management control.
Why Investigate Partial Spinoffs
- If the shares are distributed to the shareholders of the parent company, it works the same as a full spinoff. If the shares are sold to the public through an IPO, indiscriminate selling is not likely so the opportunity is not as good.
- By knowing the market value of the division, it allows you to know the market value for the rest of the parent’s company.
Partial Spinoff Example #1: Sears
- Announcement date: Sep 1992.
- Sears to sell a 20% in two subsidiaries, Dean Witter (including Discover) and Allstate Insurance, and distribute the remaining 80% interest to shareholders some time in 1993.
- 20% in Dean Witter was sold in Feb 1993.
- 20% in Allstate was sold in Jun 1993.
- In July 1993, Dean Witter was at $37, Allstate at $29, Sears at $54.
- 80% in Dean Witter distributed in Jul 1993.
- Subtracting the value of Dean Witter and Allstate from Sears meant that Sears retail business was valued at $10 or $11.
- Subtracting away Sears Mexico, Sears Canada, and Coldwell Banker, leaves $5 a share or a market cap of $1.5B for a retailer with $27B in sales and little debt.
- Possible to long Sears and short Allstate to just capture the Sears portion (when the 80% of Allstate was not yet distributed).
- How it played out
- Sears was up 50% over the next several months.
Spinoffs via Rights Offering
Why Investigate Spinoffs via Rights Offering
- The parent has chosen not to pursue other alternatives that require the directors, as fiduciaries, to seek the highest possible price for the spinoff’s assets.
- There is a general tendency for a spinoff to be offered at an attractive price in a rights offering. A telltale sign of a bargin is the inclusion of oversubscription privileges for investors who purchase spinoff stock to buy more shares if the rights offering is not fully subscribed.
- With oversubscription privileges, insiders can own more of the spinoff by discouraging other investors from exercising their rights.
- Always try to figure out what’s in it for the insiders!
Rights Offering Example #1: Liberty Media
- Announcement date: Jan 1990
- Tele-Communications (TCI) was the largest cable operator, and wanted to spinoff its programming assets and minority interests in cable TV systems to lessen the regulatory pressure.
- Mar 1990: Announcement that a rights offering will be used. The spinoff will be scaled down.
- Oct 1990: Spinoff is scaled down again.
- Nov 1990 and Jan 1991: Value of spinoff assets down to $600M (vs. $15B in TCI)
- Liberty Media reported a $20.4M loss for year ending Sep 1990.
- TCI shareholders receive 1 transferable right for every 200 shares they owned. Each right, together with 16 shares of TCI can be exchanged for 1 share of Liberty Media.
- This puts the price of Liberty Media at $256 with total of 2M shares.
- 2M shares was too illiquid for institutional investors [intentional].
- The number of Liberty shares issued would be equal to the number of rights exercised, even though the assets will remain the same.
- Any rights not issued will be replaced by preferred stock owned by TCI which gave money to Liberty at very good terms.
- John Malone, CEO of TCI chose to receive his compensation in the form of stock options for 100,000 shares of Liberty.
- The $20.4M loss did not include the equity stake in other companies, which is the bulk of Liberty’s assets.
- Forbes, Bear Stearns, and Lehman all recommended not to participate in the rights.
- How it played out
- TCI’s Chairman Bob Magness and CEO John Malone bought up all the shares of Liberty, with Malone owning 20% of Liberty.
- TCI’s clout was used to make sure Liberty thrived.
- Liberty split its stock 20 for 1 less than 1 year after the rights offering.
- Liberty went up 10x in less than 2 years.
Risk arbitrage is not recommended
- A deal may not go through for a number of reasons (regulatory, financing, extraordinary changes in the business, discoveries during the due diligence process, personality problems, people changing their mind, etc.), resulting in large losses.
- Deals can take 1 to 18 months to close, tying up the money.
- Risk arbitrage is now a very competitive business making the spread low.
Close Shave Example #1: Harcourt Brace Jovanovich / Florida Cypress Gardens
- April 1985, Harcourt Brace Jovanovich (HBJ) announced an acquisition agreement with Florida Cypress Gardens..
- Each share of Cypress Gardens will get 0.16 share of HBJ.
- Potential annualized gain of 50%.
- For every Cypress Gardens stock bought, shorted 0.16 HBJ stock.
- Shareholder approval risk is low: For Cypress Gardens, the Chairman owned 44% of stock outstanding. For HBJ, the deal is so small that no shareholder vote is required.
- Deal made sense because both are in the same business..
- No financing risk because the offer is in common stock.
- No regulatory issues.
- No antitrust considerations.
- What happened
- The main pavilion of Cypress Gardens fell into a sinkhole (physically).
- Cypress Gardens announced that the deal can be affected.
- HBJ stock had already climbed by 17.1%.
- If the deal is called off, the loss could be 59%. If Cypress Garden dropped further due to damaged facilites, the loss could be 85%.
- How it played out
- The short in HBJ was covered.
- The purchase price was reduced but still allowed a small profit.
- Final loss was 13.3%.
Close Shave Example #2: Combined International / Ryan Insurance Group
- July 1982, Combined International agreed to acquire Ryan Insurance Group.
- Chairman of Ryan Insurance was to be the new CEO and Combined’s founder Clement Stone was to step down.
- Ryan and his family owned 55% of Ryan Insurance Group, so no shareholder approval risk for Ryan.
- The upside is $2, downside is $14, but the deal looked relatively riskless.
- What happened
- Clement Stone changed his mind about giving up his company during Combined’s shareholder meeting.
- How it played out
- Stone and Ryan managed to iron things out at the end of the day after the market had closed.
Why Investigate Merger Securities
- Retail investors don’t understand complicated securities and will just sell.
- Most institutional investors do not have the mandate to hold both stock and bond investments, and even if they can, merger securities are unlikely their top choice.
Merger Securities Example #1: Super Rite Foods
- Super Rite Foods was 47% owned by Rite Aid Corp.
- Jan 1989, Chairman and management of Rite Aid Corp wanted to take Super Rite private in a LBO transaction.
- Other parties made bids for Super Rite, and the final bid consisted of cash, preferred stock with 15% yield, and warrants for 10% of the company.
- Face value of preferred was small, likely indiscriminately sold.
- Value of warrants per Super Rite share was even smaller.
- Management projections in the proxy showed that the company will have free cash flow of $5 per share in 3 years, making the shares worth $50 each.
- Warrants were trading at $6 and allowed one to buy shares at no cost.
- How it played out
- Decided against buying Super Rite shares in case the deal collapsed.
- Super Rite went public 2 years after the deal closed.
- Warrants trading at $6 were valued at $40.
- Preferreds were trading at 50-60% of face value, and sold for 100% of face value at the IPO.
Merger Securities Example #1: Paramount Communications / Viacom
- Sep 1993, Viacom agreed to purchase Paramount for stock and cash.
- Feb 1994, Viacom won bidding war again Barry Diller and bought 50.1% of Paramount.
- Jul 1994, Paramount shareholder meeting closed the deal. They were given Viacom stock, debentures of Viacom, Contingent Value Rights (CVR), and Viacom warrants.
- CVR gave a backstop to the value of Viacom shares.
- The warrants can be exercised using the debentures.
- How it played out
- The debentures traded at 60% of face value.
- Effectively the warrants + debentures gave the right to buy Viacom stock for 5 years at $42 even though the stock was at $32.
- Buying both warrants and debentures was a winning trade.
Why Investigate New Common Stock of Company Emerging from Bankruptcy
- Company’s past performance, new cpapital structure, management’s future projections for the business, are contained in the registration or disclosure statement. Many new shareholders may not care to read.
- Stock issued to banks, former bondholders, and trade creditors, are not interested in being long-term shareholders, so they will sell quickly.
- Wall Street generally ignores the stocks of companies coming out of bankruptcy.
- Some companies are too small to justify vultures’ time and effort.
- Study by Edward Altman, Allan Eberhart, and Reena Aggarwal found that stocks emerging from bankruptcy outperformed the market index by over 20% during their first 200 days of trading. [“The Equity Performance of Firms Emerging from Bankruptcy,” New York University Salomon Center and Georgetown School of Business Working Papers, May 1996.]
Quality of Companies
- Companies got bankrupt because they are in difficult, unattractive, uncompetitive businesses or have lack of capital. Quality of the companies are not good.
- Stick with good businesses, companies with a strong market niche, brand name, franchise, or industry position.
Types of Companies to Investigate
- Companies that went bankrupt because they were overleveraged due to a takeover or LBO.
- Operating performance of a good business suffered due to a short-term problem.
- Earnings of a company involved in a failed LBO grew slower than hoped.
- Companies that filed for bankruptcy to protect itself from product-liability lawsuits (e.g. Walter Industries).
- Companies that shed unprofitable business lines when coming out of bankruptcy (e.g. Toys R Us).
- Plain cheap stocks compared to similar companies in the same industry.
Bankruptcy Example #1: Charter Medical Corporation
- Dec 1992, stock at just over $7.
- Operates 78 psychiatric hospitals and 10 conventional medical-surgical hospitals.
- Emerged from bankruptcy few months ago with still a sizable debt load.
- Based on comparables, it should be trading closer to $15.
- Plan to control costs, step up marketing for new patients, and increase outpatient psychiatric services, appear to be going well.
- Plan to sell its conventional hospitals to reduce leverage.
- Was going to earn $2.50-$3 of free cash flow per share.
- How it played out
- Conventional hospitals were sold for a good price.
- Wall Street discovered the sotck.
- Stock tripled.
- As a general rule, don’t buy the common stock of a bankrupt company.
- If you want to invest in the bonds, bank debt, and trade claims of bankrupt companies, quit your day job.
Why Investigate Restructuring Situations
- Sale of a major divison may create a more focused enterprise which benefits shareholders.
- Companies that pursue restructuring are often among the most shareholder oriented.
Two ways to play
- Invest after a major restructuring has been announced. There is ample time because it takes time for the market to fully understand the ramifications.
- Invest in a company that is ripe for restructuring. This is much more difficult to do. Look for a catalyst to set things in motion.
Type of Restructuring Situations to Go For
- Limited downside
- An attractive business to restructure around
- Well-incentivized management team
- Magnitude of the restructuring is significant relative to the size of the total company
Restructuring Example #1: Greenman Brothers
- Wife was impressed with Noodle Kidoodle store set up by Greenman Brothers
- Greenman Brothers is a marginally profitable distributor of toys, housewares, and stationery.
- Stock just above $5, book value of over $8.
- Most assets were in cash, receivables, and recently purchased inventory that could be readily sold.
- Huge upside – Did not seem that market is giving any value to the new Noodle Kidoodle. The upside if succesful can be huge.
- Limited downside – If the assets of the distribution business sold for $6 (assuming a 25% haircut on book value of $8), you still get the Noodle Kidoodle business for free.
- Catalyst – If Noodle Kidoodle is to grow, it needs funds. Funds can be obtained either by borrowing or by selling the distribution business.
- Business available to restructure – The distribution business.
- How it played out
- Bought before May 1994.
- Stock traded between $4 to $7.
- Noodle Kiddole stores did well, and distribution business did worse.
- May 1995, Greenman announced the possible sale of its distribution business and free up capital to grow Noodle Kidoodle.
- Stock moved up to $11 in 2 months and $14 within 4 months.
- Greenblatt sold between $10-$11.
- Noodle Kidoodle was later bought over by Zany Brainy for $4.50 in Apr 2000.
Restructuring Example #2: General Dynamics
- Jun 1992, General Dynamics announced it would buy back 13M shares (30% of shares outstanding) through a dutch auction tender.
- After announcement, stock rose to $71. In Feb 1991, stock price was only at $25.
- Tender document disclosed that management was not selling any stock back. This meant that insiders think the stock was still undervalued. The buyback will benefit those who held on.
- The restructuring plan called for selling of non-core businesses by end 1993. Subtracting the expected cash proceeds from the stock price showed that the continuing core businesses would be at a 40% discount to other defense contractors.
- How it played out
- Jul 1992, company repurchased 13M shares.
- Two weeks later, Warren Buffett announced he acquired 15% of General Dynamics.
- For next 2 months, stock traded between $75 and $80.
- By end 1993, the stock had given over $50 of dividends, and share price was at $90. The total of over $140 meant the stock had effectively doubled in 18 months.
Recapitalizations and Stub Stocks
Why Do Recaps Occur
- To ward off a hostile takeover or give value to shareholders, a company converts equity to debt or other securities. It either repurchases a large portion of its own common stock in exchange for cash, bonds, or preferred stock, OR it borrows money and distributes cash dividends.
- Result of a recap is usually a highly leveraged company that is still owned by the original shareholders. The common stock after the recap is known as the stub stock.
- Tax advantages of a leveraged balance sheet (i.e. tax shield due to debt interest).
- The total value of the recap package (value of the debt + stub stock) is usually greater than the original pre-recap price of the stock.
Why Invest in Recaps
- Investors of the pre-recap stock generally don’t want the company’s debt and preferred securities. These newly issued securities are sold indiscriminately, so they work the same way as merger securities.
- Investing in the stub stock is like investing in the equity portion of a publicly traded LBO.
- There is almost no other area of the stock market where research can be rewarded as quickly and as generously as in the careful analysis of stub stocks.
- Any increases in earnings are amplified due to the small equity base, so the percentage impact on the stub stock price is much greater. With earnings exceeding interest expense more comfortably, a higher P/E can be justified, pushing the stock price even higher.
Stub Stock Example #1: FMC Corporation
- Feb 1986, FMC Corporation announced plans for a recap to fend off a potential takeover.
- FMC shareholders will get a cash distribution of $80 + 1 new share in the recapitalized company. management and employees were to receive 5.66 shares in the recapitalized company for each share they own.
- May 1986, proxy statement filed with shareholder vote scheduled end-May 1986.
- Management was foregoing the cash dividends, so they are betting their fortunes on the success of the recapitalized company.
- By management projections, FMC was expected to earn after-tax FCF of $4.75 per share. Pre-tax earnings were expected to exceed annual interest expense by 2 to 1. At a multiple of 10x FCF, the stock could be ~$50 per share.
- FMC stock was trading at $97, meaning a stub stock can be ‘created’ at a price of $17.
- How it played out
- The stub stock hit $40 a year after the recap.
- It touched $60 a few months later just before the October 1987 crash, then fell to $25 during the crash.
LEAPS (Long-Term Equity AnticiPation Securities), Warrants, Options
- Listed options expire the 3rd Friday of each month.
- Price of options include the intrinsic value (amount the option is in-the-money) + imputed interest for the amount that could have been earned on the strike price that the option buyer did not have to put up + value of the insurance of not losing any more money if the stock falls below the strike.
Options vs. Stub Stocks
- Both are levered bets on the future of the company.
- You only lose the amount you invested.
- Options have limited life.
- Stubs have unlimited life.
- LEAPS can emulate a stub stock investment because of its long-term nature (up to 2.5 years).
- 2.5 years is often enough time for the market to recognize the results from a corporate change (spinoff, restructuring), turnaround in fundamentals (earnings gain, resolution of one-time problems), or for plain cheap stocks to be discovered or to regain popularity.
- LEAPS can be traded on hundreds of companies, while stub stocks are limited in number.
- LEAPS can be investigated as a potential investment vehicle while looking into an investment opportunity.
- LEAPS is better than leveraging through borrowed money because with LEAPS, you are essentially borrowing the entire purchase price of the stock, paying only the interest charges at a B or BB investment rating, and you don’t have to pay off the principal of the loan if the investment didn’t work out, plus you can participate dollar for dollar in the upside.
- Warrants are issued by the underlying company,
- Warrants usually have a longer time-to-expiration than typical call options. Newly issued warrants can have expiration dates that are 5, 7, or 10 years away.
Why Options Can Be Mispriced
- Option traders and quants view stock prices as numbers and not as prices of shares in actual businesses.
- The historical price volatility used to calculate option prices do not take into account the impact of extraordinary corporate transactions on companies (e.g. spinoffs, restructuring, merger).
- Buy options that expire weeks or months after an extraordinary corporate transaction is consummated.
- Option holder is entitled to receive whatever a normal shareholder would have received, as if he owned the stock on the date of the extraordinary corporate transaction.
- In spinoffs, the parent company’s stock may make a dramatic move because investors had been holding back on buying the parent’s stock until the divestiture of the unwanted business was completed. The shares of the spinoff can also be a source of surprise.
- In restructuring transactions, the date of a significant distribution of cash or securities, or the target date for the sale of assets, can correspond to significant price move in the underlying stock.
- In mergers, the closing date of the merger can be the catalyst for extraordinary stock price moves. Once a merger is completed, the selling pressure (from risk arbitrageurs) is usually relieved. Shareholders of the acquired company, who had not already sold their shares earlier, tend to sell their shares of the acquirer’s company. After the selling pressure subsides, the acquirer’s stock can sometimes move up dramatically. This is most likely if the new stock issued in the merger is large relative to the pre-deal shares outstanding.
LEAPS Example #1: Wells Fargo
- Dec 1992, Outstanding Investor Digest (OID) carried an interview with Bruce Berkowitz on Wells Fargo.
- Wells Fargo was beaten down because of its large exposure to commercial real estate loans during the real estate recession. It had $249 per share of commercial real estate loans compared to share price of $77.
- Wells Fargo had taken loan loss provision of $27 per share a year earlier and $18 per share for the first 9 months of 1992.
- Excluding the loss provisions, Wells was already earning $36 per share before tax. When the real estate environment returns to normal, loan loss provisions will drop to $6 per share, resulting in pretax earnings of $30 per share, and $18 of after-tax earnings. At 9x or 10x earnings, it can trade at $160 or $180 per share.
- Wells’ accounting was very conservative
- Loans classified “nonperforming” were still performing and giving good interest payments. 50% of these loans were still up-to-date on all payments.
- Reserves for loan losses stood at 5% of the bank’s total loan portfolio, vs. 6% of loans classified as “nonperforming”.
- Despite the large reserves for loan losses, it still had good capital ratios.
- Wells Fargo had no losses over its 140-year history.
- Wells Fargo Jan 1995 calls with strike $80 can be bought at $14. If the stock goes to $160, the profit is $66 on an investment of $14. Risk/reward ratio is 1 down 5 up.
- Risk/reward ratio of the stock is 1 up 1 down.
- How it played out
- Wells Fargo earned ~$15 per share in 1994, over $20 per share in 1995.
- Sep 1994, stock more than doubled to $160 per share.
Options Example #1: Marriott Corporation
- Spinoff was scheduled to take place on 30 Sep 1993.
- Aug 1993, Marriott Corporation stock traded at $27.75. Oct 1993 calls with strike $25 can be bought for $3.125.
- Investors who had been waiting to buy the “good” Marriott can do so in the 1st 2 weeks of Oct.
- For the “bad” Marriott, the difference between a stock price of $3 and $6 is much closer than it appeared because of its huge debt — it corresponds to an increase in total assets of only 10%, rather a seemingly difficult increase of 100%.
- How it played out
- Days before the spinoff date, Marriott stock traded at $28.50, price for October 25 calls (i.e. strike $25) moved to $3.625.
- By Oct 15, “bad” Marriott traded at $6.75, “good” Marriott traded up to $26. Option gave the right to buy one share of each at total cost of $25, so option value shot to $7.75.
- Oct 30 calls could have been bought for $0.25 on 23 Sep, and were worth $2.75 three weeks later.
- Portfolio made up of 5-6 different spinoffs can make sense.
- You can build a respectable portfolio of special-investment situations within a year if you only spot an attractive situation every 2-3 months.
- Over a 2-year period, you will probably make 8-10 different investments.
- If you have some other strategy, you can have special situation investments take up 20-30% of your portfolio.
- Investing more than 10-15% of your portfolio in LEAPS is not advised.
Where to find special investment opportunities
- Wall Street Journal (best)
- New York Times (good)
- Barron’s (good)
- Investor’s Business Daily (good)
- Regional business paper
- Forbes (best)
- Smart Money (best)
- Business Week
- Financial World
- Kiplinger’s Personal Finance
- Individual Investor
- Investment Newsletters
- Outstanding Investor Digest
- The Turnaround Letter
- Dick Davis Digest
- Copying the Masters
- Michael Price (25% undergoing corporate changes)
- Marty Whitman (special situations)
- Richard Pzena (out-of-favor large-cap value stocks)
- You only need one good idea every once in a while.
- It’s better to do a lot of work on one idea than to do some work on a lot of ideas.
Primary sources of investment information
- From 8K: Material event occurs, e.g. acquisition, asset sale, bankruptcy, change in control.
- Form S1, S2, S3, S4: Registration statement for new securities. S4 is filed for securities distributed through a merger, exchange offer, recapitalization, or restructuring.
- Form 10 (or Form 10-12B): Information on a spinoff distribution.
- Form 13D: Owners of 5% or more disclose their holdings and their intentions regarding their stake. If it is for investment, check the reputation of the investor. If it is for control, it is a first sign of corporate change.
- Form 13G: Institutional shareholders file this in lieu of 13D if it is for investment purposes only.
- Schedule 14A: Annual proxy statement containing executive stock ownership, stock options, overall compensation.
- Schedule 14D-1: Tender offer statement filed by an outside party.
- Schedule 13E-3, 13E-4: 13E-3 is filed for a going private transaction. 13E-4 is the tender offer statement for a share buyback.
Secondary sources of investment information
- Value Line Investment Survey
- Individual company reports to get an overview of a firm’s historical operating and investment performance.
- Industry valuation data for valuing spinoff and restructuring candidates.
- Hoover Business Resources
- Dow Jones News / Retrieval – Private Investor Edition, to review past news stories.
Free Cash Flow
- Free Cash Flow = Net Income + Depreciation + Amortization – Capital Expenditures
- In most healthy businesses, amortization is an accounting fiction. It is important to add back the annual amortization charges to get a true picture of a company’s cash-generating ability.
- If a company is growing quickly, a high level of capital spending (with corresponding depressed free cash flow) is not necessarily bad. The high capital spending (relative to depreciation) should be traced to capex for expansion and not for maintenance capex.