In keeping with the recent tradition of accepting guest posts to the Shares and Stock Markets blog today’s post comes from Theodor Tonca, co-founder of Graham Theodor & Co Ltd, a privately held investment holding company.
Theodor’s investment philosophy is strictly grounded upon the sound, fundamental investing principles established by Benjamin Graham and others which have subsequently contributed his business minded approach to investing.
By Theodor Tonca
“I’ve always liked special situations – they remind me of a special investigator and how he makes money somewhere where no one else is looking” – Michael Price
Just what is meant by “special situation”? Long ago, Benjamin Graham defined it rather well in a broad sense:
A situation in which a particular development is counted upon to yield a satisfactory profit in a given security, even though the general market does not advance.
But as he often did, Mr.Graham expounded well beyond allegorical quotations. He literally summarized the meaning and intricate components of such operations and that is what this text will concern itself with.
As should always be the case when it comes to matters concerning the allocation of capital, one should look well beyond the yield book. First, to the expected loss in the event of failure, then to the margin of safety between the currently prevailing price, and in the case of special situations or “workouts” the expected gain in the event of success.
Graham captured these points perfectly in a general formula which was first described in an article for the New York Society of Security Analysts Journal published in the fourth quarter of 1946:
GC-L (100% – C) / YP = Indicated Annual Return
- G is the expected gain in points in the event of success
- L the expected loss in points in the event of failure
- C the expected chance of success, expressed as a percentage
- Y the expected holding time
- P the current price of the security
To use an illustrative current example, take the case of Cooper Tire & Rubber Co. common shares quoted at $32.50 per share as of the time of this writing (late August 2013).
The company is the subject of a traditional merger plan with Apollo Tires Ltd on terms expected to yield approximately 7.7% or $35 per share.
Now that we know the expected gain to shareholders should the deal be completed, lets assume the following for our purposes: expected loss in the event of failure of 20%, given Cooper’s large operations and modest profitability as a standalone, going concern, chance of success eight out of ten or 80%, and our holding period as four months given the indicated closing date of December 31, 2013.
By applying Graham’s formula our numerations would look as follows:
2.44 x 80 = 195.2 – 6.50 x 20 = 130 / 32.50 = 2% annualised Return
Thus the attractiveness of any such special situation investment can be summarized as the indicated annual return in percentage terms, with adequate allowance for the risk factor.
Surely there must be more to intelligent speculation under this category than relatively simple quantitative considerations one is want to ask? Rest assured there is.
What follows is a list of five criteria that have assisted your author in allocating capital into close to two dozen such situations over the past half decade or so, yielding a total risk-adjusted return of over 60% during this time frame with relatively few permanent impairments.
#1 Timing Is Everything
Generally speaking, this should not exceed one full calendar year for all intents and purposes, except in very exceptional circumstances. Any longer and the variables which inevitably come into play rise exponentially; from a company’s own financial position, to that of their primary or secondary financier’s to the larger micro economics underlying the business’s sector and industry as a whole.
Of course, we are starting out with the presumption that regardless the class of special situation, the development or plan has already been submitted and publicly announced as anything short of this does not constitute a special situation in its true form. Only general or unintelligent speculation regarding future developments which may or may not transpire.
Confining one’s activity in this space strictly to opportunities falling within a tight 6 – 9 month time frame would not be a bad principle to institute.
#2 The Smaller The Safer
What is meant by this is total overall deal size.
While “the bigger the better” may be the prevailing axiom on Wall Street, “the smaller the safer” rings true more often than not in such “special” predicaments.
The reasons for this are multiple; from larger deals (say $5 billion plus in total size) facing greater regulatory hurdles – which may not always be overcome, to the financing (leverage) often needed for such mega deals being altogether prohibitively large and thus in turn correlated to the financial standing of the banks and institutions offering such funds, which themselves are often subject to the vicissitudes of the domestic and international economies at large.
Additionally, there lies another important factor which investors in smaller (by this meaning $100 million and under) transactions benefit from. That is the effect of operating in a very specialised area in which the great bulk of market participants either simply have no interest in or cannot take part in due to institutional mandates and covenants.
Suffice to say, most of the great investment records (with some exceptions) have been achieved by those working in oft overlooked corners and crevices where competition was light.
#3 Cash Is King
As in other facets of business, cash or more precisely “all cash” deals can be one’s best friend. This works to negate some of the stumbling blocks mentioned above regarding financed transactions.
All stock or majority stock mergers or acquisitions can also be the cause of unnecessary consternation due to open market revaluations of one or both participants in the interim period before the deal can be formally consummated. There is also the onerous reality of additional costs to contend with in such situations.
From purchasing into the arbitrage in the first instance to receiving stock of one of the parties involved and then having to divest this grant onto the open market sooner or later (most likely the former rather than the latter) acts to lower one’s absolute return in a not inconsiderable way. This to say nothing of the capital gains taxes incurred in any instance.
#4 Think Like An Owner
This entails having the disposition to, as a disinterested third party (before one makes the leap of becoming interested) logically assess the situation at hand and if it is fair and in the long term interests of all constituents involved. This includes the owners (shareholders) of the business (both large and small alike), management, employees and other parties as well.
The reasoning for this being that if just one of these parties feels bulldozed in negotiations by others and rightly concludes that their inherent interests are being completely cast aside, it can spell doom for any deal taking place at all and if one does eventually take shape the time to completion can be significantly protracted while the parties at odds air their grievances out.
A further fallout which can occur when all involved are not in unison on a transaction taking place, is dreaded litigation which can bring matters to a grinding halt if the above mentioned does not do it first.
A good rule of thumb is as follows: if the management and shareholders of the acquiree business aren’t for a deal taking place, you shouldn’t be either.
#5 Margin Of Safety
“The most important concept of investing”, as aptly titled by Ben Graham applies just as much to the field of special situations as it does to more traditional investments in businesses.
Whereas this is measured as the difference between the intrinsic and current value of a specific business most often, in such “special” cases one’s margin of safety lies predominantly in the yield being offered in contrast to the likelihood of eventual success of the operation as a whole.
Of course, one’s estimation in this respect will naturally be approximate rather than precise.
But this will undoubtedly always be the case if one is truly honest with oneself. To this end, the quantitative calculation mentioned above and other qualitative considerations factored in will help.
For special situations whose time line extends beyond six months, a minimum yield of 4 – 6% plus, with a corresponding chance of success averaging at least two-thirds or better may be appropriate. This will have the effect of offering one at a least a 10% annualised return or thereabouts, while appropriately accounting for the inherent risk factor involved.
The typical “special situation” has grown out of the increasing number of acquisitions of smaller firms by larger ones, as the gospel of diversification of products has been adopted by more and more managements – pg 174, The Intelligent Investor
Now, of course one shouldn’t take the above as a foolproof guide or anything closely resembling it.
Broad experience in this subject is doubtless a contributing factor to success, as sound and specialised judgement is elsewhere in business and finance. Each individual situation must always be subjected to a careful analysis in its own right, much as any other prospective investment should be.
In conclusion, while this piece has offered what I would deem to be some helpful suggestions in regards to what is the broadest sub-section of the special situation universe – mergers and acquisitions arbitrage.
There exists a whole multitude of classes of such situations, ranging from the aforementioned mergers to plans of reorganisation, recapitalisations, and spin-offs to the much smaller field of voluntary liquidations to which some of the content in this article will inevitably be applicable, though far from all, but which nonetheless offer the enterprising investor bountiful opportunities uncorrelated to the market at large.
Starting his first business at the age of 15, Theodor began managing his own private clients’ (partners) money at the age of 18 which grew into an investment partnership and holding company after the purchase of it’s first wholly-owned operating subsidiary in early 2013.