On September 17th, 2015, Seeking Alpha author, Hemlock Partners, released a very convincing buy thesis on Kansas City Life Insurance (OTC:KCLI). The article was titled "Kansas City Life Insurance: Offering a 37% Return". The investment opportunity in KCLI is a very special situation in which only small time investors can really participate in. I have highlighted Hemlock Partner's thesis below.
Source: Hemlock Partner Thesis
When I read the article, I was very surprised on how relatively easy it would be to make a quick 37%. To me, it seemed too good to be true. I am sure any economist would think so as well based on the following famous sayings.
An economist and a normal person are walking down the street together. The normal person says "Hey, look, there's a $20 bill on the sidewalk!" The economist replies by saying "That's impossible- if it were really a $20 bill, it would have been picked up by now.
So this quote pretty much states that the market is efficient. Now I do not believe that the stock market is totally efficient (especially in the nanocap realm), but I do believe it is efficient enough to wipe out this special situation that Hemlock Partners has presented to us on Seeking Alpha. What I am proposing, is that this situation with KCLI may not go through. The premise of this article will take a look at why the deal may not go through (based off of two case scenarios) and what the investor can do to take advantage of the deal falling through (shorting the stock).
A Comparable Example of a Failed Tender Offer
Odd lot tender offers are great ways for the small investor to exploit the inefficiencies of the market. There are usually only a handful of them a year and investors with a small enough portfolio can take advantages of these opportunities. The problem with odd lot tender offers, is if the opportunity gets too much publicity, the offering company may back-off of the deal completely. An example of this (which can be comparable to the KCLI situation) is when The India Fund (IFN), and The Asia Tigers Fund (GRR) announced that they plan on discontinuing their semi-annual repurchase offers.
Note: The deal between IFN and GRR is comparable to KCLI due to the fact that these companies are on the same scale (similarities in terms of market cap). KCLI and IFN also both have very similar balance sheets (a high cash position and little to no debt). They are also both in the same industry (financial).
From what I found, when conducting my investigative journalism on failed odd lot tender offers, is that when the deals are publicly announced, they have a tendency of falling through. From what I can tell, this is exactly what happened to the IFN and GRR deal. On January 29th, 2013, renowned Seeking Alpha author Chris DeMuth Jr. published an article titled; "I Got 99 Problems But A Proration Ain't One, Part II: IFN".
The premise of the article was taking advantage of the odd lot tender offer to make ~20% in the short-run. I have no idea how many views DeMuth's article got, but it did get a decent amount of comments (and even negative publicity on another blog site, talked about later). We cannot be 100% sure if the article was the reason why the deal fell through. If I was to bet though, I would bet high that DeMuth's article was a key reason why the deal fell through (as do other bloggers).
On May 13th, 2013, INF and GRR announced the following.
The India Fund, Inc. (the "Fund") (NYSE: IFN) and The Asia Tigers Fund, Inc. (NYSE: GRR), (collectively the "Funds"), jointly announced today that they will discontinue the practice of accepting all shares tendered by stockholders who own, beneficially or of record, an aggregate of not more than 99 shares before prorating shares tendered by others.
After the tender failed to transpire, the price of INF's stock fell from a $21.96/share on May 12th, to a low of $18.47/share on June 16th, in which it finally fell to another low of $17.41/share on August 25th. Because the deal failed to transpire, there was negative pressure on the company's stock price. I am expecting negative pressure to happen to KCLI, if their tender offer fails to happen. We will revisit this issue later in this article as well.
Xerty, a Seeking Alpha user, and commentator on DeMuth's article, posted a negative statement, which can be seen on DeMuth's article, for interested readers.
Xerty was not the only commenter who blamed DeMuth's article. ElijahPrice, a commentator and blogger on Wallstreetoasis.com also stated a negative comment.
I understand the frustration investors must have felt when their arbitrage deal fell through. I know I would have been upset if I was banking on the deal pulling through. I believe the author has also come to the conclusion that posting actionable ideas that have not been priced in yet, comes with negative consequences, as he has since announced that he's reserving those ideas for his subscription service as stated in his article; "The Future of Seeking Alpha , From One Contributor's Perspective".
The question that remains to be answered; will the KCLI deal fall through now that there is more publicity about the deal? Before we answer that question, let's take a look at how another deal fell through, mainly due to the public announcement of it through a blog.
Another Example of a Failed Special Situation (on a smaller scale)
Note to the Reader: The following example is not the best illustration to use when comparing the KCLI deal. First, the company expounded upon in this example is on a totally different scale (huge divergence in market caps and totally different industries). The KCLI deal is 10x bigger than the example presented here, and KCLI has much more cash than the comparable example. The reason why this example is used though, is to show readers that these deals have a tendency of falling through when they are publicly announced. Without the publicity, this deal may have went through.
On May 9th, 2014, Hancock Fabrics (OTCQB:HKFI) proposed a similar announcement. Thus they decided that the cost of being a public company were not justified by the benefits. Their end goal (as similar to KCLI'S was to deregister the common stock). I have provided the summary of the deal below.
Source: Specialsituationsinvestments
The strategy to profit from this special situation was to buy 999 shares of HKFI and wait patiently for the reverse-split. Thus, the current price at the time was $1.00/share yet the offer price was $1.20/share. This would give odd lot investors a 20% upside. So the deal was there, all you had to do was place your odd lot order, and you could make a decent return. It was like taking candy from a baby.
Note: The final costs HKFI was anticipated to incur was $1,266,000.
On Oldschoolvalue.com, there is an interesting thread/blog in which other investors became aware of this opportunity. Other investors in the comment section of the blog seemed skeptical that the deal would go through. For an example one blogger stated; "Just remember there is more risk to this. Not as close to a done deal as the others. Need to make sure financing and insiders will go through with it".
Soon other commenters started to jump in on the idea. One commenter, "Dan67Bird", had the bright idea of opening multiple brokerage accounts in order to take advantage of this situation even further. Check the oldschoolvalue.com link above to read his comments.
I am 99% sure that this post sparked other enthusiastic bloggers to do the same thing Dan67Bird was going to do (open additional brokerage accounts). HFKI then posted this SEC statement. The statement pretty much said that HFKI is aware that investors are using multiple accounts to take advantage of this special situation. The company plans to treat these multiple accounts as one account, thus reducing the potential return an investor would get if he/she would have only used one account. HFKI also said that they have the power to pull the plug on this deal if the cost to buyout people becomes too high.
On June 10th, HFKI filed a statement saying that the estimated cost is now $1,396,000. This would take them 2.2 years to recover compared to the 2 years initially planned on going private.
On July 8th, HFKI filed a statement saying that the estimated cost is now $1,588,000. This now would take the company 2.5 years to recover.
Then on July 15th, the company yet again stated that if the cost of going private becomes too burdensome (on a monetary basis), they can decided to cancel the deal anytime. The commenters then started to get more skeptical about the deal going through.
On August 4th, 2014, the bad news came. HFKI decided to drop the deal. Commenter dolfdekraai stated it the best, as seen in the oldschoolvalue.com link.
How Does Kansas City Life Insurance Compare to Hancock Fabrics?
Well first, I would like to take time to delve into what dolfdekraai said; "Thanks for sharing this…You killed it for everybody." That is a powerful statement there. The commenter is saying that if it wasn't for oldschoolvalue, this deal may have gone through. The former may be hard, if not impossible to determine, but in reality it does make a lot of sense. Oldschoolvalue brought this idea to everybody's attention thus in turn, destroying the opportunity to make a quick buck.
Note: This is exactly what happened when DeMuth posted his article.
The basis of my argument is that Hemlock Partners, may have destroyed this opportunity for everyone. I am also not alone on this idea. Check out what other Seeking Alpha users stated in Hemlock Partner's thesis.
Hemlock Partners may not have totally killed the investment opportunity, but I have a high conviction that Seeking Alpha did when they put the thesis written by Hemlock partners on the Pro Idea of the Day (right on the homepage). If Seeking Alpha didn't do that, I would have never found out about this opportunity.
KCLI and HKFI both have similar structures as well. They both are tiny companies (HKFI is much smaller though <$10mm market cap), both have high insider ownership, and they both offered similar deals. There is nothing certain in investing, and the deal that KCLI recently announced may bunk out. Investors should realize that this is not a for sure win.
Did I just keep this deal from transpiring?
As I stated before, publicity will hinder the transpiration of a deal . Does this mean that since I wrote about this deal, it has even further potential of not happening (since more people will become aware of it)? This really is a yes and no answer.
In answering the yes, I may have just hindered the deal due to this article. This article will be sent to all of my followers, plus anyone following KCLI (299 individuals). More investors will become aware of the deal, hindering the possibility of the deal going through.
Although, this article may help the deal go through. Investors will be able to see the risks in participating in a deal such as a tender offer from this article. This may influence investors to not participate in the deal. Instead of seeing just the positives of participating in this deal, investors will also get to see the negatives.
We will not know if this article will help or hinder the deal going forward. Uncertainties are a part of life, but uncertainties are what makes life worth living.
The Short-Case
When the IFN deal fell through, the company's stock fell from a $21.96/share on May 12th, to a low of $18.47/share on June 16th, in which it finally fell to another low of $17.41/share on August 25th. After the 25th, the company's stock started to rise again (hitting 52/week highs). What I am saying is that if you believe that the KCLI deal will fall through, shorting the company's common stock may be a good strategy (KCLI may have a potential to fall to the low $40s).
Note: I believe the company's share price will fall back to ~$43-42/share if the tender offer fails to transpire. If you take a look at the price chart below, the recent price spike was due solely to the announcement of the tender offer. What this means is that a ton of arbitrage investors jumped in on this deal solely due to the relatively short-term spread they can capture. If the deal falls through, I am expecting the stock to fall to pre-tender offer announcement ($43-42/share). If an investor shorts the stock at ~$48/share, they are poised to make ~12-13%, in a relatively short-period of time (2-3 months).
With a buyout at $52.50/share and a current price of ~$47.80/share, the potential of losing a substantial amount of money shorting KCLI if the deal goes through really is not that much (around a 9% loss). The market is also telling investors that the deal has a greater potential of falling through than transpiring. Currently the market believes that the deal has a ~35-40% chance of happening. On the flipside, this means there is a ~60-65% chance the deal will not go through. Any informed "betting man" would put his money on the deal falling through.
Note: Usually in a short position, an investor has the potential to lose more than 100% of their investment. In the KCLI case, there is a cap to how much you can lose (~9%). The cap exists because the company has stated that they are going to be offering at tender at $52.50/share. Thus in theory the most one can lose shorting this stock is ~9%. The reward is much higher than the risk. The probability of the deal falling through is also much higher than of it transpiring as well (according to the market).
If you believe the deal will not go through, and you have extensive experience shorting companies, you may want to consider shorting KCLI, due to the price ceiling advantage.
Will the Deal Cost more than the Estimated $10mm?
KCLI estimated originally that they will have to pay for ~0.2mm shares which equates out to ~$10mm in cash. That is also around 800 holders of 249 shares. If you take a look at the recent volume action, this will mostly likely be a lot higher.
The end of July and the beginning of August was the most volume the company has seen all year (due to the announcement of the tender offer deal). What is interesting is that on September 17th, 2015, the bullish article was published on KCLI. If you take a look at the volume traded/day, the day after the article was published, volume traded/day more than doubled. What this means to me is that Hemlock Partner's article, influenced investors/traders.
Note: On the 17th, volume traded was 39,320 (avg. volume in past three months was ~33,000). On the 18th, the volume traded was 82,915. The last time it was close to trading that high, was when the announcement happened (114,248 traded).
Based on the recent quarterly report, the company has ~9.2mm in cash and ~$23mm in short-term investments. This equates out to ~32mm all together. If the company cashes out 800 investors they pay out ~$10mm. If there are 1,600 investors the company will need ~$20mm in cash. Finally, if 2,400 investors jump on this idea, the company may have to pay out ~$30mm in cash (a complete wipeout). The question that remains on the table is; what is the limit of investors the company will cash out? Based on what they have in the bank, 3x the estimated amount will kill this deal.
The Strong Point on Hemlock Partner's Thesis
What makes Hemlock Partner's thesis strong is the fact that KCLI has a very strong balance sheet, huge insider ownership, and a very low float. Since KCLI has a top notch balance sheet ($9.2mm in cash and zero debt), they have much more room to buyout odd lots in case the cost of the deal goes up. Secondly, insiders own >70% of the shares outstanding. This means they will not only be saving the company money by taking it private, but they will also be increasing their own wealth (via rise in the stock price). Finally, the float is a low 459.00K. It may be very hard to get a position in the company at the price you want, and you may have to make multiple buys (which will lower your potential for future capital gains).
These three former reasons make Hemlock Partner's thesis strong. What side of the trade will you be on?
In Conclusion…
History can be a very valuable tool to use as an investor. Without history, we would have never seen how the deal with INF/GRR and HKFI dissipated. These former deals provide a very valuable lesson to investors; not all things are certain in investing, even when they seem 100% sure. The KCLI deal appears to be a 100% sure thing, but looking deeper into these types of situations, we can see that 100% certainty is always not the case (the market believes there is only a ~35-40% chance of the deal going through). Investors should continue to watch the volume traded per day on KCLI in order to see if more investors are realizing the value. If the volume continues to be high, shorting KCLI may be a very wise bet. For me, I will wait on the sidelines patiently awaiting the end results of this special situation.
Happy Investing, and Good Luck!
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
