3 Reasons I Like Special Situation Investing

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Includes: RILY, SPUN
by: Bram de Haas
Summary

Special situation investing encompasses a wide array of investment opportunities.

As a group, they tend to be less correlated to the market.

This is a great point in time to add special situations to a portfolio.

Special situation investing is quite a broad term, and it encompasses a lot of different types of investments. Often the definition includes spin-offs, companies doing share repurchases, companies doing rights offerings, companies engaged in mergers and acquisitions, companies liquidating their operations, chapter 11 cases, companies involved with big lawsuits, going private transactions, and companies under siege by activists. But there are more types of special situations. The focus tends to be more on the corporation transforming its capital structure, organization, or the taking place of an event as opposed to a focus on operations.

Uncorrelated returns

Because the successful outcome of special situation investing is often not dependent on the operating of the business, the results aren't as correlated to market returns.

For example, currently, I own some shares in the investment bank Riley (RILY) which is potentially on the hook for a large break-up fee related to an investment banking transaction. This case is currently in court where it will be decided (or settled) if they really have to cough up the huge fee or not. I think not. But we'll see about that. The payment is so large that it can move the stock either way.

Clearly, the share price moves when/if this is settled. When and what is decided in court has zero correlation with the movements in the stock market. If you can find special situations that offer a decent expected return, they are a terrific addition to a portfolio because they decrease market risk without limiting the returns.

Consistency

I also like special situations because it is (mostly) about hitting singles and doubles. After years of experience writing up investment ideas for subscribers, I figured out it is a much better experience if you offer actionable ideas with a high batting average. There is a lot of value to that. There are so many investable companies and so many people writing about x or y company. It is very hard to gain and keep a conviction in a company that requires years of waiting before the pay-off arrives.

One amazing book on special situations and easily the most readable is by Joel Greenblatt called 'You Can Be A Stock Market Genius'. Don't let the name deceive you because this is a foundational work. Greenblatt describes the type of special situations that helped him compound at a 30%+ rate of return over a decade.

Areas of opportunities identified by him include spin-offs, investing in bankruptcy-related equities (post-reorg and prepackaged ones) and warrants. At the time of writing, he wasn't a fan of merger arbitrage but does call out rights-offerings as interesting and does emphasize to be on the lookout for merger securities.

There is a bit of an ebb-and-flow to where the opportunities are in markets. Currently, I don't think M&A is all that bad, perhaps because so much hedge funds have been going under, while there is a rise in passive investing. Meanwhile, spin-offs may have lost some of their luster (they are probably still really good). I take these sets of situations as a starting point. They are great to look into, and some I like and some I don't. I believe I will do better over time compared to just buying a spin-off ETF like the Guggenheim S&P Spin-Off ETF and the VanEck Vectors Global Spin-Off ET (SPUN).

Less vulnerable to higher interest rates

Finally, we are currently still in a world of historically low interest rates. Unless we never get away from these lows, at some point, they will need to rise. We've seen Yellen embark on that road and Powel take another few steps before having second thoughts. When interest rates go up that is negative for securities that derive a lot of value from cash flows in the far future. This is one of the reasons growth has had a historically strong showing versus value:

Chart Data by YCharts

If interest rates are higher, it becomes more costly to sit and wait for potential future cash flows. That's when near-term cash flows are appreciated more. I'd expect stuff that derives a lot of value from future cash flows to sell off as interest rates rise; long-term government bonds, growth stocks, etc.

Special situations often depend on an event that is between 6 months and several years out. Because that is relatively near term, they are not as vulnerable when we finally get away from these low rates.

Disclosure: I am/we are long RILY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.