After years of gobbling up any special situations investment research I could get my hands on, I decided to try my hand at writing a short eBook about them in 2014.
Special situations, in my definition, are any type of unorthodox investment or speculation where there is either an inherent catalyst (like in merger arbitrage) or some sort of market mechanism that unfairly undervalues a company (like in spinoffs).
As a high schooler, I dreamed about days when I would spend all day in an office at a hedge fund reading bankruptcy filings and modeling recapitalizations to try to eke out some value where no one else cared to look.
While I’m sure some poor soul is doing just that 80 hours a week right now at Baupost, my own special situations strategy has evolved to one that targets more simple situations and spends as much time figuring out how and when to invest as why to invest.
The intention of this eBook was to explain the strategies I have used the most with case studies and develop a model portfolio. The book is in no way a textbook and at times may be lacking in financial jargon or space-wasting explanations. However, I firmly believe that for $2.99 it is one of the best ways to get an introduction to Special Situations and start to learn how to think about investing unconventionally.
The situations I wrote about included:
- A unique corporate event where-in a subsidiary of a bigger corporation is “spun-out” to shareholders for free. Typically, this event follows mass selling by large institutions who do not want to or cannot take the time to learn about the new subsidiary – this selling drives the price down, likely well below a true intrinsic value of the company.
- An arbitrage in the shares of a thinly traded subset of popular exchange traded funds.
- Piggy backing on the actions of hedge fund billionaires and benefiting when they find an undervalued company and shake it up to release value.
- The kind of deep value that you would not want your mother to know about.
- Utilizing long-term derivatives to juice the returns of an investment in an otherwise boring blue-chip stock.
- How to literally strike gold with ultra-small cap gold mining “juniors.”
About that Model Portfolio
As I write this in July 2016 the model portfolio has just outperformed the S&P over the twenty or so months since its origination: 7.8% to 6.4%. Though the total return is not very exciting the individual position performances are with six of the nine positions moving at least 30%.
The Sold Positions
- The Apple LEAPS were the first position to sell and they performed wonderfully as Apple reverted to a better valuation (it has since retreated back to being mildly undervalued). The LEAPS were purchased for $11.26 per contract and sold for $23.60 per contract turning the $1,126 minimum investment into $2,360. Nice.
- Starz was touted as a John Malone vehicle that would likely sell in the open market for much more than its current price. We paid $31/share and it jumped up to $46 over the next six months – close to a 50% return. It is very possible that in a more actively managed portfolio I would’ve sold the stock then. Unfortunately, we sat on the position and the price collapsed to $21/share before, you guessed it, someone offered to buy the company for much more than the market price: $32/share in July 2016.
- Gazprom and Richardson Electronics were the two deep value picks – both traded for extraordinarily low valuations. Gazprom (Russian oil giant) was massacred by the drop in oil prices and we stopped out of the position with a 37% loss – about $740 in the $100k portfolio. Richardson Electronics drifted down to $7/share from $9.93/share where it was purchased to stop out at a 30% loss. For what it’s worth, Richardson now trades for about two-thirds of its net asset value – sometimes stocks that look like values are just value traps that won’t ever rise out of the hole. In the future I will look to pair momentum and trend following with the deep value picks to better avoid the value traps. All in all, our strategies of using small position sizes and stop losses protected the portfolio when both of these stocks dropped 30% or more; the total impact to the portfolio was a drop of just 1.4%.
- FTD Companies, Inc. was another big loser who joined the 30% loss club. Following an acquisition, the company lost $80mm in 2015 and now trades for 50x TTM EBITDA. It’s possible there is still a case to be made that the company will get its cash flow margins back to pre-merger level, however in this portfolio we are looking for easy, catalyst-based, decisions and right now FTD falls into the too hard pile.
Current Positions as of July 2016
- Biglari Holdings and Third Point Re are the two activists. Biglari is up 16% and Third Point is down 16%. Biglari’s back of the envelope valuation still looks low: $350mm of cash and investments net of debt make up just over a third of the $870 market cap – when you back them out the company trades for just 8.7x FCF. Third Point’s Dan Loeb recently called the first quarter of 2016 one of the most catastrophic quarters in hedge fund history. Meanwhile his fund lost 2.3% in the quarter and 1.4% in 2015 – not huge losses but when a company trades based on the performance of the portfolio these losses will kill it in the short term.
- Silver Wheaton and Sprott Gold Miners ETF were up 55% and 73% respectively. We have entered into a potentially long-term gold and silver up trend and these two positions should power the portfolios performance going forward.
For more on the current structure of the portfolio please visit the portfolio page and for more details on the current position, subscribe to my newsletter where I update the portfolio once monthly.
If you click on these links to buy the books I recommended I get paid a commission and you’ll learn a lot and become rich in the long-term. So best of both worlds.
You Can be a Stock Market Genius is definitely the investing book I have read the most times. Though, strangely, I have still read it probably only a fraction of the times I have read several different fantasy novels. This likely spells disaster for my future investment returns. Anyway, Greenblatt goes over a bunch of strategies he used in the 80’s and 90’s to take the market out behind a dumpster a shoot it.
The best part isn’t learning the strategies and then picturing yourself diving into the pool of gold coins you will soon be able to accumulate after reading the book it is the way Greenblatt recounts the events surrounding his best investments using the strategies. It’s still one of a very few investment books that became a page turner for me.
Peter Lynch books are not typically included in lists of special situations books because he is mostly a story stock investor – finding where consumer demand is strongest and finding a way to profit off those names. I do, however, really like the way Lynch divides up investment opportunities, talking about spin-offs, turnarounds and all his different categories. He’s also pretty good at telling stories, like Greenblatt, this falls into the page turner list. When I was 13 I got through a nine hour bus ride in Wales or England or something (didn’t know it would take nine hours to go through the entire country) solely by reading this book. So that’s somethin’.
James Altucher has successfully transitioned into a self-help guru since these books came out. I think he’s a millionaire now, thought I’m not entirely sure he has actually come out and talked about his net worth anytime lately – he prefers to talk about the millions he has lost in the past – and that’s what we’re going for on this site. For whatever reason he dislikes these books now and has talked about just throwing away all his copies. This is not a great argument for you to buy the book I know (though you should buy it I’ll get like $4ish if you do), but I do still like the books.
How to Trade Like Warren Buffett goes through several special situation strategies Buffett has used in the past to make money when the stock market isn’t lending itself to traditional value investing and then Altucher interviews Zeke Ashton and Mohnish Pabrai both of whom I have a lot of respect for. Supercash is similar but for hedge funds. Both books are more a collection of 10-20 page articles than a coherent book, but I like them more that way and have read each chapter probably 7x but never either of the whole books in a row.
John Mihaljevic is ultra smart and puts more work into his monthly newsletter than I do annually, probably. I mean, seriously, they’re all like 100 pages. Mihaljevic does a great job taking complicated investing strategies and explaining how they work in an easy to understand matter, which is perfect for most people, including me. This book goes over the traditional value investing in quality companies and cigar butts angles and then talks about special situations, investing in equity stubs, international stocks, small caps, etc.