Special Situations

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Chapter 20 — Special Situations
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Special Situations

 

A special situation is an investment opportunity that comes from something outside the company’s normal business routine. Special situations are considered a one-time event, but they often give you a chance to make a great long-term investment. The most common categories of special situations are bankruptcies and takeovers, mergers and acquisitions, and spinoffs.

 

Special situations must be analyzed through fundamental analysis because they are based on the performance of the business. Most special situations can only be recognized by people who constantly monitor the market, but sometimes they occur with companies that you are already watching, so it is a good idea to be familiar with how they might affect your investment.

 

i. Turnarounds (Bankruptcies and Takeovers)

 

Bankruptcies and takeovers are considered turnaround situations. This means that the company is not performing, and you expect its performance to “turn around.”

 

When a company’s performance is declining, there is a unique set of investors called corporate raiders who “take over” the company’s management. Their goal is to buy a large stake in the company, improve its performance, and then sell their position for a one-time gain.

 

Investing in takeovers is very risky. When you make this type of investment, you have to be sure that the company has a good business, and that the takeover artist understands the company’s business. Some of these managers have a very successful record, but you should still evaluate each situation individually.

If the business is in bankruptcy or near bankruptcy, but there are no takeover investors interested, the same rules apply. You should first figure out if the company will be able to survive at all, and then evaluate whether the changes will make the company’s future better.

ii. Mergers and Acquisitions (M&A)

Mergers and acquisitions are the most common type of special situation.

When a company wants to buy another company, they will make an offer that is much higher than the stock’s current price. To compensate for this new information, the price of the target company shoots up to the target price. There is always some difference between the stock’s price and the offer to allow for the risk that the merger doesn’t go through.

 

There are M&A specialists who bet on the likelihood that a merger will go through, and sometimes bet on the likelihood that a company with no offers will be acquired. As an individual investor, you can’t compete with an M&A specialist. Your time is better used by focusing on the company making the acquisition.

 

The purpose of M&A is to enhance the larger company’s business. Usually, this means buying a company that is in the same industry or a related industry. The goal in these situations is to integrate the operations of both companies to make the combined company more efficient. Your evaluation can focus on how successful you expect the combination to be. An important question for this situation is whether the management has a history of successful acquisitions.

Sometimes mergers happen between companies in unrelated industries. Unless the acquiring company is a conglomerate that focuses on buying high-quality businesses in any industry (such as Warren Buffett’s Berkshire Hathaway), this type of merger is usually a complete disaster. You should be wary of any company that is using its money to buy unrelated businesses. Investing experts call this behavior “diversifying.”

iii. Spinoffs

A spinoff is when a large company decides to sell part of its business. This usually happens because the spinoff operates in an unrelated industry and the parent company believes that the whole business cannot be properly valued unless it is split up into parts. Sometimes a spinoff is part of an antitrust ruling.

 

The motive for creating a spinoff is less important than the results: Spinoffs are probably the most successful type of special situation. At least one study has proven that a spinoff company beats the market by an average of 10% for three years after becoming an independent company, and the parent company outperforms its industry by 6%.

 

When a company is a spinoff from its parent company, the shares are usually distributed to the parent company’s shareholders. This can be a great opportunity because institutional investors have limits on the type and size of company they can own. If the spinoff is too small, then they will be forced to sell even if they know the spinoff company is a great investment. As an individual investor, you won’t have that limitation.

 

The business side of a spinoff is also compelling. The managers of the newly independent company now have more freedom to grow the business and a better incentive. Both companies’ financial reports also become more focused and the businesses become less complex. This all adds up to higher long-term value.

A spinoff is rarely considered a bad business move or a bad investment, but that doesn’t mean that you should ignore the company’s financial statements. Sometimes the purpose of a spinoff is to sell the “crap” part of the company. An evaluation checklist should still be applied.

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