Special Situations

**teenvestor2** Fri Jan 27, 2006 3:15 pm

Special Situations
Special Situations Part 1

Arbitrage is totally risk-free. An example of arbitrage could be buying shares of a company on the NYSE, then selling them immediately on another exchange -- like a foreign one -- for more money. There is no risk in this -- unless your phone breaks and you can't call your broker -- there also so isn't much reward, because of this I'll be writing about a different kind of arbitrage, with more potential returns.

Risk arbitrage, is arbitrage, with the risk of losing money attached. Joel Greenblatt wrote the primer on risk arbitrage, he is also the creator of The Value Investor Club Website. I recommend his book for a further look at Risk Arbitrage, or as it is more commonly know Special Situation investing.

There are a number of ways to invest in special situations:

-Spin-offs
-Bankruptcies
-Restructurings
-Rights Offerings
-Re-Caps
-Merger Securities
-Companies Going Private

I'll write about four of those now, and finish in part two

Spin-offs

Spin-offs are my favorite types of investing in special situations. Sometimes a company will decide it will do better, or a section will do better, if part of it is spun-off. Basically a division is separated from the parent company.

A study conducted by Penn St. -- for twenty-five years ending in 1988, seeYou Can Be a Stock Market Genius for details -- found spin-offs out-perform the S&P by 10% per year, during the first three years of independence.

Peter Lynch talked about spin-offs in his first book.

Institutions have a lot of limitations, detailing the amount of companies they can own, the sizes of companies they can own, the percent of a company they can own, etc. Usually when a division is spun-off the institutions have to sell their shares immediately, resulting in the spin-off being undervalued, if you can understand the new company and find a spin-off undervalued you will likely beat the market over time.

Follow this page to find up-coming spin-offs, if you don't find it here simply reading The Wall St. Journal will point you towards spin-offs.

Merger Securities

By looking at the above mentioned website -- Investhelp -- you may have found a few companies that are trading below what they will be acquired for. I would strongly advise against investing in any mergers, the risk is to great to make up for small potential returns. If you need to invest in a merger to get your adrenaline pumping before working-out I would say only invest when both companies are 80% owned by insiders who are dead set on the merger going through.

Merger Securities on the other hand are different. Usually companies pay the shareholders of the company being acquired with cash, sometimes shares, when they pay with bonds, preferred stock, warrants, or rights, etc. Companies usually only use merger securities to pay for a portion of the payment - they use them because they probably exhausted their ability to raise cash.

Like spin-offs - and Rodney Dangerfield - merger securities don't get any respect, institutions sell them almost immediately, producing a great buying opportunity.

This means, don't try to invest in pending mergers because they're too risky, but follow the merger and if any merger securities are being used to pay for the company wait a while after the deal goes through - if it goes through - and try to put a value on the securities, they're probably undervalued.

Bankruptcies

Just reading that makes you think about Airplane companies, doesn't it? You'd think that investing in bankrupt companies would be a way to become one of them, but it turns out it could make you rich, if you do it at the right time...

Don't buy shares of a company that is currently going through chapter 11, that won't be profitable until a cow jumps over the moon, and if you have that money to burn you can just subscribe to an expensive newsletter and you won't need to invest for yourself.

You could buy bonds, bank debt or trade claims from bankrupt companies, but that wouldn't be smart unless you specialized in bankrupt companies.

There is a profitable way to invest in a company that went bankrupt... After the company comes out of bankruptcy it has to pay off it creditors, usually doesn't pay them with cash, it pays them with its brand new common stock, and of course do the creditors want this common stock? NO!! Seems like this is happening a lot, institutions own a company and it spin-offs shares or pays them with merger securities and it sells the shares almost immediately, creditors are paid with common stock from a company that went bankrupt and they sell the shares, because they don't have any reason to hold them.

Investigating this is pretty easy, go to the SEC website, www.sec.gov, and you'll find a filing for bankrupt companies that tells you when the bankruptcy issues will probably be resolved, read this and pick your spots only invest in these companies when you are totally sure of the outcome, and have learned more than what you've read here.

Going Private Transactions

Cheap Stocks provides a good tutorial here. And Old Niu here The SEC here.

Bascially micro-cap companies usually have very small revenues, sometimes under $1,000,000, the ~$100,000 they have to pay to the SEC could be 20% of their potential profit, the company will probably want to get rid of these fees.

This is where we come in, if the company can reduce the number of shareholders it has to under 300 it can file at will, and is no longer required to do so quarterly. To do this they have a reverse split, ex. 1-100 for every 100 shares you have they give you one.

If you have less than 100 shares, then the company pays you for the remaining fractional shares. In their SC 13E3 (usually announces the intention to go private, kind of like a proxy statement) they will declare a tender price, which is the price they'll pay for fractional shares.

When you find a company that is trading well below the tender share price, then, after investigating risk, you would usually buy one less than the split amount to make all your shares fractional. The bad part is: usually these company'

Micro caps' share prices are so low $100-$1000 is the most you'd be able to invest to make a good profit, sometimes companies will want to go private for reasons other than not wanting to file, they may be big enough that more money could be invested in the situation.

Finding these situations is extremely easy, check this page on the SEC website to find companies that filed the SC 13E3 filing. The Cigar Butt Hunters Group on Yahoo! follows these situations intently. George on Fat Pitch Financials follows all of these transactions, and for $5 a month or $50 a year he tracks the difference between tender and current prices for most arbitrage situations.

Investing here does not go without risk, read this post on TMF. There is also the problem with the amount of time it takes for the cash to appear in you account.

Restructurings

Corporate Restructurings are similar to spin-offs; in restructurings a business sells a badly performing division of the company -- a really big division. Except in restructurings we're looking to buy the company after the restructuring...

The reason to buy restructurings is hidden value may be obtained from the selling of the bad division, and the company being more profitable. Say a company is trading for $20 per share and it's earnings $1 per share, it has a P/E of 20x and a 5% earnings yield, but one really bad division is losing $1 per share. Joel Greenblatt looks for companies that restructure and sell the bad division, which was depressing earnings. After selling the division the company is making $2 per share, and has a 10% earnings yield (probably above bond yields) the company is now relatively undervalued.

Look for situations that are well managed, have a great business to be restructured around and limited downside. Lastly, make sure the restructuring is significant in comparison to the total value of the company.

Recaps & Stub Stocks

In a Recapitalization a company usually buys a large portion of shares back from shareholders.

An example of this is a company trading at $18 that decides to distribute $15 dollars of bonds to investors, at $18 per share we’ll assume it earns $1.50 per shares, or a P/E of 12x, taking out the 40% tax rate it is making $2.50. After the recap it should be trading at $3 per share ($18 minus the $15 in bonds), it still earns $2.50 per share, assuming the bonds paid ten percent we first subtract $1.50 from earnings for interest expense, which is tax deductible, to get $1 per share, then multiply it by the 40% tax rate to get $.60 EPS.

If the company is trading ay $3 this is a P/E of 5, probably too low. Of course the highly leveraged stub stock (stock after recap) probably doesn’t deserve the same P/E as it did before, but if we assume an 8.33 P/E is justifiable – it’s has the same business model, the only thing that has changed is the amount of debt - it should trade at $5, giving us a recap package of $20 ($5 stock, plus $15 bonds), this is a gain of 11% from the original $18.

Recaps aren’t as popular as they were in the mid ‘80’s, but when you find one Joel Greenblatt says, “There is almost no other area of the stock market where research and careful analysis can be rewarded as quickly and generously.”

Rights Offerings

Profiting from rights offerings is a little bit more complicated then the other situations described here, so I encourage you to buy You Can Be a Stock Market Genius : Uncover the Secret Hiding Places of Stock Market Profits and explore it, to find how to profit from this and other special situations.

Opportunities

So far I’ve only found opportunities in spin-offs and going private transactions, the going private transaction have been completed, but the spin-offs are listed below:

DISCA
FNT
CBS

Mike Price

The author owns share of DISCA, but no other companies mentioned in this article. Do your own DD before making any decisions.

right Price investing

**blast_investor** Fri Jan 27, 2006 5:17 pm

Hi Mike,

Great summary for special situations.

Just a note, the URL link is off for this article. I modified one link
for spin-off paragraph, you can follow that to make link working.
You can highlight text for link and then click "URL" button.

By the way investhelp web site does not provide spin-off information, I only see the merger information there.

**blast_investor** Fri Jan 27, 2006 5:27 pm

Merger arbitration is no longer that attractive.

I myself have studied quite many merger deals before and found the potential return is too low for an arbitrage. The profit potential right now usually is at 10% annualized range, too low in my opinion.

Going private is probably only good for small pocket money, may not be worth the effort for serious investors in this forum.

The best bet is in spin-off, bankruptcy, and restructuring plays.

**teenvestor2** Fri Jan 27, 2006 5:28 pm

I agree.

I would discourage mergar/risk arbitrage because of the risk. Merger securities, on the other hand, can provide good investing oppurtunities.

-Mike

**teenvestor2** Fri Jan 27, 2006 5:30 pm

Thanks

Fixed the links, wasn't sure how to do it on these boards...

-Mike

**Value-Investing-Forum** Sun Feb 05, 2006 8:20 pm

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**grapes** Wed Feb 08, 2006 8:41 pm

This is indeed an excellent article. Good work Mike.

There are one thing I don't quite understand yet. Can you illustrate a little bit more about difference of merger and merger security? Or is it in Joel's book "You can be a stock market genius?"
Also, can you list other reference about this topic?

teenvestor wrote: I agree.

I would discourage mergar/risk arbitrage because of the risk. Merger securities, on the other hand, can provide good investing oppurtunities.

-Mike

**teenvestor2** Wed Feb 08, 2006 11:06 pm

Merger arbitrage is just buying the about to be acquired company and hedging yourself by shorting the acquirer.

Some companies pay with merger securites, like bonds, convertibles, etc. usually mutual funds can't hold these so they sell immediately, this depresses the price of the bond, or whatever, allowing you to buy it at less than fair value.

-Mike

**grapes** Thu Feb 09, 2006 6:54 pm

I can see that the first three strategies are all about buying the security that institution investors, mutual funds or banks does not want and prohibited from owning when a value oppurtunity emerges.

Can you give out some places or reference about more in this topic. I think they are pretty interesting.

teenvestor wrote: Merger arbitrage is just buying the about to be acquired company and hedging yourself by shorting the acquirer.

Some companies pay with merger securites, like bonds, convertibles, etc. usually mutual funds can't hold these so they sell immediately, this depresses the price of the bond, or whatever, allowing you to buy it at less than fair value.

-Mike

**teenvestor2** Thu Feb 09, 2006 7:31 pm

I don't really know about any references other than Joel greenblatt's book, but if you think about it it makes sense.

Most mutual funds can only own ten percent of a company - for risk reasons - so depending on thier size sometimes they can't buy anything less than 500 million or even 1 billion in market cap.

Also some funds can only buy stocks, as is stated in thier prospectus, so they have to sell bonds or other things immediately.

Uno mas cosa, a lot of times when a copany announces it's going to be bought out a lot of shares are bought by ppl who just want the arb spread, they prob don't care about owning any of the company after they're paid...

-Mike

e-mail me at teenvestor@gmail.com,...

**blast_investor** Thu Feb 09, 2006 7:35 pm

Mutual funds have tons of restriction. Mid-cap funds can only buy mid cap. If the merger security is spin-off of small cap, they will sell.

S&P500 fund can only buy S&P stocks. If a spin-off is from S&P500 stock, you can guess the selling pressure.

Joel greenblatt's book covers a lot of special situations in detail. A very nice read.

teenvestor wrote: I don't really know about any references other than Joel greenblatt's book, but if you think about it it makes sense.
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**grapes** Fri Feb 10, 2006 4:53 am

I can see you also used similar technique in you lastest pick :)

blast_investor wrote: Mutual funds have tons of restriction. Mid-cap funds can only buy mid cap. If the merger security is spin-off of small cap, they will sell.

S&P500 fund can only buy S&P stocks. If a spin-off is from S&P500 stock, you can guess the selling pressure.

Joel greenblatt's book covers a lot of special situations in detail. A very nice read.

teenvestor wrote: I don't really know about any references other than Joel greenblatt's book, but if you think about it it makes sense.
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