Arbitrage and Special Situations

In the past, these have been the domain of professional investors, who have access to lower brokerage rates.

In the world of arbitrage and special situations, the high retail brokerage rates formed an almost impassable barrier of entry for lay investors.

Simply their brokerage costs often exceeded any potential profit in the trade.

With the advance of the Internet and with the lower rates now available, the world of stock arbitrage and other special situations are opened up to the masses.

Aggressive investors can learn how to identify the bet with the least risk, which can enable the investor to take very large positions and produce results that can be spectacular.

Special Situation is where a Definite Corporate Event creates undervalued security in which profits is expected to be realised.

A particular kind of undervalued security in which the profit is expected to be realized from a definite corporate event, rather than from a mere change in the market's attitude is known as a "special situation."

Such events include

• sale of the business, 
• merger, 
• recapitalization, 
• reorganization, and 
• liquidation.

A great deal of money has been made by shrewd investors in recent years through the purchase of bonds of railroads in bankruptcy - bonds which they knew would be worth much more than their cost when the railroads were finally reorganized.

Similar large profits have been made in the preferred and common stocks of public-utility holding companies which either were being broken up under the so-called death-sentence clause of the 1935 legislation or were subject to recapitalization plans.

The underlying factor here is the tendency of the security markets to undervalue issues which are involved in any sort of complicated legal proceedings.  

An old Wall Street motto has been: "Never buy into a lawsuit."

This may be sound advice to the speculator seeking quick action on his holdings.

But the adoption of this attitude by the general public is bound to create bargain opportunities in the securities affected by it, since the prejudice against them holds their price down to unduly low levels.

"In general, the market undervalues a litigated claim as an asset and overvalues it as a liability.  Hence students of these situations often have an opportunity to buy into them at less than their true value, and to realize attractive profits - on the average - when the litigation is disposed off."

The exploitation of special situations is a technical branch of investment which requires a somewhat unusual mentality and equipment.  Probably only a small percentage of our enterprising investors are likely to engage in it.



Benjamin Graham
The Intelligent Investor

Special Situations: Spin-offs

How to invest in
‘special situations’

• Why I love company spin-offs and you should as well

Have you ever wanted to invest in a merger, acquisition, spin-off, or even a bankruptcy? It’s called special situation investing, and it can be a profitable way to take part in the stock market.

In many cases, special situations end up performing well because the businesses concerned have had a run of poor performance, and this has spurred management into drastic action to resolve the situation.

Spin-offs and other special situations are definitely high on our radar.

Spin-offs, the special situation of choice

I like all special situations, but spin-offs are my favorite. 

In this case I’m talking about corporate spin-offs, where a larger company decides to take a small part of its business, list it separately, and distribute the shares to current shareholders, such as the 1997 British Gas spin-offs, which gave birth to BG Group (LSE: BG), Centrica (LSE: CNA), and what is now National Grid (LSE: NG).

They don’t come along often, but I believe the potential returns make it worth investigating them thoroughly. For example, so far this year, the Bloomberg Spinoff Index is up 30%, and a 2010 report from UBS also showed that the 75 European spin-offs from the past decade outperformed Europe’s top 300 companies.

Why companies pursue spin-offs

There are many reasons a company might pursue a spin-off, instead of keeping a company in-house. One of the more common reasons is that the two businesses aren’t related, and very little is gained by keeping them under one umbrella and having them share capital.

I think the Primark retail group within Associated British Foods (LSE: ABF) is a perfect example of this, though ABF has repeatedly stated it has no plans to spin-off or sell the unit. In other cases, one division is considered a good business by the investment community, while another unit is considered an anchor or dead weight that slows the good business down.

Spinning a business off to shareholders instead of selling it is generally the more shareholder-friendly action. Arguments against a spin-off are because a business is too small to list, or lacks the management talent needed to run a publicly traded company, but in many cases taxes are the ultimate deciding factor. If a business has substantially depreciated assets, the tax hit can make a sale prohibitive for the company and shareholders, while a spin-off can often allow shareholders to realise the value of the business without triggering any tax payments.

Why spin-offs tend to do well

No two spin-offs are alike, and in some cases the larger parent may outperform the business being spun-off. But, in most cases, I find it is the smaller business that tends to outperform, but this can come with some initial volatility because shareholders often must tolerate an initial dip in the share price of the spin-off. Such dips might happen because large, institutional investors or fund managers have invested in the parent to gain exposure to the larger business, and have no interest in the smaller spin-off. In some situations, fund managers simply can’t own the spin-off, because they have limits on the size of companies they can invest in. So, as soon as the shares are received, they are sold off.

I reckon these types of situations only make spin-offs juicier opportunities for astute investors, but there are other signs to look for as well. High up on the list is a management team with incentives for growing the business, earning high returns on capital and, if you can find it, an ownership stake in the business at spin-off. Any time you can find these qualities, it becomes even more likely that management is going to take advantage of its newfound ability to allocate capital and grow the business without having to worry about their former corporate overseers.

Final thoughts

I’ve shared the basic reasons behind why spin-offs tend to outperform. But if you’re hungry for more information on spin-offs and special situations in general, I recommend the excellently written – though horribly titled – You Can Be a Stock Market Genius by Joel Greenblatt. The book provides a thorough look at a few spin-offs from the past and the clues investors were given in the filings that a unique opportunity was about to unfold.

From:  Motley Fool

12th October, 2012

Welcome to the World of Stock Arbitrage and Special Investment Situations

Give a man a fish and you will feed him for a day.  Teach a man to arbitrage and you will feed him forever.
- Warren Buffett

One of the great secrets of Warren Buffett's investment success has been his arbitrage and special situations investment.

With the advance of the Internet, brokerages started offering online trading at deep discounts from their full-service retail rates.  With the lower rates the world of stock arbitrage and other special situations are opened up to the masses.  Sitting alone with a computer and an online brokerage account with deeply discounted trading rates, an individual investor could compete in the field of arbitrage with even the most powerful of Wall Street firms.

Warren Buffett is probably the greatest player in the arbitrage and special situations game today.  Not because he takes the biggest risks.  Just the opposite - because he learned how to identify the bet with the least risk, which has enabled him to take very large positions, and produce results that can only be described as spectacular.

It was Warren's arbitrage investments that took a great investor and turned him into a worldwide phenomenon.  Professors Gerald Martin and John Puthenpurackal's study of Berkshire Hathaway's stock portfolio's performance from 1980 to 2003, they discovered that the portfolio's 261 investments had an average annualized rate of return of 39.3%.  Even more amazing was that out of those 261 investments, 59 of them (22.7%) were identified as arbitrage deals.  And those 59 arbitrage deals produced an average annualised rate of return of 81.28%.

In 1987, Forbes magazine noted that Warren's arbitrage activities earned an amazing 90% that year, while the S&P 500 delivered a miserable 5%.  Arbitrage is Warren's secret for producing great results when the rest of the stock market is having a down year.

With Warren's incredible arbitrage performance in mind, and the knowledge that the average investor now has access to institutional brokerage rates, it was high time that you took a serious look at the arbitrage and special situation investment strategies and techniques that produce Warren's mind-numbing results.

You must explore how he find the deals, evaluates them, and makes sure that they are winners. You will dwell into the mathematical equations and intellectual formulas that he uses to determine the probability of the deal being a success.   In Warren's world, certainty of the deal being completed is everything.  It is how the high probability of the event happening that creates the rare situation in which Warren is willing to use leverage to help boost his performance in these investments to unheard-of-numbers.