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