Ended: April 16, 2013
When viewing the stock market, Graham said, you should imagine that you are in business with “Mr. Market” and that the price of a stock merely represents the cost of a certain percentage ownership of an entire company. Some days Mr. Market will be inordinately happy and quote you a ridiculously high price for your stock and other days he will be unduly fearful and quote an unreasonably low price. Only at these extremes should you take advantage of Mr. Market and care what he has to say. Otherwise it’s best, according to Graham, to forget about the market and concentrate on a company’s operating and financial fundamentals.
Buffett tries to focus on well-managed companies that have a strong franchise, brand name, or market niche. In addition, his investments are concentrated in businesses that he understands well and that possess attractive underlying economic (that is, they generate lots of cash) and competitive characteristics. In this way, when Buffett buys a business at what appears to be an attractive discount to current value, he also benefits from the future increase in value generated by owning all or part of a business that is well situated. Graham’s statistical bargains generally do not benefit from this added kicker. In fact, according to Buffett, the risk in buying poor businesses is that much of the bargain element of the initial purchase discount may well be dissipated by the time a catalyst comes along to unlock what appeared to be the initial excess value.
Stocks of spinoff companies, and even shares of the parent companies that do the spinning off, significantly and consistently outperform the market averages.
In the Penn State study, the largest stock gains for spinoff companies took place not in the first year after the spinoff but in the second. It may be that it takes a full year for the initial selling pressure to wear off before a spinoff’s stock can perform at its best. More likely, though, it’s not until the year after a spinoff that many of the entrepreneurial changes and initiatives can kick in and begin to be recognized by the marketplace. Whatever the reason for this exceptional second-year performance, the results do seem to indicate that when it comes to spinoffs, there is more than enough time to do research and make profitable investments.
In case you haven’t been paying attention, we’ve just managed to build a very viable investment thesis or rationale for investing in Host Marriott stock. To review, Host could turn out to be a good pick because: Most sane institutional investors were going to sell their Host Marriott stock before looking at it, which would, hopefully, create a bargain price. Key insiders, subject to more research, appeared to have a vested interest in Host’s success, and Tremendous leverage would magnify our returns if Host turned out, for some reason, to be more attractive than its initial appearances indicated.
As a general rule, even if institutional investors are attracted to a parent company because an undesirable business is being spun off, they will wait until after the spinoff is completed before buying stock in the parent. This practice relieves the institution from having to sell the stock of the unwanted spinoff and removes the risk of the spinoff transaction not being completed. Often institutional buying of the parent’s stock immediately after a spinoff has a tendency to drive the price up. That’s why, if the parent company appears to be an attractive investment, it is usually worthwhile to buy stock in the parent before the spinoff takes place. Although it is a little more trouble to “create” the bargain purchase by buying stock in the parent before the spinoff is completed, it is usually worth the extra effort—even if you don’t get a great price when selling the spinoff shares.
Any time you read about a spinoff being accomplished through a rights offering, stop whatever you’re doing and take a look. (Don’t worry, they’re quite rare.) Just looking will already put you in an elite (though strange) group, but—more important—you will be concentrating your efforts in an area even more potentially lucrative than ordinary spinoffs.
Insiders who wish to increase their percentage ownership in a new spinoff at a bargain price can do so by including oversubscription privileges in the rights offering. In certain cases, insiders may be required to disclose their intention to oversubscribe for shares in the new spinoff in the SEC filings. The implications of this type of disclosure are obvious. Keep one more point in mind: When oversubscription privileges are involved, the less publicized the rights offering (and the lower the trading price of the rights), the less likely it is for rights holders to purchase stock in the rights offering, and the better the opportunity for insiders and enterprising investors to pick up spinoff shares at a bargain price. While we could review other ways the rights-offering process can result in big spinoff profits, it is more important to remember one simple concept: no matter how a transaction is structured, if you can figure out what’s in it for the insiders, you will have discovered one of the most important keys to selecting the best spinoff opportunities. In this next example—one of the most complicated and lucrative spinoff transactions of all time—practically the only way to figure out what was going on was to keep a close eye on the insiders.
SPINOFFS: A QUICK SUMMARY Before we leave the spinoff area, let’s take a moment to review some highlights: 1. Spinoffs, in general, beat the market. 2. Picking your spots, within the spinoff universe, can result in even better results than the average spinoff. 3. Certain characteristics point to an exceptional spinoff opportunity: a. Institutions don’t want the spinoff (and not because of the investment merits). b. Insiders want the spinoff. c. A previously hidden investment opportunity is uncovered by the spinoff transaction (e.g., a cheap stock, a great business, a leveraged risk/reward situation). 4. You can locate and analyze new spinoff prospects by reading the business press and following up with SEC filings. 5. Paying attention to “parents” can pay off handsomely. 6. Partial spinoffs and rights offerings create unique investment opportunities. 7. Oh, yes. Keep an eye on the insiders. (Did I already mention that?)
A QUICK SUMMARY 1. Risk arbitrage—NO! 2. Merger securities—YES! 3. The square of the hypotenuse of a right triangle is equal to the sum of the squares of the other two sides. (I threw this one in because the summary was so short.)
Despite this fact, the common stocks of bankrupt companies often trade at very high (and usually unjustified) valuations. This overvaluation may be due to the low dollar price of the shares, ignorance, or unwarranted speculation. The reason for this phenomenon, however, is irrelevant. The important thing to remember is that purchasing the common stock of bankrupt companies is rarely a profitable investment strategy.
Nevertheless, it still stands to reason that the combination of anxious sellers and unpopular businesses should at least lead to some low initial stock prices. In fact, a study completed in 1996 by Edward Altman, Allan Eberhart, and Reena Aggarwal* found that stocks of companies emerging from bankruptcy significantly outperformed the market. For the study period of 1980 to 1993, newly distributed bankruptcy stocks outperformed the relevant market indices by over 20 percent during their first 200 days of trading. But, be careful with these statistics because it doesn’t always work that way—especially in some of the larger bankruptcies. (According to the study, much of the outperformance came from the stocks with the lowest market values. It may, therefore, be difficult for large investors to duplicate these results.)
Well, one way to stay out of trouble is to follow Warren Buffett’s lead and stick to good businesses. This should narrow the field substantially. As mentioned earlier, a good place to start is the category of companies that went bankrupt because they were overleveraged due to a takeover or leveraged buyout. Maybe the operating performance of a good business suffered due to a short-term problem and the company was too leveraged to stay out of bankruptcy. Maybe the earnings of a company involved in a failed leveraged buyout grew, but not as fast as initially hoped, forcing the bankruptcy filing. Sometimes companies that have made large acquisitions end up in bankruptcy simply because they wildly overpaid to acquire a “trophy” property.
When do you sell? The short answer is—I don’t know. I do, however, have a few tips. One tip is that figuring out when to sell a stock that has been involved in some sort of extraordinary transaction is a lot easier than knowing when to sell the average stock. That’s because the buying opportunity has a well-defined time frame. Whether you own a spinoff, a merger security, or a stock fresh out of bankruptcy there was a special event that created the buying opportunity. Hopefully, at some point after the event has transpired, the market will recognize the value that was unmasked by the extraordinary change. Once the market has reacted and/or the attributes that originally attracted you to the situation become well known, your edge may be substantially lessened. This process can take from a few weeks to a few years. The trigger to sell may be a substantial increase in the stock price or a change in the company’s fundamentals (i.e., the company is doing worse than you thought). How long should you wait before selling? There’s no easy answer to that one either. However, here’s a tip that has worked well for me: Trade the bad ones, invest in the good ones. No, this isn’t meant to be as useless as Will Rogers’s well-known advice: “Buy it and when it goes up, sell it. If it doesn’t go up—don’t buy it.” What “trade the bad, invest in the good” means is, when you make a bargain purchase, determine what kind of company you’re buying. If the company is an average company in a difficult industry and you bought it because a special corporate event created a bargain opportunity, be prepared to sell it once the stock’s attributes become more widely known. In Charter Medical’s case, even though the company’s earnings continued strong after I bought it, I still kept in mind the difficulty and uncertainty surrounding its main business. The stock price started to reflect positive reports from Wall Street analysts and the popular press, so I sold it. No science. The stock still looked relatively cheap, but Charter was not in a business I felt comfortable investing in over the long term. The profit on the transaction (though much bigger than usual) was largely due to a bargain purchase resulting from investors’ initial neglect of an orphan equity. On the other hand, a company whose prospects and market niche I viewed more favorably, American Express, turned into a long-term investment. American Express, as you recall, was the parent company of a spinoff. It appeared to me that the unpredictability of the spinoff’s business, Lehman Brothers, masked the attractiveness of the parent company’s two main businesses, charge cards and financial advisory services. Purchasing these businesses at a price of nine times earnings before the spinoff took place, looked like a hidden opportunity to buy a good company at a bargain price. Because American Express owned what appeared to be good businesses, I was much more comfortable holding American Express stock for the longer term.…
There are basically two ways to take advantage of a corporate restructuring. One way is to invest in a situation after a major restructuring has already been announced. There is often ample opportunity to profit after an announcement is made because of the unique nature of the transaction. It may take some time for the marketplace to fully understand the ramifications of such a significant move. Generally, the smaller the market capitalization of a company (and consequently the fewer the analysts and institutions following the situation), the more time and opportunity you may have to take advantage of a restructuring announcement. The other way to profit is from investing in a company that is ripe for restructuring. This is much more difficult to do. I don’t usually seek out these situations, although sometimes an opportunity can just fall in your lap. The important thing is to learn how to recognize a potential restructuring candidate when you see one. If it’s obvious to you, many managements (especially those with large stock positions) are often thinking along the same lines.
Ordinarily, with this type of opportunity, I don’t care what I think. What a great concept! What a fantastic new product! This could be a home run! These are thoughts I have from time to time, but I do my darnedest to ignore them. Whenever you can buy into one of these great new concepts or products through the stock market, there’s usually a price tag that goes along with it. The stock price could be twenty, thirty, or fifty times earnings. In many cases, the price/earnings ratio could be infinite—in other words, the business is so new, there are no earnings; in the case of “concepts,” there may be no sales, either! My negative attitude toward investing in fast-growing (or potentially fast-growing), high-multiple stocks will probably keep me from investing in the next Microsoft or Wal-Mart. But I figure, since I’m no wizard at forecasting the next big retail or technological trend, I’ll probably miss out on a pile of losers, too. For me, this is a fair trade-off because (as I’ve pointed out before) if you don’t lose, most of the other alternatives are good.
1. Bankruptcy—some points to remember a. Bankruptcies can create unique investment opportunities—but be choosy. b. As a general rule, don’t buy the common stock of a bankrupt company. c. The bonds, bank debt, and trade claims of bankrupt companies can make attractive investments—but first—quit your day job. d. Searching among the newly issued stocks of companies emerging from bankruptcy can be worthwhile; just like spinoffs and merger securities, bargains are often created by anxious sellers who never wanted the stuff in the first place. e. Unless the price is irresistible, invest in companies with attractive businesses—or as Damon Runyon put it, “It may be that the race is not always to the swift nor the battle to the strong—but that is the way to bet.” 2. Selling Tips a. Trade the bad ones; invest in the good ones. b. Remember that hypotenuse thing from the last chapter—it won’t tell you when to sell, but at least I’m sure it’s right. 3. Restructuring a. Tremendous values can be uncovered through corporate restructurings. b. Look for situations that have limited downside, an attractive business to restructure around, and a well-incentivized management team. c. In potential restructuring situations, also look for a catalyst to set things in motion. d. Make sure the magnitude of the restructuring is significant relative to the size of the total company. e. Listen to your spouse. (Following this advice won’t guarantee capital gains, but the dividends are a sure thing.)
This is because, in many cases, option traders (including the quants) view stock prices as simply numbers—not as the prices of shares in actual businesses. In general, professionals and academics calculate an option’s “correct” or theoretical price by first measuring the past price volatility of the underlying stock—a measure of how much the price of the stock has fluctuated. This volatility measure is then plugged into a formula that is probably some variant of the Black-Scholes model for valuing a call option. (This is the formula used by most academics and professionals to value options.) The formula takes into account the stock’s price, the exercise price of the option, interest rates, and the time remaining until expiration, as well as the stock’s volatility. The higher a stock’s past volatility, the higher the option price. Often, however, option traders who use these formulas do not take into account extraordinary corporate transactions. The stocks of companies undergoing an imminent spinoff, corporate restructuring, or stock merger may move significantly as a result of these special transactions—not because historically their stocks have fluctuated in a certain way. Therefore, the options of companies undergoing extraordinary change may well be mispriced. It should be no surprise, then, that this is where your opportunity lies.
In merger situations, where a portion of the acquisition price is paid with common stock, it is the closing date of the merger that can be the catalyst for extraordinary stock price moves. Shares of the acquiring company (into which your options on the target company become convertible once the merger is completed) are under all sorts of pressure before and immediately after the merger is finalized. First, in most cases, risk arbitrageurs start buying shares of the target company and simultaneously begin shorting shares of the acquirer almost immediately after a merger is announced. Only once the merger is completed is this source of selling pressure on the acquirer’s stock usually relieved. Also, in the weeks immediately after the closing of a merger, those shareholders who had not already sold their shares when the merger was announced tend to sell the shares they received in the acquirer’s company. This is usually because the original investment in the target company’s shares was made for reasons specific to that company—reasons not applicable to the acquirer’s shares. After this selling pressure subsides, the acquirer’s stock can sometimes move up dramatically. This is most apt to take place when a large amount of new stock is issued in the merger relative to the amount of predeal shares the acquirer had outstanding.
1. Stub Stocks. There is almost no other area of the stock market where research and careful analysis can be rewarded as quickly and as generously. 2. LEAPS. There is almost no other area of the stock market (with the possible exception of stub stocks) where research and careful analysis can be rewarded as quickly and as generously. 3. Warrants and Special Situation Option Investing. There is almost no other area of the stock market (with the possible exception of stub stocks and LEAPS) where research and careful analysis can be rewarded as quickly and as generously.
The prospectuses for the funds in one of the top mutual-fund groups in the United States, the Franklin Mutual Series Funds (phone: 800-448-3863), can be an excellent hunting ground for ideas. About 25 percent of this fund group’s portfolios concentrate on companies undergoing extraordinary corporate changes. Michael Price, who manages the funds, is a well-known (and outstanding) value and special-situation investor. Of course, you’ll still have to look through a rather extensive portfolio to figure out which securities were purchased as a result of a past or pending significant corporate event. Concentrating on those special situations that are still close to Mr. Price’s average cost (disclosed in the prospectus) might be a good place to start. Marty Whitman’s Third Avenue Value Fund (phone: 800-443-1021) provides similar opportunities for investors to pirate good ideas. Mr. V/hitman is a long-time Wall Street pro who specializes in value-oriented investment situations that are unique and off the beaten path. The newest fund on the list, the Pzena Focused Value Fund (phone: 800-385-7003), is run by Richard Pzena, the former director of U.S. equities at S. C. Bernstein & Co. As this fund concentrates mostly on out-of-favor large-capitalization value stocks, it can be an excellent source for good LEAPS ideas. Mr. Pzena’s three or four largest holdings (position size is also disclosed in the prospectus) would probably be a good place to start. (Note: While I do own shares in Mr. Pzena’s firm, since I’m telling you to steal his best ideas, I’m hoping any potential conflicts even out.) The
If you can’t get to a Value Line, you might check out the Hoover Business Resources area on America Online. Here you can find, classified by name or by industry, the financial and background information on thousands of companies. This type of information is available, in one form or another, on all the major on-line services.
Once again, the basic on-line services can do the job, but a more specialized news service, Dow Jones News/Retrieval—Private Investor Edition (phone: 800-522-3567), can come in pretty handy when doing background searches. Don’t worry, you don’t need a service this powerful to find and research one good idea every few months, but if you’re really hooked on these special situations, at $29.95 per month for unlimited evening searches of the Dow Jones newswires, The Wall Street Journal, Barron s, and hundreds of other publications—it’s tough to beat.
In many cases, as long as the earning power of the acquired business doesn’t decrease over time, the amortization charge that is deducted from a company’s earnings is merely an accounting fiction. (That’s why I’m about to add it back to net income.)
One more point. If a company is growing quickly, a high level of capital spending (and therefore a depressed free-cash-flow number) is not necessarily bad news. That portion of capital spending used to maintain already existing facilities is the important issue. Although a few companies disclose the breakdown between maintenance capital spending and capital spending for expansion, usually you must call the company to get this information. In any event, by itself a high capital spending number relative to depreciation is not a cause for concern—if it can be traced purely to the growth of a business that you believe will continue to be successful.
David Dremen, Contrarian Investment Strategies: The Next Generation (New York: Simon & Schuster, 1988). Benjamin Graham, The Intelligent Investor: A Book of Practical Counsel (New York: HarperCollins, 1986). Robert Hagstrom, The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor (New York: Wiley, 1994). Robert Haugen, The New Finance: The Case Against Effective Markets (New York: Prentice Hall, 1995). Seth A. Klarman, Margin of Safety (New York: Harper Business, 1991). Peter Lynch and John Rothchild, One Up on Wall Street (New York: Simon & Schuster, 1993) and Beating the Street (New York: Simon & Schuster, 1994). Andrew Tobias, The Only Investment Guide You 11 Ever Need (revised and updated edition) (New York: Harcourt Brace, 1996). John Train, The Money Masters (New York: HarperCollins, 1994).