Whats So Special About Special Situation Investing?
Special situation investing is something that can excite both investors and traders who want to make a quick buck in the market by incredibly improving the odds. What exactly is this strategy and how does one put it into practice to make handsome profits? Read on as Yogesh Supekar throws some light on this exciting topic
The equity market is full of investors with conflicting views and is made up of investors who adopt unique approaches to create wealth for themselves. On the one hand you will see the disciplined kind who will invest regularly, every month if not every week. On the other hand you will also notice that some investors simply buy and forget – they don’t even think of selling their shares in the markets. Ironically, we will find winners and losers in both these categories! We have value investors who want to buy undervalued stocks and then we have growth investors and momentum investors who don’t mind buying overvalued stocks if there is a promise of high underlying growth.
Such a huge variety of investors participating in the markets on a daily basis is what makes the market one of the most enriching wealth-creating exercises. Indeed, the equity markets are accommodative in nature and provide a level playing field for each one of us to explore opportunities to make money in quick time – quicker than most other asset classes. In this scenario, special situation investing is one strategy that brings to the fore the best of growth investing, value investing, market timing speculating on future prospects – all at once. We say so because the trick is to bet on undervalued stocks that can show rapid growth because some corporate action is likely to trigger market reaction.
As such, the timing of purchase has to be accurate and this calls for trading skills. If you are an investor who can differentiate between an undervalued stock and an overvalued stock while also being able to estimate the growth triggers due to a corporate action while alongside you have some decent trading skills then that makes you a ‘special situation investor’. The best of investment minds the world has seen have used this strategy at least once in their investment careers. Warren Buffet is famous for having adopted special investing strategies on a regular basis during the early part of his career.
Understanding Special Situation Investing Special situation investing is all about investing in a stock when a special corporate action is initiated. It is a once in a while kind of a corporate action, one that an investor cannot expect every year. The biggest corporate action one can expect is an IPO. Other major corporate actions are mergers and acquisitions, spin-offs, buyback of shares, change in capital structure, stake sale, bankruptcy litigation and stock splits. This list of corporate actions is not exhaustive but these are the main corporate actions that actually prompt and excite active investors and often put them into an action mode.
Special situation investing is always about identifying an opportunity owing to any such corporate action and taking a hefty position to bet in the direction of the underlying securities. Interestingly, there are hedge funds that operate with this strategy. One example of special situation investing can be the acquisition of UK-based Corus by Tata Group’s Tata Steel. When it was announced that a struggling and capital-starved Corus had agreed to be taken over by Tata Steel, it immediately created the right environment for a special situation investor who could sense the opportunity to make a quick killing on the back of this news – that of merger and acquisition in this case.
Empirically, the company that takes over the target company will see its share prices drop rapidly as the acquirer is expected to raise money (debt or equity) to fund the acquisition and that may result into the EPS slipping a little bit. There is also a high probability of the acquirer’s stock price slumping, at least in the near term, while the share price of the target company jumps by a good percentage. Any special situation investor will, in such a special situation, go short on Tata Steel and long on Corus, thus making quick returns on invested capital.
Similarly, a fine case of special investing was that of United Spirits in 2011-12 when Vijay Mallya had to sell his company to Diageo. The stock prices jumped manifold, turning out to be a multibagger. A special situation investor will not invest in TCS, Infosys, HDFC Bank, Nestle, Pidilite or any such company which are proven compounders – turning out to be multibaggers over a period of time. Rather, this breed of investor hunts for unique opportunities or corporate actions that trigger positive or negative price impact on the stock prices and then go full throttle with long or short strategy.
Jitendra Upadhyay
SeniorEquity Research Analyst, Bonanza Portfolio Ltd.
Corporate Actions & Stock Reactions
How do stocks normally react to buyback news?
The unexpected nature of buybacks often leads to a company’s stock price reacting sharply to a buyback announcement. When buyback is announced at a good premium to the prevailing price, it can have a positive impact on the stock price. Further, buybacks lead to reduction in number of shares outstanding – which increases the earnings per share (EPS) – this in turn can boost the stock price in the long term if the PE ratio remains unchanged. Reduction of cash balance, alongside reduction in equity base due to buyback also improves return on equity (ROE) and return on assets (RoA) metric, which acts as an additional positive support for the stock price.
Large buybacks at a premium can thus be a useful tool for the management to support a company’s stock price. In most cases, companies choose buyback as a means to distribute cash to shareholders because they are more tax-efficient than dividends. A decision to buy the company’s stock indicates that the management believes that the current stock price levels undervalue the company. The signalling is strongest when the promoters or controlling shareholders do not participate in the buyback offer.
Here is an example: The ex-date of TCS had been announced on November 26, 2020. TCS announced (buyback on October 7, 2020) a Rs 16,000 crore buyback. 5.33 crore shares (1.42 per cent of current total shares outstanding) bought back from shareholders by TCS at a price of Rs 3,000, which was a 20 per cent premium to the price. Currently, TCS’ stock price is trading at Rs 3,285(52-week high at Rs 3,358). As of September 30, 2020, TCS had cash and equivalents of Rs 47,000 crore. So, Rs 16,000 crore amounted to a distribution of a whopping 34 per cent of TCS cash to its shareholders. In addition to the buyback, TCS had also announced a dividend of Rs 4,500 crore. Tata Sons holds 72 per cent in TCS.
How do stocks normally react to stock split?
A stock’s price is also affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding increases. In an example of a two for one split, the share price will be halved. Thus, although the number of outstanding shares and the stock price change, the market capitalisation remains constant. For example, Eicher Motors surged 10 per cent to Rs 2,389 on the BSE after the stock turned ex-date for stock split in the ratio 1:10. The company had fixed August 25, 2020 as record date for the stock split. The company announced this on May 25, 2020. Its stock split plan was to reduce the cost per share with a stock split. Stock split also helps it increase its overall liquidity as new investors and even small investors may get interested in purchasing these shares.
How do stocks normally react to a rights issue?
In a rights issue, when a company offers the rights issue its share price gets diluted and is likely to go down post the issue due to an increase in the number of shares floating in the market. Cash-strapped companies generally turn to a rights issue to raise money. This could either be for debt reduction or to finance the company’s expansion. Do check out the reason for the rights issue before you opt for it. Also, make sure the company has strong earnings’ visibility and credible management. The impact of the rights issue on the stock price is that the share price falls in the same proportion as the rights issue. For example, a 1:5 rights issue implies that you are entitled to buy one additional share for every five shares you hold.
Stock Buyback and Special Situation Investing
For special situation investing sharp decision-making is required and cash needs to be available to make the most of the opportunity as the stock prices move fast. It is important to time the market as accurately as possible or as soon as the corporate action is announced. Most individual investors may find it difficult to identify opportunities in case of mergers and acquisitions or a spin-off, etc. as the deal size and the valuations need to be studied to analyse the impact of the corporate events on the stock prices. It needs a market expert or a professional to do so rapidly. An individual investor can also do so if he or she is tracking some particular companies regularly. Buyback announcements however are easy to understand for individual investors and to act upon such corporate action is not very difficult.
"Bottoms in the investment world don't end with four-year lows; they end with 10- or 15-year lows."
-Jim Rogers
"The most contrarian thing of all is not to oppose the crowd but to think for yourself"
- Peter Thiel
What is a Spin-Off?
A spin-off is an operational corporate strategy wherein the parent company separates a particular division into a new independent publicly traded entity or subsidiary which gets its own unique identity divergent from the parent company. The entity gets its own management, employees, assets, products, technologies and becomes solely responsible for its own profits. Usually the shares of the new entity are distributed to the existing shareholders of the parent company in the form of special dividends. In essence, a spin-off is similar to a de-merger or divestiture. It is better known as a star burst or spin-out.
Why Spin-Offs?
Now that you’ve got a grasp of what spin-offs are, let’s delve deeper to discern the multitude of reasons behind a spin-off.
Value Unlocking - If a particular business division is consistently generating robust profits and faces bright prospects of future growth, making it more valuable on its own. Then the smart move for the parent company would be to opt for a spin-off and achieve lucrative value unlocking.
At Odds With Long Term Vision– It is a common occurrence that companies tend to over diversify into sectors distant from their core operations during an economic up cycle. Years later when complications arise, the management decide to streamline operations by getting rid of all units that are not in accordance with the company’s long term vision. Hence, they frequently opt for a spin-off.
Spin-offs can be used as a strategy to offload debt or hive off underperforming divisions, thereby improving financial standing and profitability of the parent company. Parent companies often undertake spinoffs to avoid capital gains tax on sale of that particular division.
Example of Spin-offs in India : In 2011, Almebic Ltd operated in two business segments, namely – bulk manufacturing of penicillin and branded pharmaceuticals formulations. While the penicillin unit suffered heavy competition from international players making losses, the pharmaceuticals division was making huge profits and faced vigorous growth opportunities in the future. The management of Alembic Ltd resolved to demerge the pharma division and implemented a spin-off into a new entity known as – ‘Alembic Pharmaceuticals Ltd.’ Alembic Pharmaceuticals got re-rated post the demerger and shareholders experienced tremendous value unlocking. Today Alembic Pharmaceuticals and Alembic Ltd stand at a market capitalization of Rs.19,287 crore and Rs.3,723 crore, respectively.
A spin-off is a corporate action which aids a company to stay focused on its long term vision and not get distracted. It furnishes an opportunity for other profitable divisions to step out of the parent company’s shadow, operate on a standalone basis and get recognized by the market and investors in a light of its own. However, investors should conduct thorough research into a spin-off, comprehend the intricacies before taking a call.
Investors can make some market-beating returns in a shorter timeframe once a buyback announcement is made by a listed entity. The positives of a buyback announcement are well-documented. The EPS improves post buyback, it’s sentimentally positive, and mostly it’s a way to reward the shareholders. The stock prices usually shoot up once the buyback announcement is made. Investors can use this opportunity to take a long position on the announcement date and can book profit at an appropriate time. To improve the strike rate in such strategies, one can bank on those shares which have good fundamentals and proven track record. Those companies which regularly make such buyback offers can be relied upon, an example being Infosys.
Conclusion
Special situation investing is a sophisticated investment strategy and may not be a doable strategy for those investors who do not have enough time to research the prospects and understand the risks of such a strategy. That said, special situation investing opportunities have increased manifold in India right now with the new bankruptcy code and NCLT proceedings in full swing. Lots of mergers and takeovers, stake sales and recovery in business operations are expected in the coming months. The ideal targets to book a multibagger opportunity is also to identify a bankrupt company with good assets that can be of value to other business houses. One has to think like an investment banker to spot special situation investing opportunities. Buybacks and spin-offs are two corporate actions that investors can easily understand and work with in the beginning. As one grows rich with experience and capital, other advanced special situation arbitrage strategies can be deployed to capitalise on market-beating returns. As with any strategy, one has to carefully study the pros and cons and only then enter the strategy.