Special situations for amateur investors

 

These two words, “special situations”, seemingly imply that only experts can understand these specific concepts & situations of investing and profit from it. Yes, while some extra effort is required to understand “special situations” or travel a path that is different from what everybody else does, the expectation of superior returns is also there. And, why should such investors not expect a little extra percentage points while treading such a path?

But, it’s not rocket science at all for the small, amateur investors who are looking to learn and profit from such instances of investment. Briefly, we can go through what the term “special situations” means and what are the different instances which investors can look at.

As per the investing website, Investopedia.com, a special situation refers to particular circumstances involving a security that would compel investors to buy the security based on the special situation, rather than the underlying fundamentals of the security or some other investment rationale. This type of investment is an attempt to profit from a potential rise in valuation that the special situation presents. There could be a near-term catalyst to quickly gain from the resolution of a special situation, or it could take many months or years.

Let’s look at some of the special events or circumstances which might qualify as special situations where ordinary investors can hope to make some extra buck.

Merger arbitrage

When two listed companies merge, or one acquires another via share swap mechanism or cash payouts, opportunities arise many a time. The market price of the shares of the two companies getting merged will not necessarily be in the same ratio as the swap ratio. There will always be a divergence to account for the risk of failure of the merger since it takes typically up to a year to implement the same due to various regulatory approvals. Essentially, there is an arbitrage present.

The prices of both the companies typically tend to converge to the swap ratio as the finality of the merger nears. This gives us an opportunity to enter into the stock at a discounted price.

Buybacks

Companies routinely announce buybacks of their stock. This is a way of cash rich companies giving back some of the cash back to the shareholders in case they don’t have a better use of cash. Typically the buyback prices are tad above the prevailing market prices and the buyback process is completed within 3 to 6 months’ time.

This is very common nowadays with almost all IT companies announcing huge buybacks.

Large dividend payouts

Companies routinely sell business divisions, assets like real estate or accumulate cash over a period of time. Many a time, there is a huge windfall as well due to various economic reasons in case of commodity/cyclical companies. Sometimes the companies declare a one-time special dividend as well. There is a good opportunity to participate in such events.

Some of the PSU routinely declare large dividend pay-outs. Also, the MNCs operating in India do pay out regular dividends.

Spin-Offs

De-mergers of spin offs are favourites of special situation investors. Classical spin off cases involve separating smaller businesses from the main larger company. Investors, who believe that the smaller company is not valued appropriately within the larger company, can bet on a better valuation on being spun off. They can look at investing in the parent before the spin off happens. Not every spin off situation results in gains for investors, but a proper analysis can easily help identify the profitable situations.

Here are some examples in the recent past. A large retail company spun off its back end retail infra business some years back. A large conglomerate spun off its FMCG business into a separate entity recently. An IT company spun off its products business into a separate entity.

Partly Paid Shares

Yes, we do have partly-paid shares which are listed and traded on the Indian markets via a separate symbol on the exchanges. These shares are periodically called to pay up the remaining capital at a decided price at various points of time. Essentially they are fully paid up in 4-5 tranches.

There will arise opportunities in the market which will give enough arbitrage as compared to the fully paid-up shares at various points of time. They key is to keep a track when the price arbitrage moves in our favour. Eventually, as the share capital is called and it becomes fully paid-up, the prices converges to the main equity listed on the bourses.

Rights issues

Many promoters now go in for rights issues to raise additional funds for the company. This is also one way to increase the shareholding in the company since many retail investors don’t participate in such issues. These issues are generally priced at a significant discount to the market price. In many a case, when the new shares get listed on the market, the adjustment in the share price of the company is not linear to the dilution. In effect, the investors get a fair upside over the rights issue price.In the last two years, a cursory glance at the BSE website shows that approximately 30 companies have raised money via rights issues.

These are some of the common ways of participating in special situations since these are not tracked by all the investors. People fear that it is difficult to understand, and such situations don’t happen often.

Key risk

But, it is not all that rosy while it comes to such type of investment. Obviously, there are risks as well. The key risk in the above situations will be on investment done in the stock before the event takes place. While we wait for the extra delta return to be played out due to the situations at hand, what also needs to be looked at is the value of the stock. It can go down as well during the same course of time.

One way of learning would be to understand the current situations in the markets and how they are working out. Once you feel comfortable, small positions can be taken to gain real time experience and make that extra buck. Then, nothing would stop us from making special situations an inherent part of our portfolios to get that additional kicker in the returns.