- Apart from finding bargain investments, understanding the catalysts that will unlock value is even more important.
- Complex securities, risk arbitrage, liquidations, and spinoffs are bargain hunting territory for the value investor.
Today, we’ll look at Chapter 10 of Seth Klarman’s seminal work on value investing, Margin of Safety. Chapter 10 digs deeper into value investing and discusses complex situations.
We would all love to just run a screen, find a few cheap stocks to buy, and then wait a year or two to enjoy triple digit returns. However, as the book value of the S&P 500 is just a third of its market value, value investors are in a difficult position and therefore are forced to look for bargains in all kinds of places, dig deeper, and comprehend complex situations.
Unfortunately, if a value investment is simple to analyze, it’s also an obvious thing for other investors which limits the discount and potential returns. This leads value investors to do research into areas such as corporate liquidations, complex securities, risk arbitrage, and spinoffs.
An investor isn’t done when they find a bargain. What’s very important after you’ve found a bargain is to understand what catalysts are going to unlock its value. Finding a bargain that has some triggers that are going to unlock the value separates the investment’s reliance on market forces, speeds up the unlocking of value, and increases the margin of safety. Examples of catalysts are an imminent liquidation of the business, a change in voting control, spinoffs, share buybacks, recapitalizations, and asset sales.
Catalysts allow for the realization of profits, which is the most important factor in investing. They also reduce risk because if the discrepancy between the underlying value and the market value is closed quickly, the chances for new aggravating market or business circumstances are minimal.
We’re all attracted by businesses with growing revenues, earnings, and dividends. The problem is that such businesses are usually fairly valued if not even overvalued. On the other hand, a business going into liquidation is usually a very complicated situation, with many uncertain outcomes ranging from labor settlement costs to asset sale prices or tax implications. The complexity of such situations makes investors prefer ongoing businesses, but this is exactly why liquidations are a great place to look for bargains.
In this market liquidations will be rare, but as soon as a recession hits the economy there could be many bankruptcies and liquidation sales because lots of businesses have been kept alive artificially by low interest rates on high-yield debt. Perhaps only one in twenty distressed companies will be a good investment, but finding such an investment is surely worth it as it’s a low risk high return investment. If there are any kind of catalysts attached to it, even better.
In this chapter, Klarman discusses securities where the distributions are usually dependent on some contingent event. For example, in 1985, Bank of America issued preferred shares at a $25 par value where the payouts depended on the performance of a specific loan portfolio. The shares had a fixed dividend of five years but afterwards if the losses on the loan portfolio surpassed $500 million, Bank of America could retire the preferred shares at only $2 per share. Given the complexity of the situation, the preferred shares were trading at prices that were attractive even with the worst-case scenario materializing and shareholders getting only $2 per share.
Such investments require deep insight, due diligence, and lots of research to find. Few investors have the time to search for such situations and therefore there is often mis-pricing.
Risk arbitrage involves taking advantage of temporary market inefficiencies where the gain or loss depends on the completion of a business transaction, usually a merger or an acquisition.
In today’s environment, this is typically related to acquisitions where the transactions necessitate significant regulatory approvals. However as investors, we have to look at risks and rewards. If an acquisition doesn’t go through, the risk is that the stock price of the target company returns to the pre-acquisition levels. While if the acquisition goes through, shareholders are rewarded with cash. You can read more about merger arbitrage here.
What’s important from Klarman’s book is the description of the Risk-Arbitrage cycle. If merger or risk arbitrage becomes an attractive way of investing, the spreads are usually very small. This leads to fewer investors being attracted to the strategy which in time increases the benefits for those who do use risk or merger arbitrage.
A clear example is the Bayer Monsanto acquisition. Bayer announced a $128 per share offer for Monsanto (NYSE: MON) in September 2016 while previously announcing lower bids. Despite the fact that the deal was expected to close in a year’s time, MON’s stock price fell to a price below $100. At such a low level, the risk of the deal not going through would mean a minimal decline in MON’s stock price while the upside represented a 30% return in addition to MON’s 2% dividend yield.
It’s clear that merger arbitrage opportunities aren’t appreciated much in this market due to the complicated regulatory processes and the fact that everybody is buying index funds. This creates excellent opportunities for the patient value investor.
Another interesting opportunity for investors in today’s market are spinoffs. As the new entity isn’t immediately included in an index, there isn’t much demand for such a stock, analysts are not incentivized to cover small stocks, and shareholders that got the new shares usually tend to sell the spinoff as they prefer to keep owning the mother company. In such a situation, the spinoff company can trade at an irrationally low price. Five of the most recent six spinoffs have been very profitable investments for those who acquired them on the first day of trading.
Figure 1: HGV, PK, VREX, LOGM, BIVV, and DXC are recent spinoffs. Source: Nasdaq.
Investing in the above described special situations requires patience and discipline. Patience to wait for the opportunities to arise, and discipline to do proper analysis on them.
In this 8-year old bull market, investing seems easy as all you need to do is buy the S&P 500. However, investors following such a strategy have been burnt twice in the last two decades and have achieved meagre returns. Knowing that the average investor achieves much lower returns due to bad timing or funds availability, the situation is even worse.
The above described options provide an excellent way to lower your risks and increase returns. The essence of Klarman’s investing style. Happy hunting!