The Secret Hiding Spot of Stock Market Profits

It's nice to have a go-to place for consistently finding undervalued stocks. I've found mine.

Spinoffs. They are loathed, sold off by investors, and most importantly they are often undervalued. I love the smell of spinoffs in the morning. Anytime, in fact. And you should, too, if you like making money in the market.

Let me tell you how I stalked an undervalued Frontier Communications (NYSE: FTR  ) , following a recent transaction with Verizon (NYSE: VZ  ) , and knew exactly when to buy. Then I'll give you a free idea that I'm watching now, with no obligation.

The secret hiding spot
The field of special situations can be a happy hunting ground. As Joel Greenblatt details in his book You Can Be a Stock Market Genius, special-situation investing led him to 50% annualized returns for a decade. That type of return transforms a $1 investment into $52 in just 10 years.

Such special situations are created by transactions that transform the business -- spinoffs, reorganizations, and recapitalizations, to name a few. But the value created by such transactions often isn't reflected in financial statements, and so agile investors can get a jump, and a good price, on these stocks before they appreciate to full value. These situations can be superficially complicated, but it's this transactional complexity that often creates value for agile investors.

Here's how it worked with Frontier.

The special transaction
In mid-2009, Frontier announced that it was buying a massive amount of access lines from Verizon, a move that would effectively triple the size of the company. To pay for this deal, Frontier agreed to take on several billion in debt and issue hundreds of millions of new shares of its stock, nearly 700 million, in fact. That move would more than triple the share count. Verizon received the stock as payment and agreed to distribute it to its own shareholders when the deal closed.

It took a little over a year for the deal to pass all the regulatory hurdles, and during that time Frontier's stock traded in a narrow range of between about $7 and $8 per share. In July 2010 the deal was officially consummated, Verizon dispensed the shares, and Frontier's price proceeded to drop as Verizon's investors sold the stock in droves.

But that price action was entirely predictable. Investors who wanted to own a megacap play on wireless telecom weren't likely to want to own a midcap wireline player. Also, Verizon stock was owned by index funds and mutual funds that have a mandated style and composition, so they were disallowed from owning Frontier, even if they thought it was an undervalued stock. They were forced to sell. With hundreds of millions of shares coming to the market in a short burst, the price was bound to drop.

As a result, the stock traded five to 10 times its average volume for about three weeks, but never closed below $7 per share. During that selling, Frontier shares were yielding at least a 10% dividend. But finally, the selling abated, it was time to buy in, and the stock appreciated more than 30% in the following six months as the deal's uncertainty was eliminated and synergies were realized.

Special-situation investing is all about taking advantage of these market inefficiencies, which have nothing to do with the value of the company, and riding them to profit.

The next opportunity
Here's the free idea I mentioned at the top of this piece. It's a special situation involving Mosaic (NYSE: MOS  ) that is scheduled to take place soon. For reasons unconnected to Mosaic's prospects, Cargill wants to dispose of its 64% stake in Mosaic. That 64% won't come onto the market all at once because of how the deal is structured. However, we can reasonably expect Mosaic's publicly available float to soar at least 50%. That's a huge amount of shares coming to the market, which will cause selling pressure. When the deal was announced recently, shares dropped 10% on the anticipation. Once complete, the deal should allow Mosaic to be added to the S&P 500 index, causing a wave of buying regardless of price as funds that mimic the S&P follow suit.

But before you run out and buy Mosaic now, please note that shares look expensive, at a 13.7 EV/EBITDA multiple. Mosaic produces potash, among other things, and that has been a particularly hot sector of late, as a play on the developing world's agriculture. Australian commodities giant BHP Billiton (NYSE: BHP  ) tried unsuccessfully to buy out PotashCorp (NYSE: POT  ) last year, and the latter's shares went on a tear. There's speculation that other big commodities players want in, and Mosaic could be their answer. If Mosaic's price starts to fade before those new shares come to the public, I'll be looking pretty hard at this deal. It has a lot of the components that make an attractive situation.

Special deals like this are being struck all the time, if you know where to look. DryShips (Nasdaq: DRYS  ) recently announced its intent to spin off a newly acquired suite of tankers in 2011, and Diana Shipping (NYSE: DSX  ) just recently completed a share spinoff of Diana Containerships. They have some of the dynamics that made the Frontier situation so interesting.

Want more ideas like this?
If you're intrigued by special situations like these, then you'll probably be very interested in Motley Fool Special Ops, an exclusive service that looks for such hidden values, telling you just when to buy and sell and how much. In the next few weeks, the service is being opened -- the only time this year -- and you'll receive an invitation if you enter your email in the box below.

Jim Royal, Ph.D., owns shares of Frontier. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (36)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 15, 2011, at 8:39 PM, Pat4Ra wrote:

    Jim,

    Apart from getting info from your news letter, where can the information be had about the kind of companies you describe? How often (%) does the thesis go sour? Thx. Pat

  • Report this Comment On February 16, 2011, at 12:19 PM, TMFRoyal wrote:

    Hi, Pat,

    A lot of these deals are found by digging through the SEC filings or search screens.

    I'm also following these deals as part of the Fool's Rising Stars program, and you can find my real-money portfolio here: http://www.fool.com/specials/risingstars/rising-stars-jim-ro...

    The value in these deals is that they often have depressed prices due to technical factors that are unrelated to the business, giving individual investors yet another opportunity to beat the market.

    But I can't speak in percentage terms, since every deal is different and I don't have those numbers. It certainly isn't wise to buy every spinoff. Sometimes the parent company is a better buy, and sometimes the spinoff is better. Sometimes both are more attractive as a result of the transaction. Those are the kinds of things that Special Ops is attempting to ascertain, as am I, in my Rising Stars portfolio.

    Foolish Best,

    Jim

  • Report this Comment On February 17, 2011, at 7:27 PM, SWATDaddy wrote:

    "I love the smell of spinoffs in the morning."

    The odor of Verizon's last two spinoffs is pretty repugnant. Idearc and Fairpoint both filed for bankruptcy only a few years after Verizon cut them loose and investors were wiped out. I'm glad I sold mine shortly after the spinoff and did the same with Frontier.

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