Invest in Special Situations

People often assume that value investors are looking only for businesses with low price-to-earnings and price-to-book ratios. And although value-centric investors are indeed attracted to companies that trade below book value and sport high earnings yields (the lower the P/E ratio, the higher the yield, since the earnings yield is the inverse of the P/E), there are other categories of investments they like to exploit. One of them is what we call special situations.

To understand the value behind special-situation investing, an investor must be able to differentiate between an investment operation and a speculative one. In his book Security Analysis, Benjamin Graham offers the best explanation of the difference that I'm aware of. He says an investment operation is one that "upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative." (Emphasis mine.)

So the key to investing prudently and successfully is not tied merely to finding businesses that exhibit strong valuation ratios but rather to those that offer preservation of capital coupled with a high probability of a significant increase in value. And special situations can offer some of the best value-oriented opportunities in the market.

What's so special about a special situation?
Most of what value investors hold are securities referred to as generally undervalued, or just "generals" for short. In the simplest terms, these are good businesses that sell at discounts to intrinsic value. The philosophy behind holding generals is that over time, the undervaluation will correct itself, the market will return these investments to intrinsic value, and investors will enjoy a satisfactory return on invested capital.

Special situations are completely different, in that their performance is not directly tied to any market environment. A special-situation investment is one whose performance and financial results are dependent on corporate action rather than the supply-and-demand factors that buyers and sellers create in the stock market. Sometimes referred to as "workouts," these investments are securities for which investors can predict, with a high degree of confidence, when they will get a return, how much they can expect, and what might upset the apple cart along the way. In other words, investors can determine how long it will take for the security's troubles to work themselves out. The critical element here is that, if executed properly, the investment return is possible regardless of the current stock-market environment.

Warren Buffett, who never experienced a down year when he was running his partnerships in the 1950s and 1960s, actively participated in special situations. The Oracle wrote to his partners in 1962 that workouts "produce reasonably stable earnings from year to year, to a large extent irrespective of the course" of the markets. He further observed that a workout's investment performance "will look extremely good if it turns out to be a declining year for the Dow." One such investment for Buffett was American Express (NYSE: AXP  ) , during its part in the salad oil scandal of the '60s. The company's shares tanked, and Buffett was able to ascertain with a high degree of confidence that the company would come out intact. Most importantly, Buffett realized that AmEx was offering a satisfactory margin of safety and a very reasonable rate of return. Ultimately, Buffett invested big, and he made big.

Special-situation investments come in various forms. Because you're relying on a particular corporate action to occur, you should make such an investment only after an extremely detailed drill-down. The effort can be long and involved, but the rewards can be immense. And whether these investments work or not, they are always excellent educational exercises. One such case: WCI Communities (NYSE: WCI  ) , a homebuilder (yes, a homebuilder) that specializes in high-end tower construction and amenity-heavy communities in Florida (yes, Florida).

The simplified explanation here centers on Carl Icahn, an activist investor who bid $22 a share for WCI this past March. Management rejected his offer as too cheap for the assets and set out to shop the company around to other suitors. When word leaked that no one else was interested, WCI's share price eventually fell all the way to $4 a share. A lot has happened in the housing market since March, but even back then, Icahn was very well aware of the dismal housing market. That's why he bid for the company in the first place. No doubt, WCI is feeling lots of pain right now, and the company is modifying its debt obligations to avoid triggering its debt covenants. WCI has a new condo tower coming on the market later this year, and the company is relying on its condo closings to generate much-needed cash flow.

On the other hand, WCI has a wonderful collection of assets, including golf courses and land that was purchased pre-2002, before the Florida land boom took off. WCI's assets are jewels, and they're clearly the reason why Icahn made his play. If your reasoning and analysis can lead you to deduce that someone like Icahn would easily pay $13-$15 a share today for WCI, even at today's price of around $9, you can see that the upside is very substantial.

It's a perfect example of what we mean when we talk about special-situation investing.

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