What is

Special Situations Investing?

Image Credit: Hedgeye

A favorite of the likes of Peter Lynch, Joel Greenblatt and Warren Buffett, Special Situations Investing is a strategy that focuses on one-time events that will have an impact on the stock price of a company.

This typically includes activities like mergers, reorganizations, spin-offs, bankruptcies, etc., and they offer a measurable short-term source of alpha.

As they are difficult, if not impossible, to automate they also offer an uncrowded corner of the market to invest.

Are These Opportunities Rare?

147

Average weekly number of potential Updates or New Additions from the categories we consider.

While few will make the cut of a suitable Special Situations Investment, that is a sizable “pond” to be fishing in.

A Quick Case Study

Elon Musk (Begrudgingly) Buys Twitter

Elon Musk’s acquisition of Twitter for $44B in 2022 was a widely publicized event that perfectly fits the definition of Special Situation Investing.

Not only is it a good case study that most everyone is at least casually acquainted, it also shows that these sorts of scenarios can pop up even in the widely covered areas of the Market.

Despite all the noise made by Musk, it was a shockingly simple investment case…

The Background

  • April 25, 2022: Twitter (“TWTR”) announces Elon Musk and TWTR had entered into a definitive agreement where Musk would take TWTR private at $54.50/share, or roughly $44B.

  • This announcement followed Musk acquiring 9.2% of the outstanding shares (the initial sign post there might be something to watch), Musk proving $46.5B in secured financing via SEC filings and public conversations regarding Musk joining the Board.

  • Not long after, it appeared Musk got cold feet and announced he was breaking the deal causing the share price to crater back to pre-announcement levels.

The Important Parts

  • When a definitive agreement is reached, two parties are no longer toying with an idea, they are putting pen to paper and lawyers are involved. It is a legally binding contract stating terms. An important distinction for avoiding the rumor mill.

  • Musk waived all financing and due diligence requirements in the agreement. This would be the “house-purchase-equivalent” of saying you are willing to be legally obligated to buy a house regardless of what the inspection says and/or if the bank pulls their funding. In Musk’s case, the Delaware courts could have obligated him to sell other assets such as Tesla or SpaceX stock to close on the deal.

  • For two months after trying to walk, with only force majeure or “act of God” options remaining (read as meteor strike), Musk tried to sow claims of purposeful deceit around the presence of bots on the Twitter platform. Admittedly the most esoteric part of this case, in the footnotes of TWTR’s annual reports several years prior was the necessary language to protect them from having to know or be able to speak to the exact count of bots on the platform.

The Thesis

With the above details in place, unless Musk somehow gets a pass from the most stringent corporate law jurisdiction in the U.S. (simply because he is Musk), there is no legal reason or precedent that would allow him to walk from this deal.

Unfortunately for Musk, in Delaware Court of Chancery when a purchaser has waived all contingencies and secured financing, they have historically been forced to close +95% of the time. Something anyone with an internet connection could have discovered. Yet, for two months the Market was offering +35% short term returns for a +95% chance of a win with arguably less downside than upside.

The Timeline

The Outcome

We picked entry points between $38/share and $42/share, for a blended cost of $40/share.

Once the news broke that Musk had agreed to accept the initial terms, we felt comfortable exiting and not waiting around for the last ~$5, selling near the $49.50/share mark.

When all was said and done, gross returns were 24%, while on an annualized basis it was roughly 115% given the short time frame.

Why Consider Special Situations?

In the “Strike Zone” of an Equal Playing Field

In the investing world there are only three levers to pull in order to gain an advantage. That is informational, analytical or behavioral (i.e., longer time horizon).

In most cases, both informational and analytical are tough propositions. Renaissance Technologies famously grows their research information database by 40TB per day and groups like Citadel hire full time weather PhDs to their global equities team (yes, that’s a real position).

Up against that, why would a sub-institutional size fund or an individual do anything but relegate themselves to the behavioral camp?

Primarily, because just about everyone ignores Special Situations.

They are typically, too complex to automate (even for AI), too small/too illiquid for institutional funds, and too hard to incorporate into portfolio mandates.

In areas of the Market ignored by the larger institutions, suddenly all three levers become equally available and the playing field levels.

If looking for those pitches worth swinging at, Special Situations are more often than not squarely in the strike zone.

Superior Risk vs. Reward

Mispricing coupled with a probabilistic outcome allows us to find situations where the upside outweighs both the downside and potentially the volatility. This is flipped from the typical market influenced approach where the average annual volatility is greater than the average annual return.

In simple terms, we are looking for opportunities where the Market is offering 3:1 odds on 50/50 chance situations set to occur in the near term.

While position sizing plays a key role in outcomes, in a trailing seven-year survey of our contributors, average annual returns were 1.2x greater than the average annual volatility.

Or, for every 1.0% of volatility shouldered, 1.2% of gains were realized compared to 0.77% return for each 1.0% of volatility in the S&P during the same timeframe.

What’s better, they also managed to beat the market return by more than 2.5x during that timeframe.

Uncorrelated and Effective Compounding

While some may be quick to point out that Quality or Growth investing have the same upside to downside mismatch (a company can certainly grow more than 100%), they come at the cost of an unknown, or at best loosely definable, timeline.

In a Special Situations Investing, one can attach a reasonably accurate timeline to the investment thesis and they typically move in relation to their specific scenario rather than with the tide of the general Market. This not only makes entry and exit criteria much easier to formulate, but it provides for very effective compounding when applied across many situations.

As an example, a situation that may have a nine month timeframe and an expected upside of 25% would have an annualized (or IRR) return of 33.3%. Assuming short and long term capital gains tax rates of 37% and 15%, respectively, the example Special Situation is net gain equivalent to an annual pre-tax long term gain of 24.7%.

As many opportunities push above the 40% IRR range, the compounding advantages are clear.

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